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Throughout the last decades, the nominal interest rate became the dominant monetary policy instrument. Looking backward, the early 1980s proved to be a transition period in terms of monetary policy. After the monetarist experiences of Thatcher and Reagan, there was a pragmatic shift from the supply of the monetary base to the interest rate as monetary policy instrument. The recognition that the control of the monetary base could not only impose extreme volatility to the interest rate but also deeply affect the whole economy challenged, in fact, the previously stable empirical relationship between money supply, demand for money, prices, and income supported by Milton Friedman.

At the theoretical level, the so-called “New Consensus in Macroeconomics” favoured the short-term interest rate as the policy instrument in conjunction with inflation targeting. The new-Keynesian so-called “Taylor rule” has increasingly turned out to be adopted by central banks to manage the interest rate as the policy instrument. In this policy approach, the central bank, mainly through open market operations, sets the short-term interest rate in order to adjust its level in response to changes in inflation and output. In a framework of capital account openness, however, the autonomy of monetary policy, aimed to stabilize prices, subordinates the fiscal budget.

After the global financial crisis, academic economists and policy makers have actively participated in the debate on monetary policy. After the bail-outs, central banks in the US and European Union focused on lender-of-last-resort program extensions and dealt with multiple challenges: how to prevent a recessionary downturn, how to avoid asset and credit bubbles and inflationary pressures. The unprecedented actions of the Federal Reserve, European Central Bank and the Bank of England, for example, suggest the need to rethink the traditional scope of the lender of last resort. The scope of the recent central banks’ interventions has been expanded in order to include not only the provision of liquidity as lender of last resort, but also to include the expansion of repurchase agreements as buyer of last resort and the supply of liquidity to specific markets  as market maker of last resort.

The modern Keynesian literature emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future nominal and real interest rates. Thus, recent research indicates that monetary policy is far from being ineffective at zero bound levels, but it worked mainly through expectations. So far, the key-issue is how very low or negative interest rates translate into improved growth rates since austerity programs are biased towards entrenching mass unemployment and introducing anti-social structural reforms.

The debate about the appropriate policies to achieve economic growth has been recently fuelled by the advocates of the MMT (Modern Monetary Theory). According to Warren Mosler, for instance, the mainstream version of fiscal responsibility is based on false premises. In his view, MMT provides new guidelines for the fiscal position for governments since the role of   fiscal policy is to ensure there is no spending gap. Fiscal interventions, through direct government spending and/or a tax cut to increase private disposable income, aim to create demand and provide enough jobs for all the workers who desire to work. Therefore, a zero spending gap occurs when the level of national income is a full employment

Against the Non-Accelerating Inflation Rate of Unemployment (NAIRU) that refers to the concept of full employment irrespective of how many workers are unemployed or underemployed, the MMT advocates propose the NAIBER – the Non-Accelerating Inflation Buffer Employment Ratio. The concept of NAIBER, designed by the economists Bill Mitchell and Warren Mosler, is associated to the idea of a Job Guarantee programme managed by the government in order to hire unemployed workers as an employer of last resort (ELR). Beyond negative rates and quantitative easing, MMT specifies a new discipline for the fiscal policy: if the goal is full employment and price stability, then the full-employment fiscal deficit condition has to be met.

Although the idea of ELR is not new, the current debate on price stability  considers the creation of jobs at the center of policy making.  Against mainstream economics, it is urgent to develop alternatives to face the social challenges of unemployment, underemployment, informality and poverty at large scale.

Published in  Dawn, Mar 27, 2019 , a leading Pakistani newspaper, in context of public debate about moving to a floating exchange rate regime —

In 1971, when Nixon shocked the world by abandoning the convertibility of dollars to gold, he dragged all of us, unwillingly, into the modern era of floating exchange rates. Since then, economic theories have changed. But old habits die hard; economists and policymakers today continue to think and operate as if they live in the old world. This article examines the question of fixed versus floating exchange rate regimes from the new perspective of Modern Monetary Theory (MMT).

In a floating exchange rate regime, the Central Bank allows the supply and demand for dollars and rupees to determine the exchange rate. This can lead to sharp and erratic movements in exchange rates because of speculation, shifting expectations, and manipulation. The “fear of floating” refers to Central Bank efforts to stabilize exchange rates by buying and selling dollars to counteract the market forces. These efforts ensure that movements in exchange rates are smooth, stable, and predictable, making foreign trade much easier for exporters and importers.

