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Modern Monetary Theory
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This continues from the previous post on Post-Keynesian Response. A large number of contributions from different areas need to be integrated to build an economics for the 21st Century. For an acknowledgement of the failure of 20th Century Macro from one of its architects, see Romer’s Trouble With Macro. This post explains Modern Monetary Theory briefly.
Since the time of Keynes, major changes have taken place in the global financial system. Against wishes of Keynes, Bretton-Woods created a dollar centered system based on notional exchangeability of dollars for gold. The Nixon Shock in 1971 removed the gold backing from dollars, leading to the modern world of floating exchange rates. Dramatic changes in the monetary exchange systems and financial institution play no role in orthodox modern macroeconomics, since money and finance are not (supposedly) part of the real economy. Taking the nature of modern money and the financial institutions into serious considerations leads to many important insights which lie at the core of MMT. Three major innovations lie at the foundations of this theory. These are summarized below:
Endogenous Money: MMT reflects an institutional perspective on the creation of money. When Central Banks set discount rates, they lose control of the quantity of money, which must be issued in amounts required to equilibrate the demand/supply of money at the policy rate. Private creation of money depends on bank-lending, which in turn depends on the investment climate. Bank credit depends on expectations, sound collaterals, and also a keeping-up-with-the-Joneses effect – if everyone is lending, banks cannot afford to stay out. Theories of endogenous money underlie Minsky’s Financial Fragility Hypothesis, which suggests that the money creation process is inherently destabilizing because private credit is expanded at the top of the business cycle and contracted at the bottom, exactly the opposite of what is required for good economic management.
Functional Finance: Orthodox macro enforces a budget constraint on the government, embodied in the so-called “Ricardian Equivalence”. A key proposition of MMT is that the government does not face a budget constraint. The “deficit” number is meaningless; both taxation and spending serve different economic purposes, and should be used as required by economic considerations. Taxation does not provide revenue for the government, but rather serves to dampen aggregate demand. It also creates value of money, by providing an essential use for money. Government spending is required to generate profits for firms, and savings for households by injecting money into the economy. The government can and should achieve full employment using appropriate fiscal policy measures. However, this fiscal spending must be carefully targeted and suitably constrained, in order to avoid inflation.
Intersectoral Flow of Funds: MMT incorporates Kalecki’s approach towards inter-sectoral balances, which provides a refinement of Keynesian ideas. Fiscal policy should take careful account of the different sectors of the economy. Money creation may pump money into the wrong sectors, leading to inflation long before it reaches the sectors with excess capacity, where it could reduce unemployment. Thus a carefully crafted job guarantee program, which does not compete with private jobs, is at the core of policy recommendations generated by an MMT perspective. For more details on how these ideas could be implemented, see Zaman (Jan 7, 2020).
The completes our brief summary of how MMT can contribute to creating a Macroeconomics for the 21st Century. Next, we will discuss how politics, which was removed from economics, can and should be re-introduced within a “Political Economy” approach to Macro.
Post-Keynesian Response
This continues from previous post on New Directions in Macroeconomics. Among the heterodox responses to the crisis in economic theory created by the Global Financial Crisis 2007, we will briefly discuss the following: Post-Keynesian Economics, Modern Monetary Theory, Political Economy, Evolution of Global Finance, Ecological Economics, Complexity Economics, Islamic Economics. This post is about Post-Keynesian Economics.
The response of mainstream macroeconomists to this crisis has been disappointing; see for example Antara Haldar (2018) “Economics: The Discipline that refuses to change”. The failure of classical economics in the Great Depression of 1929 led Keynes to the create the field of macroeconomics, which was revolutionary many different ways. Unfortunately, as Romer remarks, the profession went backwards, losing hard-won insights. All of the revolutionary Keynesian insights (discussed in greater detail below) have since been rejected by the orthodoxy. Similarly, there has been little or no response to the demonstrated failure of macroeconomic models following the Global Financial Crisis. In “Models and Reality: How did Models Divorced from Reality become Epistemologically Acceptable?”, I have explained how current economic methodology prevents economists from creating better models in response to empirical failure. Instead of re-thinking economics, mainstream economists have closed ranks along a defense of the orthodoxy. A consensus has emerged that no major change is required. For example, Krugman attributes the failure of macro to three factors: (i) a “Black Swan event” of such low probability that it could not have been foreseen by anyone, (ii) prolonged maintenance of low interest rates by the Fed (flawed monetary policy), and (iii) emergence of a huge shadow banking sector not taken into account by macroeconomists monitoring the economy. The point of this deeply flawed defense is to argue that there is no need to change the fundamental frameworks for macroecnomics. As a result of this failure to reform theory, the same macro models which failed catastrophically in the Global Financial Crisis continue to be used all over the world. DSGE-based macro models with no role for money and banking, and GARCH models forecasts of volatility, are still in use at Central Banks throughout the world, because no viable alternative has emerged.
While mainstream economists have failed to respond, there has been substantial recognition of the challenge, and many important heterodox responses to the crisis in macroeconomics created by the Global Financial Crisis. We have listed some of the major schools of heterodox response in the opening paragraph. In the remaining post, we will discuss
Post-Keynesian Economics:
By now, this is an advanced and sophisticated school of thought which builds upon multiple revolutionary insights of Keynes, rejected by mainstream macroeconomics. We discuss three of these briefly below. A fourth insight of great importance was the understanding that macro phenomena did not emerge by aggregating the micro phenomena – the system is not just the sum of its parts. This is now called “complexity economics” and is discussed in a separate subsection.