The Bretton-Woods institution of the IMF was formed in 1945 to ensure stability of exchange rates in the post-WW2 era, by lending currencies to member nations facing temporary balance of payments deficits. Post-WW2, instead of adapting to the strange and unfamiliar demands of a floating exchange rate regime, the vast majority of developing countries preferred to peg their soft currency to the dollar (or some basket of hard currencies). This is known as a “managed float” or “dirty float” regime because the Central Bank intervenes to ensure that the floating exchange rates remain fairly close to some fixed rate determined by policy makers.

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In this post, we provide some details regarding the origins of the Bank of England, the mother of all Central Banks and discuss some implications of this early history for our modern world. A link to a video-lecture on the topic is given at the bottom of the post. 

We start with an excerpt from Ellen Brown in the Web of Debt: The Shocking Truth About Our Money System and How We Can Break Free. Below, selected passages from Chapter 6: Pulling The Strings Of The King: The Moneylenders Take England: [passages in italics are my comments on the text, rest are quotes]

The first passage discusses how Queen Elizabeth asserted her sovereign right to issue money, and how the financiers worked to undermine this:

In 1600, Queen Elizabeth issued base metal coins as legal tender in Ireland. All other coins were annulled and had to be returned to the mints. When the action was challenged in the highest court of the land, the court ruled that it was the sovereign’s sole prerogative to create the money of the realm. What the sovereign declared to be money was money, and it was treason for anyone else to create it. Zarlenga states that this decision was so detested by the merchant classes, the goldsmiths, and later the British East India Company that they worked incessantly to destroy it.

Cromwell’s revolution was instigated and financed, on the condition that financiers were allowed back into England. In the process, the power to print money was given to the Parliament.

The moneylenders agreed to provide the funds to back Parliament, on condition that they be allowed back into England and that the loans be guaranteed. That meant the permanent removal of King Charles, who would have repudiated the loans had he gotten back into power. Charles’ recapture, trial, and execution were duly arranged and carried out to secure the loans to the Parliament.

Having wrested the power of creation of money away from the King, the moneylenders restored the aristocracy, but gained much greater powers in the process, by providing financial aid to the King. The process of “Enclosure” which was the privatization of the “commons” – land belonging to the public – enriched the wealthy elites enormously. It has been called a revolution of the rich against the poor by Polanyi. The financiers consolidated their grip on the power to print money:

After Cromwell’s death, Charles’ son Charles II was invited to return; but Parliament had no intention of granting him the sovereign power over the money supply enjoyed by his predecessors. When the king needed a standing army, Parliament refused to vote the funds, forcing him to borrow instead from the English goldsmiths at usurious interest rates. The final blow to the royal prerogative was the Free Coinage Act of 1666, which allowed anyone to bring gold or silver to the mint to have it stamped into coins. The power to issue money, which had for centuries been the sole right of the king, was transferred into private hands, giving bankers the power to cause inflations and depressions at will by issuing or withholding their gold coins.

None of the earlier English kings or queens would have agreed to charter a private central bank that had the power to create money and lend it to the government. Since they could issue money themselves, they had no need for loans. But King William III, who followed James II, was a Dutchman and a tool of the powerful Wisselbank of Amsterdam

Important additional historical detail, taken from Wikipedia:

England’s crushing defeat by France, the dominant naval power, in naval engagements culminating in the 1690 Battle of Beachy Head, became the catalyst for England rebuilding itself as a global power. England had no choice but to build a powerful navy. No public funds were available, and the credit of William III‘s government was so low in London that it was impossible for it to borrow the £1,200,000 (at 8% p.a.) that the government wanted.

Back to Ellen Brown

A Dutch-bred King Charters the Bank of England on Behalf of Foreign Moneylenders

The man who would become King William III began his career as a Dutch aristocrat. He was elevated to Captain General of the Dutch Forces and then to Prince William of Orange with the backing of Dutch moneylenders. His marriage was arranged to Princess Mary of York, eldest daughter of the English Duke of York, who reigned as James II of England from 1685 to 1688. James was then deposed, and William and Mary became joint rulers in 1689.

William was soon at war with Louis XIV of France. To finance his war, he borrowed 1.2 million pounds in gold from a group of moneylenders, whose names were to be kept secret. The money was raised by a novel device that is still used by governments today: the lenders would issue a permanent loan on which interest would be paid but the principal portion of the loan would not be repaid.6 The loan also came with other strings attached. They included:

  1. The lenders were to be granted a charter to establish a Bank of England, which would issue banknotes that would circulate as the national paper currency.
  2. The Bank would create banknotes out of nothing, with only a fraction of them backed by coin. Banknotes created and lent to the government would be backed mainly by government I.O.U.s, which would serve as the “reserves” for creating additional loans to private parties.
  3. Interest of 8 percent would be paid by the government on its loans, marking the birth of the national debt.
  4. The lenders would be allowed to secure payment on the national debt by direct taxation of the people. Taxes were immediately imposed on a whole range of goods to pay the interest owed to the Bank.7

The Bank of England has been called “the Mother of Central Banks.” It was chartered in 1694 to William Paterson, a Scotsman who had previously lived in Amsterdam.8 A circular distributed to attract subscribers to the Bank’s initial stock offering said, “The Bank hath benefit of interest on all moneys which it, the Bank, creates out of nothing.”9 The negotiation of additional loans caused England’s national debt to go from 1.2 million pounds in 1694 to 16 million pounds in 1698. By 1815, the debt was up to 885 million pounds, largely due to the compounding of interest. The lenders not only reaped huge profits, but the indebtedness gave them substantial political leverage.

The Bank’s charter gave the force of law to the “fractional reserve” banking scheme that put control of the country’s money in a privately owned company. The Bank of England had the legal right to create paper money out of nothing and lend it to the government at interest. It did this by trading its own paper notes for paper bonds representing the government’s promise to pay principal and interest back to the Bank — the same device used by the U.S. Federal Reserve and other central banks today.

End of Excerpt from Ellen Brown.

Some more detail of interest is that the creation of Bank of England was tremendously beneficial for England. The King, no longer constrained, was able to build up his navy to counter the French. The massive (deficit) spending required for this purpose led to substantial progress in industrialization. Quoting Wikipedia on this: “As a side effect, the huge industrial effort needed, including establishing ironworks to make more nails and advances in agriculture feeding the quadrupled strength of the navy, started to transform the economy. This helped the new Kingdom of Great Britain – England and Scotland were formally united in 1707 – to become powerful. The power of the navy made Britain the dominant world power in the late 18th and early 19th centuries”

The events described can be viewed from the perspective that accumulation of capital is a central driver of history:

Lessons from History

Contrary to what is commonly believed, history is not a sequence of facts, recorded observations of events. The central contribution of Ibn-e-Khaldun in his study of the rise and fall of civilizations was to discover the hidden logic, the short and long run causal chains, which were the drivers of history. In such a study, there is always room for error, because these causal chains can only be recovered on a speculative basis – they are not present on the surface. Yet, we must make the effort required for this deeper examination, because without it, we would be blind to the possibilities for our future. In attempting to understand the drivers of history, we come across the difficulty that there is always a multiplicity of causes, with complex interactions between them. In such situations, it is useful to isolate and simplify, and attempt to explain history on the basis of a small number of causal factors, while knowing that the reality is more complex. Another way of saying this is that every attempt to understand history is necessarily subjective; the best we can do is to present history from a multiplicity of perspectives. One of these perspectives is the view that money and finance have been the central drivers of history. As Giovanni Arrighi puts it, history is driven by cycles of accumulation of capital. While we understand this is a vast oversimplification, it is useful to take this perspective, just to see how far it can take us, without committing ourselves to believing in this perspective. It is in this spirit that we offer a “finance drives history” view of the creation of the first Central Bank. The history above can be encapsulated as follows:

  1. Queen Elizabeth asserted and acquired the sovereign right to issue money.
  2. The moneylenders (the mysterious 0.1% of that time) financed and funded a revolution against the king, acquiring many privileges in the process.
  3. Then they financed and funded the restoration of the aristocracy, acquiring even more privileges in the process.
  4. Finally, when the King was in desperate straits to raise money, they offered to lend him money at 8% interest, in return for creating the Bank of England, acquiring permanently the privilege of printing money on behalf of the king.

The process by which money was created by the Bank of England is extremely interesting. They acquired the debt of the King. This debt was used as collateral/backing for the money they created. The notes they issued were legal tender in England. Whenever necessary, they were prepared to exchange them for gold, at the prescribed rates. However, when the confidence of the public is high, the need for actual gold as backing is substantially reduced.

There is a small mystery here. The King’s debt was used as the backing for the money issued by the Bank of England. Why couldn’t the King issue debt directly, and have it used as money? This is the basic concept of sovereign money, and would have saved the King the 8% interest on the amount he had to borrow. The key here is to understand Minsky’s dictum: “Anybody can create money. The problem lies in having it be accepted.” The reason King William could not create money which would be widely acceptable by the public are the following

  1. The authority to create money had been transferred to the Parliament.
  2. The King could borrow, but did not have gold to pay back his debts.
  3. When the King borrowed from the moneylenders, they did not give him gold. They gave him the authority to write checks on the Bank. The Bank could redeem these checks in notes which were backed by the King’s debt. Thus, the Bank “monetized” the debt of the King.
  4. The Bank’s created money was far more acceptable than the King’s debt, because it had the appearance of being backed by gold (in addition to the King’s debt). The bankers, unlike the King, could convert bank-notes to gold as needed. This ability of the Bank to do so, created the confidence in the public, which allowed the bank to keep only a fraction of the entire amount of notes in circulation, in the form of gold.