Money matters, in the short run and in the long run. It is surprising that this needs to be said, since it seems entirely obvious to everyone except economists, who teach that money is neutral. Real Business Cycle Models of the economy currently in use for monetary policy have no direct role for money and no financial sector. As somebody quipped, this is like trying to figure out how birds fly, without taking into account their wings. Romer (Trouble With Macro) expresses his exasperation at major league macroeconomists who write that money plays no significant role in the economy, and provides strong empirical evidence for the importance of money by study monetary policy of Volcker. Arestis and Sawyer (2006) provide a comprehensive review in their Handbook of Alternative Monetary Economics. An example of how these post-Keynesian theories affect orthodox views of growth, interest, and money is provided by Dutta and Amadeo (1993),
Radical Uncertainty: Keynes argued that the future is inherently uncertain and unpredictable. Unfortunately, some erroneous technical arguments were used to show that rational decision making could be based on probability estimates of future events, denying the possibility of radical uncertainty. John Kay (2019) writes the “To acknowledge the role of radical uncertainty is to knock away the foundations of finance theory and much modern macroeconomics.” For example, rational expectations is at the heart of modern theories of finance and macroeconomics, and makes events like the Global Financial Crisis impossible. A landmark book on Radical Uncertainty by Kay and King (2020) argues that rejection of Keynesian uncertainty was a central reason for the blindness of economists, and economic theories, to the possibility of the Global Financial Crisis. These theories continue to dominate, while recognition of radical uncertainty is a necessary preliminary to the rebuilding of a more relevant economic theory. For a deeper discussion of the technical arguments which led to the rejection of uncertainty, see Zaman (2019).
Demand Driven Output: Keynes opens his famous book by rejecting Say’s Law, which states that supply creates its own demand. In contrast, he argued for the principle of effective demand, that demand matters in the long as well as the short run. Unfortunately, modern macroeconomics has re-instated Say’s Law, and ruled out the possibility of long-run unemployment of labor or other resources. The success of the counter-revolution of Chicago style free market economics, launched against the Keynesian revolution, has left economists blind to the mysteries of the labor market. For example, Borjas (Labor Economics) agrees that ‘marginal productivity theory bears little relation to the way that employers actually make hiring decisions’. He writes that “We do not yet fully understand why the recent evidence differs so sharply from the evidence presented in the earlier literature, and why the implications of our simple-and sensible supply and demand framework seem to be so soundly rejected by the data.” Similarly a recent conference on the mystery of rising productivity together with stagnant wages was the subject of a recent conference, where top economists admitted to being bewildered by this phenomenon. See Denning (2013) for a collection of quotes displaying the confusion and frustration of economics, and an explanation of the problem based on the evolving structure of corporate finance. Post-Keynesian theories build on Keynesian ideas to provide deep insights into the functioning of the labor market. Providing good jobs to everyone is arguably the most important function of an economic system, and one which modern economies fail miserably to do. To create full employment, it is essential to fix economic theory, which solves the problem by pretending it does not exist.
For full article, with references, see Zaman & Basci: “New Directions in Macroeconomics”, International Econometric Review, Vol 12, Issue 1, p1-23
From Clearinghouses to Central Banks
This continues from the previous post: Coffee and Banking Clearinghouses. It explains how clearinghouses started to perform many of the functions we identify with Central Banks today.
To understand modern central banks, it is useful to look at how they evolved out of the needs of the banking system. The Clearinghouse seems like a mechanical and unimportant part of the system. It is a way for the banks to clear checks written between any two banks in the system. However, as we will see in this post. This simplicity is deceiving. Many aspects of Central Banks emerge directly from the functions of clearinghouses. In this post, we will summarize the article “Private ClearingHouses and the Origins of Central Banking by Gary Gorton, published in Business Review, Jan-Feb 1984.
By 1850, the 50 banks in New York found that daily bank-to-bank clearing could not be completed in time. The use of checks had soared, and if each bank had to clear with every other bank, 50 x 49 = 2450 transactions would be required to complete clearings. In contrast, creation of a central clearinghouse substantially reduced the transaction cost of clearing. Every bank only needed to calculate ONE net figure – total incoming checks minus total outgoing checks. If this was positive, it would receive gold from the clearinghouse. If negative, it would pay gold to the clearinghouse. With 50 transactions, one between each bank and the clearinghouse, the market would clear. Once the efficiency of this system became apparent, it was widely imitated throughout the USA and elsewhere.
Once the clearinghouses were setup, there were some natural extensions to their functions. Clearing involved giving or taking gold to each of the fifty banks. If each of the banks had some reserves in the Clearinghouse, the clearing could take place in-house. The Clearinghouse would keep the reserves for all the banks, and simply adjust entries in its book regarding which bank has how much gold. No actual gold needed to be moved, saving transactions and security costs. This system was improved and supplemented by the addition of specialized “Clearing House Specie Certificates”. Banks could deposit gold at certain large and secure designated banks and receive these certificates for use at clearing. The certificates would be equivalent to gold, but would be much easier to transport and have much higher security.
The Role of Banking Crises
Evolution of functions of the clearinghouses occurred in response to banking crises which used to occur regularly following the ending of business cycle booms. In the fractional reserve banking system, each bank holds only a fraction of the gold which it owes to its depositors. All of the banks would collapse (become il-liquid) if all depositors demanded gold in return for their deposits. In a crisis, only a few banks would actually be in financial trouble, but depositors did not have information as to which banks are sound and which are not. So there would be a general panic as depositors rushed to demand gold. Such a general rush could collapse the banking system. Many measures were developed to quell these panics. One of the first was temporary suspension of liquidity. Depositors were not allowed to convert deposits to gold. But this would only be a temproray and delaying measure. In order to meet demand for gold, clearinghouses created a new instrument called the Clearing House Loan Certificate”. Whereas the Specie Certificate had to be backed by gold, the Loan Certificate was backed by other financial assets of the bank. These Loan Certificates could be used by banks at the clearing just like the Specie Certificates. This reduced the need for gold at inter-bank clearing, in order to make gold available for payment to depositors. It was in the collective interest of banks to prevent bank failures, since failure of one bank could easily trigger a panic which would take down the entire system. That is why some flexibility (use of loan certificated instead of specie certificates) in interbank clearlngs was accepted by all banks. The Loan Certificates were issued as a collective liability of the banking system (and hence valid even if any particular bank failed) and they were issued with collateral backing of financial assets worth significant more than the loan. Use of these loan certificates was able to prevent a financial crisis in 1960, by making enough gold available to meet depositor demand.
The clearinghouse loan certificates were used only for inter-bank transactions at clearing, and not issued to general public. Later, the success of this model led to an extension. The Loan Certificates could be exchanged for Clearing House currency, which could be given to general public. While the clearinghouse issued currency was not a perfect substitute for government issued currency, it was the joint liability of the entire private banking system, and hence much safer than checks of any particular bank. Use of the clearinghouse currency substantially expanded the ability of banks to respond to crises by issuing their own certificates which would substitute for gold. These developments led to clearinghouses having the following functions normally associated with Central Banks. First, they became the lender of the last resort, issuing both clearinghouse loan certificates and also clearinghouse currency to banks in need, against financial assets of the bank. Secondly, they became creators of currency in times of need. Third, associated with these functions, they became regulators of the banking industry. This was because, in order to issue Loan Certificates or Clearinghouse Currency to member banks, it was necessary to be sure that the bank was sound. This required a certain amount of regulatory authority on part of the clearinghouse.
The regulation of private banks was achieved by a combination of measures. State Laws in the USA required transparency – each bank was required to publish a statement of accounts weekly which would show it reserve position, assets and liabilities. Clearinghouses generally required the maintenance of 20% gold reserves against deposit liabilities. They also required the private banks to submit to audits, as a condition of joining the clearinghouses. From this summary, it seems clear that most of the features of Central Banks were already initiated by private banking clearinghouses.
New Directions in Macroeconomics
Asad Zaman, Sidika Basci: “New Directions in Macroeconomics”, International Econometric Review, Vol 12, Issue 1, p1-23 — Article excerpted below (Section 1 only) provides introduction to new directions for 21st century macroeconomics, and invites submissions in outlined areas to our journal – International Econometric Review. We are broadening the focus of the journal to include all innovative areas in economics – micro, macro, or econometrics. We are particularly interested in attracting heterodox submissions.
ABSTRACT: The glaring failure of modern macroeconomics to predict the Global Financial Crisis, and to provide remedies for the Great Recession which followed, has led to renewed interest in alternative approaches to Macroeconomics. There is huge amount of ongoing work aimed at creating a Macroeconomics for the 21st Century. The task is of the highest priority, as failures of economic theory have led to misery for millions. Wrong measures of GDP, and cost-benefit calculation which fail to account for environmental costs, and prioritize private profits over social welfare, have created a climate catastrophe which threatens to destroy the planet. In accordance with the importance of this task, we are expanding the scope of this journal, to cover all new approaches to economics, which fall outside of the boxes of conventional macro, micro, and econometrics of the 20th Century. This article outlines seven broad categories of research directions, and four different methodological principles which fall outside the boundaries of the conventional approach, and offer promise for building a Macroeconomics for the 21st Century. We hope to invite contributions in these areas for future issues.
1. HISTORICAL CONTEXT OF CURRENT CRISIS
There is widespread awareness of the catastrophic failures of modern macroeconomic theories, especially in the wake of the Global Financial Crisis of 2007. For instance, Krugman (2009) wrote that the profession as a whole went astray because they mistook the beauty of mathematics for truth”. Paul Romer (2016), recent Nobel Laureate, wrote “The Trouble with Macroeconomics” which contains a devastating critique of modern macroeconomics. In particular, Romer writes that modern macro got started when Lucas and Sargent wrote that predictions based on Keynesian economics “were wildly incorrect, and that the doctrine on which they were based is fundamentally flawed”. But after three decades of research, during which the profession has gone backwards, losing hard-won insights into the nature of the economy, exactly the same criticism can be leveled at modern macro theories — they give wildly incorrect predictions and are based on fundamentally flawed doctrines, beyond the possibility of repair. Economists were unable to forecast the Global Financial Crisis, and were unable to take policy actions to prevent the Great Recession which followed. This created levels of homelessness and hunger not seen in the USA since World War 2. The general public noticed this failure. The Queen of England went to London School of Economics to ask “why no one could see it coming”. In an unprecedented move, the US Congress appointed Subcommittee for Investigations and Oversight to hold hearings on “Building a Science of Economics for the Real World”; see Solow (2010). The committee was charged with investigating the failure of economics profession to predict the crisis. Even worse, “generally accepted economic models inclined the Nation’s policy makers to dismiss the notion that a crisis was possible”.Not only did economists fail to predict the crisis, many economists and practitioners who issued warnings were silenced and dismissed, because the possibility of a crisis did not exist in macroeconomic models then in use. Sadly, these models continue to be the mainstream macroeconomic models being studied and taught all over the world today, even though better alternatives are available. We will use the general label “21st Century Economics” to refer to these alternatives, and describe them in this introductory article.
In a blog post on “What Went Wrong”, Paul Romer (2020) describes how economic theorists became central to policy making in the USA in the 1970’s. He argues that this experiment of turning over policy to economists has been a disastrous failure, and economic theory-based policies have resulted in low growth and lowered life expectancies. In this brief outline and survey, we will discuss the many dimensions where radical changes are required in methodology and approach to fundamental economic questions. This is merely and outline and a sketch, not a detailed argument. Our goal is to encourage submissions to this journal in the areas discussed, so as to create the basis for a change towards “21st Century Economics”. In future issues, we will adopt this as a subtitle, to signal a change in editorial policies and subject matter for this journal.
END OF SECTION 1 — I will reproduce later sections of the paper in later posts. To read the full paper, see: International Econometric Review, Vol 12 No. 1 or SSRN Version.
Fisher VS Reality: Comparison of Statistical Methods
Post shows how conventional statistics attempts to make inferences about imaginary parameters. It proposes an alternative. Real Statistics should use data to make inferences about the real world, instead of an imaginary world.
[bit.ly/dsia05E] – Part E of Lec 5:Descriptive Statistics: An Islamic Approach. This lecture explains the difference between classical Fisherian approach and our REAL statistics approach, within context of a study of the Quantity Theory of Money.
In previous portions of this lecture, we have emphasized the need for a new approach, which we call “Real Statistics”. In this lecture, we illustrate the differences between the conventional approach and our new approach using the already studied example of Australian Inflation. In this connection, it is of great importance to understand the following:
The DATA is ALL we have – The STATISTICAL ASSUMPTIONS imposed on the data DO NOT PROVIDE US with additional information. HOWEVER, all statistical inferences we make RELIES HEAVILY on these UNVERIFIABLE (and typically false) ASSUMPTIONS.
First Step of a REAL analysis: LOOK at the DATA with reference to a REAL world issue under examination. In this case…
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Private Creation of Money
In a previous post (Coffee and Banking Clearinghouses), we explained how a clearing house substantially improves efficiency of transactions. Suppose that there are ten banks and there are thousands of checks written on each bank. The clearance of each check requires a transfer of gold from one bank to another. If we sum all of the checks, that will give us a NET figure, which will still require 90 transactions (10 x 9): each bank must clear its accounts with every other bank. The clearinghouse adds efficiency by requiring only 10 transactions. One between the clearinghouse and each of the banks separately. Each check which transfers money from bank X to bank Y can be thought of as a payment from Bank X to the CH and a separate payment from CH to Bank Y. This way, all checks can be converted into transactions between Banks and the CH only. At the end of the day, there will be one net figure between each banks and the clearinghouse. Some banks will receive money from the CH while others have to pay money to the CH. Note that the sum of all transactions MUST be ZERO. The total money coming into the CH must equal the total money leaving. This is because each check creates ZERO liability for the CH – it received from one bank and pays to the other. So the sum of all checks must also create ZERO liability and also ZERO gain for the CH.
Once we understand the transactional efficiency of the clearinghouse, we can see the system would evolve naturally towards creating clearinghouses, just because of these benefits of simplification. Once a clearinghouse is created, there are some natural extensions in its functions, which simplify matters further. Suppose that each of the banks maintains some reserves of gold as deposits at the CH. Then the settlement at the end of the day can be done using these deposits as an in-house operation at the CH. The CH can take gold from the deposits of one bank and transfer its ownership to another bank just by changing book entries, without any movement of gold. This leads naturally to the idea of “reserve” requirements: each bank must place a certain amount of gold, in proportion to its deposits, at the CH, to enable end-of-day (or week) clearing of checks.
After understanding these mechanical details of how clearinghouses work, we are in a much better position to understand the creation of money by private banks. The gold based system is much easier to understand than the modern system based on paper and electronic entries, so we continue to explain workings of a clearinghouse in a gold-based system. First, let us consider the simplest case. This is when everyone has 100% trust in banks ability to pay checks in gold. Also, there is complete financial penetration so that everyone has a checking account. Then it is possible to conduct all business entirely via checks. Gold exists in the banks, but is only used to settle inter-bank accounts and not used by general public.
Now we can discuss the topic of money-creation by banks in this scenario. For this purpose, it is useful to make a mental shift in the way we think of checking accounts. Our standard mental framework thinks of each account as a separate box, where the bank puts our money for safekeeping. When we write a check to someone else, the bank takes money out of my box, and gives it to someone else. This is the wrong way to think. Instead, consider a checking account as a Financial Product which is sold by the bank. The account is just a ledger entry in a book the bank keeps (nowadays, It is an electronic entry). When I open an account, the bank creates an entry which is equal in value to the amount of gold I deposit – the gold does not go into my account. It is better to think of the transaction as a purchase. I pay the bank $1000 in gold, and the bank sells me a checking account with an entry of $1000. Now the bank puts my gold into a kitty which contains all the gold, undifferentiated by owner. The checking account I own allows me to write checks to others. If Mr. X writes a check to Mr. Y, this is handled by changing the ledger entries for both accounts, without any reference to gold.
At this point, if everyone deposits gold and gets a checking account, then the amount in the checking accounts would be exactly equal to the amount of gold that the banks collectively have. However, if people use only checks, then banks have a strong incentive to create money. This is done by making loans. Suppose that Mr Z goes to the bank and asks for a loan of $1000 for one year at 10% interest. The bank responds by opening an account for Mr Z which contains $1000. This account is just like any of the other accounts at the bank. However, unlike the other accounts which were created by deposits and therefore correspond to an equivalent amount of gold, this one was created without any corresponding gold. Suppose Bank A has 10 depositors, each of whom opened an account for $1000 by depositing $1000 worth of gold. Then the bank has $10,000 worth of gold as assets, and $10,000 worth of liabilities in the form of checking accounts. But after it makes a loan of $1000, it has the same $10,000 worth of gold in assets, and $11,000 in liabilities in the form of checking accounts. $1000 of new money has been created by the loan. The depositors collectively own $11,000 in the form accounts, but there is only $10,000 worth of gold with the bank. The reader may wonder what would happen in the event that all depositors come and want to cash out their accounts. This is the problem we study next. This also covers the case where some gold is withdrawn by depositors to use for transactions, as opposed to the simpler case where only checks circulate between the consumers.
Suppose Bank A has 10 depositors with account of $1000 each. This gives the bank $10,000 worth of gold. Now suppose that investor X comes to the bank and asks for a loan of $100,000 – far more than the gold in the possession of the bank. The bank will happily open a checking account in the amount of $100,000 for Mr X, even though it only has $10,000 worth of gold. How can this be? How can the bank create money, when it has NOTHING behind the account? A common misconception is that the bank loans money by TAKING money from other depositors. This point-of-view consider banks as financial intermediaries. This is NOT true. All depositors have equivalent checking accounts – they are entries in the ledger. It is not that some entries are BACKED by gold and other entries are not backed by gold. They are all just entries. So, the bank has just created $100,000 out of nothing, with no gold to back it, and without taking any money from any depositor. What happens next?
To make the problem as severe as possible, suppose that investor X comes into the bank with a check for $100,000 and demands payment in gold. The bank only has $10,000 worth of gold from its earlier depositors. What will it do? The answer is that the bank has an ASSET, which is the PROMISE of the investor to PAY $110,000 one year from now. That is the investor promises to pay back the entire amount plus 10% interest one year from now. This promise is a legal obligation plus it is usually backed by collateral worth significantly more than the amount promised of $110,000. The written form of this promise is called a secured promissory note, and is effectively guaranteed, because of the collateral. Now the bank can SELL this note to raise the amount it needs – $100,000 today, to give gold to the investor X. What happens is that this note is used as collateral by the bank to BORROW in the inter-bank market. The bank sells the note at a DISCOUNT. The note is worth $110,000 a year from now, and the bank sells it for $105,000 in gold on the inter-bank market. It can now pay $100,000 in gold to the investor, and pocket $5000 in cash today.
What really happens is more complicated. Instead of SELLING the secured promissory note, the bank offers the note as a collateral in order to borrow for just one day, the full amount of $100,000 it needs. This short term loan, or overnight loan, is obtained at the inter-bank borrowing rate, which is generally much lower than the commercial rate charged to borrowers. The bank borrows only for one day because it is very possible that much of the gold that left the bank will come back to the bank tomorrow. That is because the investor will take the gold and use it to pay others. These others will take their gold and deposit it into banks. Some part of this gold is likely to come back to the original bank. When the bank used this gold repay the overnight loan, it avoids the overnight interest rate charges on the loan. But consider the worst-case scenario, where none of this gold ever comes back. In this case, the bank will borrow the full amount, $100,000 overnight for every night over the entire year. Thus the bank loans $100,000 for one year at a high commercial interest rate. To finance this loan of money which it does not have, it borrows the full amount every night, repeatedly for the whole year. This is called a “maturity transformation”. The bank converts a one-year loan into a sequence of 365 short term overnight loans. That is, a loan of maturity one year is converted into a sequence of loans of maturity one day. The bank still makes a profit in this worst case scenario as the difference between the low inter-bank rate at which it borrows, and the high commercial interest rate at which it lends.
Finally, within this scenario, we can explain two terms of critical importance since Bagehot. When the investor asks the bank for $100,000 in gold, this creates a LIQUIDITY crisis for the bank. The bank has an asset (the secured promissory note of the investor, which promises to pay $110,000 in the future), but this asset is not liquid. The bank can convert this asset to cash by borrowing from other banks, offering this note as collateral – only if other banks are willing to lend. The bank is SOLVENT because it does have enough assets to cover its liabilities in the long run, but it is not LIQUID – it does have the cash required to cover its short term needs. Consider however a different scenario where the investor at some later stage in the game declares bankruptcy. The bank seizes the collateral assets of the investor – maybe a house originally worth $200,000 when the loan was initiated. Now suppose that a housing crisis led to the collapse of the investor leading him into bankruptcy and ALSO reducing the value of the house to only $50,000. Now the bank does not have LIQUIDITY and ALSO does not have SOLVENCY. That is, now it cannot meet its liabilities either in the short run or in the long run. The famous Bagehot rule says that we should support SOLVENT banks generously, providing them with liquidity to meet current needs. But we should not support banks which are not solvent. Instead, these banks should be allowed to go into bankruptcy, and taken over and managed by the state (or by other suitable management) for an orderly liquidation. This rule was NOT followed in the Global Financial Crisis. Not liquidating banks when they become insolvent creates the problem of excessive risk taking by banks – they know they will be bailed out if they fail.
Real Statistics
Fisher invented brilliant mathematical techniques to reduce large amounts of data to a small set of sufficient statistics, to make analysis possible. These are now obsolete because amazing advances in computational capabilities enable direct analysis of large data set. We need to rebuild the discipline on new foundations, as described in post linked below.
[bit.ly/dsia05D] – Part D of Lec 5:Descriptive Statistics-An Islamic Approach. In previous lectures, we have explored some of the reasons why foundations of modern statistics constructed by Sir Ronald Fisher are deeply flawed. In this lecture we explain the basics of our alternative approach to the subject.
This lecture will explain how we can re-build Statistics on new foundations. To do this, we will first explain the foundations of conventional statistics – which may be called “nominalist” or Fisherian statistics. Then we will explain the alternative approach we propose, naming it REAL statistics. Our goal in this lecture is to provide clarity on the differences between the two approaches.
The Fisherian approach is based on fancy mathematical models, which are purely IMAGINARY – That is, the models come from the imagination of the statistician, and have no corresponding object in reality against which they can be verified. A Fisherian MODEL…
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Galton: Eugenicist Founder of Statistics
Bit.ly/dsia05b – Part B of Lec 5:Descriptive Statistics-An Islamic Approach. This portion discusses the racist ideas of Galton, and some statistical tools he developed in his attempts to prove them.
The Islamic tradition asks us to look at both the nature of the knowledge, as well as the character and intentions of the transmitters of knowledge. In this lecture, we will look at Sir Francis Galton, the Founder of Eugenics. The following quote from his student and admirer Karl Pearson (1930, p. 220) explains Eugenics:
“The garden of humanity is very full of weeds, nurture will never transform them into flowers; the eugenist calls upon the rulers of mankind to see that there shall be space in the garden, freed of weeds, for individuals and races of finer growth to develop with the full bloom possible to their species.”
Looking through the metaphor of flowers (Europeans) and weeds (others), Eugenics…
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Coffee and Banking Clearinghouses
This post continues the reading course on Charles Goodhart’s Evolution of Central Banks. Readers can enrol for an online version of this course via the registration link: https://portal.alnafi.com/enroll/735855?price_id=782356 Currently, this beta-test version of the course is being offered free in exchange for feedback on how to improve the course. The sequence of posts leading up to Chapter 4 is available from the online course linked above. The same sequence is also available in previous posts on this blog starting with Reading Course: Central Banking. So far we have covered the first two chapters, together with extensive commentaries. We now cover some preliminary materials required for understanding Chapter 3.
To understand Goodhart Ch3 Clearinghouse, it is useful to have a deeper understanding of how banks worked in 18th Century England. This is the era of gold money, and we all have a vague understanding the fractional reserve system. The banks issued credit far more than the gold supply they had. This was possible because the proportion of credit, in form of bank checks, which was actually converted into gold was small. This way of thinking about the matter – that some portion of a checking account held at the banks is backed by gold, while another portion is not backed – creates confusion. Clarity can be achieved by changing our ways of thinking about this system.
Alternative Model of Fractional Reserve Gold-Based Banking. We consider two separate monetary systems. One system is that of inter-bank transactions, and the other is the Bank-Depositor interface. It is helpful to begin with the simplifying assumption that all Depositor transactions are conducted purely by check. Everyone has an account at one or more of the banks. In each monetary transaction, the payer gives a check drawn on his account to the payee, who deposits it in her own account. Gold is not used by depositors at all.
To make the picture more concrete, assume there are ten banks labeled B0, B1, …, B9, and there are a 1000 Depositors labeled D1, D2, …, D1000. Each depositor has an account at one of the banks. During the course of the day, there are numerous financial transactions. Depositors buy goods or services from other depositors and write checks to them, which are deposited in their accounts. At the end of the day CLEARING takes place. Let us consider more carefully how this clearing takes place. First, there are internal checks. A depositor at B0 wrote a check to another depositor at B0. In this case, the bank B0 just changes the entries in the accounts of the two, reducing the deposits of one, and increasing the deposits of the other. This happens at each bank. Next, we consider the external checks. Each bank holds deposit checks which are payable by other banks. These checks are settled in gold, which is only used in inter-bank transactions. Each bank sends a runner to collect the gold it is owed from all other banks from which it has received checks. Of course, this process has a lot of duplications and cancellations. That is, suppose bank B0 has a check of GBP 100 drawn on B1, while B1 has a check of GBP 100 drawn on B0. Then the runner from B0 to B1 will get 100 pounds of Gold from B1 and bring it back B0. Later, the runner from B1 to B0 will pick up this same 100 pounds and bring it right back to B1. These runners have to do a huge amount of extra work. To illustrate this, consider an extreme case of symmetry. Suppose that depositors at Bank B0 write 10 checks of GBP 1000 each to each of the 10 banks B0, B1, … , B9. The internal check is cleared without any gold liability. There is GBP 900 in external checks and Bank B0 must pay 1000 pounds in gold to each of the other banks. But now suppose that EXACTLY the same picture holds at ALL of the other banks. Depositors at each bank have written checks of GBP 1000 to each of the ten banks. Runners at each bank will make 9 runs and collect 1000 pounds on each run from each of the other banks, and bring them back to their own bank. A total of 90 runs will be made each run will involve taking 1000 pounds of gold from one bank to the other. But at the end of the day, the gold balances at each bank will be exactly the same as they were at the beginning of the day. Note that this does not mean the runners can stay at home. Each transaction DOES involve changing the numbers in accounts of the depositors, and each transaction DOES make a difference in terms of the amount of money that depositors hold in their accounts. But there is no need for the runners to carry any gold. They just need to change the ledger entries in the accounts of the depositors. Substantial efficiency would result if the runners could just meet in a central place to adjust the account entries, and figure out the NET gold transfers required as a result of the sum of all the transactions, instead of doing each transaction separately. This is how the centralized clearinghouses emerged naturally, to create efficiency in transactions. With a central clearinghouse, 90 transactions can be replaced by 10 — one transaction for each bank. All we need to do is to figure out the NET position of each bank separately. Those with negative balance should pay the required balance of gold to the Central Clearinghouse while those with positive balance should receive the gold from the Central Clearinghouse. One transaction per bank is sufficient for clearing all the checks.
In later posts, we will cover how this model extends to situations where some depositors demand gold, and also how banks extend credit.
The Influence of Malthus on Statistics
This is the first of three posts on the intellectual heritage of founding fathers of modern statistics Sir Roland Fisher, Sir Karl Pearson, and Sir Francis Galton. An uncomfortable fact, suppressed or diminished in Eurocentric accounts, is the deeply racist views of nearly all major European intellectuals. In particular, the founding fathers of modern statistics – Sir Francis Galton, Sir Karl Pearson, Sir Ronald Fisher, were all prominent Eugenicists. Statistics arose out of the attempt to establish central ideas of Eugenics about how genes of superior races were transmitted to their descendants and therefore there was no chance, genetically, to improve or educate the inferior (non-white races).
Statistics is presented as an objective and ethically neutral body of tools and techniques. However, it was developed for a very clear, evil, purpose. There are polar Views on Transmission of Knowledge:
- Look at the CHARACTER & Purpose of the transmitters of knowledge
- Look at the CONTENTS – the body of knowledge transmitted
The fundamental underlying question is: “Can the THOUGHTS be separated from the THINKER?”. The balanced position is that BOTH are necessary. We need to Look at the BODY of KNOWLEDGE being transmitted. Also look at the CHARACTER and the PURPOSE of the transmitter/creator of knowledge. In contrast, the Western Intellectual Tradition says: “Look at the SUBJECT MATTER ONLY”. As opposed to this, a popular strand of the EASTERN tradition says: “look at the AUTHORITY of the TRANSMITTER only.” In the West, the MEANING of the word “Probability” changed to reflect this transition – Initially, the word referred to the authority of the transmitter. Later the word was used to mean the weight of the evidence for the matter (see Ian Hacking: The Emergence of Probability).
The Western intellectual tradition defines knowledge as being purely objective, and excludes subjective and personal experiences from the realm of knowledge. This leads to a clear NO answer to the fundamental questions: “Do INTENTIONS of producers of knowledge matter?”, and “Does the CHARACTER of producers of knowledge matter?”. This is in dramatic contrast with Islamic views, according to which ‘Value of Actions Depends on Intentions’. It is easy to see that the nature of scientific knowledge produced depends on the intentions and purpose for which the knowledge is being produced. This topic is now known as the sociology of knowledge, and many simple examples can be given as a proof:
The strong drive for profits led to multi-million dollars for high yield varieties of wheat, but genetically modified to have terminating seeds. This is to enable corporations to sell the same seed year after year. If the intentions had been to feed the hungry, different types of technologies and seeds would have developed.
- “Orphan drugs” refers to drugs which provide cures to afflictions affecting masses of the poor, who are unable to pay enough to generate a profit on the production of the drug.
- While there is little work on these, massive efforts are being made on designer-drugs, personalized and individually tailored to the genetic structures of billionaires.
- The search for power has shaped the development of war technology, the developments of bombs, missiles and so much else. A humanistic bent would have led to developments of science in different directions.
With this as preliminary, we consider the personalities and intentions of the some of the major founding fathers of modern statistics: Sir Francis Galton, Sir Karl Pearson, Sir Ronald Fisher. Today it has been discredited and forgotten, but Eugenics was EMINENT and RESPECTABLE field of knowledge, taught at universities, and with prominent and influential supporters in the early 20th Century. All three of these founding fathers were big names in Eugenics, and statistics was developed by them as a tool to support their Eugenicist views. Eugenics asserts the Racial Superiority of Whites and the inferiority of the other races. Even more, it asserts that the elite classes are genetically superior to the commoners. According the Eugenics, the only Path to Progress lies in the Extermination of Inferior Races (negative Eugenics), and Increasing Growth of the Superior Race (positive Eugenics). Another way to deal with the inferior races was “specialization” – give them roles to fulfill which would fit their limited genetically determined capabilities (for example, making slaves out of the Blacks to do menial chores not demanding intelligence). A brief sketch of the background which led to the emergence of Eugenics as a prominent field of “science” is given below
A convenient point to start is the question of “Why is their poverty?” and “How can we reduce it?”. It will surprise the reader to learn that these are NEW questions. Even though poverty is an age-old phenomena, the idea that this is a social problem which can be, and should be, remedied, is new. For details see An Islamic Approach to Inequality and Poverty. In pre-capitalist world, poverty was not seen as a social problem. Social responsibility, and the idea of a society as one body, where we must take care of each other, was sufficient to deal with problems of poverty. The emphasis on charity in Islamic teachings led to extraordinarily high levels of spending on the poor, especially via the WAQF, which created endowments to deal with different social problems. But similar patterns of charitable institutions for taking care of the poor are seen in all pre-modern societies.
The driver of major change in Europe was the Industrial Revolution which started in England in the 18th Century. The complex circumstances which created this change, and its effects on the transformation of economic, political, and social institutions, are described in The Great Transformation by Karl Polanyi (and many other books). Of relevance to our current discussion is the fact that industry requires a Labor Force – lives for rent and sale for money. In a capitalist society (like our society today), education is meant to CREATE mindsets suitable for labor force. This means training students to make the goal of life the pursuit of pleasure, power, and wealth. For this purpose, students are trained to pursue CAREER over other concerns like family, society, spiritual growth, or excellence in any human dimension. For more discussion of this fundamental problem with modern education, see Learn Who You Are!. Social change resulted from the chosen solution to the fundamental problem created by the Industrial Revolution: “How to create a labor market?”
The solution created by Europeans was deeply racist. We must believe in TWO classes of people: REAL human beings are capable of enjoying finer things of life. LOW level humans may LOOK like us, but they do not have rich inner lives – they cannot think and feel as deeply. They are closer to animals than to humans. Eugenics is based on the idea that the aristocratic elites have superior genes to the common masses. A little more historical detail is useful in understanding the emergence of these ideas.
A Tale of Two Cities by Charles Dickens opens with a scene where the carriage of a French aristocrat speeding through the crowded streets of Paris crushes a poor child. The aristocrat tosses a few coins to the bereaved mother, and continues on his way without further concern. The extreme inequality, and oppression of the poor by the elites led to the French Revolution, which changed the course of European history. As a consequence of the revolution, there was considerable debate about policies to help the poor, with a view to preventing a similar revolution in England. At this crucial juncture, the ideas of Malthus regarding the causes of, and solution to, the problem of poverty, had a dramatic impact on the policy debate. Humanitarian and compassionate solutions were replaced by cruel and harsh measures to punish the poor for their poverty. Malthus argued that poverty was due to a poor genetic endowment, and was inherited. The problem of poverty arose from the fact that the poor BREED faster than the rich. Thus, poverty is inherited, and being kind to poor, providing social services, is counterproductive. This will only increase the rate of growth of the population of the poor. INSTEAD – we should sterilize the poor, keep them in crowded conditions, encourage spread of disease among them, to keep their numbers low.
This theme became linked with emerging theories of evolution and Mendelian genetics. How much of our makeup comes from inheritance, and how much is due to the environment and education we receive? This is often called the Nature Versus Nurture DEBATE. The dominant and widely accepted point of view leaned heavily in favor of Nature (heredity) having an overwhelming effect. This means that superior races will remain superior, and it is not possible to educate the inferior races to bring them up to the standards of the white people. The inferior people can either be exterminated or enslaved. The Malthusian approach to poverty was strongly based on the “nature” point of view. That is, poverty was due to bad genes which led to poor character and intelligence, and their was nothing we could do to change this, in the form of education or other interventions.
The wrong theories of Malthus led to a dramatically wrong approach to poverty. Malthusian theory suggested that providing support to the poor would only increase poverty, since that would allow them to breed faster. Thus social support for the poor was made deliberately humiliating and degrading, to discourage all but the extremely needy to resort to the poor houses. These theories and policies stand in stark contrast to Islamic teachings which urge us to provide support to the poor without humiliating them in the process. Furthermore, Islam teaches us that every human life – whether poor or rich, black or white, Arab or other – is equally precious. Indeed each human life counts as heavily as all of humankind. There were similar humanitarian streams of thought in the European Christian heritage, but Malthusian views came to dominate policy.
Even though nearly all of the predictions of Malthus turned out to be wrong, his theories had tremendous impacts on thinking about population. As we will see in the next portion of this lecture, the founding fathers of modern statistics invented the subject, tools, and techniques, in an attempt to prove the theories of Malthus. Our main goal is to show that tools developed have been influenced by the underlying agenda, and are not neutral and objective. Malthus created his theories without a shred of empirical support, purely from his imagination. Since then, the theories of Malthus have been decisively proven wrong by the empirical evidence. The article, Malthus: the False Prophet, from the Economist, documents some of the major errors made by Malthus.
- Malthus argues that the population would increase geometrically. However, over the 20th Century, a Demographic Transition was observed, when increasing prosperity, and increasing likelihood of survival of children led to a reduction in birth rates, and stable population sizes.
- Malthus argued that food supplies would increase linearly, leading to shortages. However, continuing sequences of technological advances in agriculture have led to increasing food supplies per capita on a global basis.
- There were many other false predictions, based on the first two. For example, he argued in 1798 that Britain population would quadruple in 50 year to 28 million, but food supplies would only be sufficient for 21 million, leading to a crisis. But nothing remotely resembling this happened.
Despite numerous fallacies and failed forecasts, the ideas of Malthus continue to be exceedingly popular. WHY? The simple answer is that these theories are ALIGNED with class interests of the RICH. The POOR are to blame for their poverty. Furthermore, the rich have no responsibility to help the poor, because helping them only increases their breeding rate, leading to increased poverty, as well as increasing the stock of bad genes in human population. These deeply mistaken ideas, strongly in conflict with Islamic teachings, have had a deep and disastrous impact on human history, adding to misery of millions. They continue to guide thinking and policy of an influential minority of economists and politicians. In the next portion of this lecture, we look at the development of statistics as a tool of Eugenics, a field of study built on the foundational ideas of Malthus and Darwin.