This same system, fractional reserve banking, and the monetization of the debt of the Government, is still in operation. But very few have correct understanding of how the system works. It is worth pointing out that the reason the Bank of England was able to obtain a charter to print money was because it offered very generous terms to King William. It offered to provide him with all money that he needed, in return for his IOU’s — After all, having captured the Sovereign right to print money, it had the ability to print arbitrary amounts. Also, it did not ask for repayment of the principal, but only the interest on the debt. Finally, it also offered to collect this repayment, in form of taxes, on behalf of the King. This was a very sweet deal for the cash-strapped King. 

For more material, see: The Battle for the Control of Money

The first 16m of video-lecture linked below discuss the material in the above post:

StiglitzRicardian equivalence is taught in every graduate school in the country. It is also sheer nonsense  [see “Quotes Critical of Economics” for more.] This post explains why.

NOTE: Many readers have pointed out that this modern fallacy is not actually due to Ricardo. As with comparative advantage, and with the Invisible Hand, modern theories which serve interests of the rich and powerful, are given respectability by being given a forged pedigree.

In this post, we will create a simple model that demonstrates some fundamental truths of Modern Monetary Theory.  This is a variant of “.Simple Model Explains Complex Keynesian Concepts“, We will show the following phenomena

  1. A Market Economy naturally creates an equilibrium with high unemployment and under-employment, showing existence of under-employment equilibria
  2. Government Deficit Spending increases aggregate demand, and moves the economy to full employment.
  3. Deficit Spending, also massively improves social welfare, by providing food even to the unemployed, using the additional output created by the increased aggregate demand
  4. Deficit Spending is not  “FINANCED” from any source. Government spending money which it does not have, creates welfare by injecting money into the economy. This money leads to increased output and is not inflationary. The government can continue this deficit spending forever, without worrying about sustainability or “paying back” the debt.
  5. Government Deficit injects money into the system which is exactly equal to the PROFITS of the firms, plus the SAVINGS of the laborers. Since firms work for profits while households wish to save, neither can succeed UNLESS the government runs deficits. Thus deficit spending is crucial to a capitalist economy — without it there would be no profits for business, and without profits and savings the economy would collapse.

Consider a simple isolated village, which has 10 Farmers each of whom owns 1 Acre of Land. There are 40 laborers in the village. The production function is 1 Laborer plus 1 Acre will yield 100 units of corn. Going wage rate (determined by wages in nearby city) is $100 per laborer for full duration of period. For simplicity assume period is 100 days, and hiring a laborer for N days costs $N and produces N units of corn. When N is less than 100, the laborer is under-employed.

As per Keynesian assumptions, production decision are made first. At start of period, all farmers hire one full-time laborer for $100, assuming they will be able to sell their product. There are two key differences here from the neoclassical models.

  1. The wages are determined by reference wage in nearby labor market, and NOT by marginal product. Wage bargain is in NOMINAL terms, not in real terms.
  2. The future is uncertain. Farmers do not know what price they will get for corn at the end of the period, so it is impossible for them to compute the required marginal product. As we will see, the price can vary substantially, due to a number of different factors, none which can be known at time production decisions are made. This is why wage bargain CANNOT be made in real terms.

At the end of production period, all laborers have earned a wage of $100 and all Farmers have produced an output of 100 units of corn. We now consider several different scenarios regarding what may happen at the end of the period.

  1. All of the corn – 1000 units – is placed on the market for sale. The ONLY buyers are the employed laborers. No one else has money. Total wages are $1000, so price of corn will be $1 per unit to clear the market. Each laborer will consume 100 units of corn. Note that PROFITS of the Farmers will be ZERO. Since there are no injections of money into the economy, it is impossible for Farmers to make profits in the aggregate.
  2. Suppose Laborers want to save some of their income. Suppose they save $50 and spend $50. Now supply is 1000 units but $500 is available for purchase. Market clearing price will be $0.50, and each laborer will still consume 100 units of corn. Note the massive difference in real wage between cases A & B. In this case, the Farmers will make a LOSS. The Consumer Savings of $500 will offset by Farmer Losses of $500 and Aggregate savings plus profits will still be ZERO.
  3. Suppose Farmers consume 20 units of the corn produced. Thus, only 80 units is available for marketing. Aggregate supply is 800 units of corn, and $1000 is available to purchase it, so market clearing price will be $1.25 per unit. Each employed laborer will be able to purchase 80 units of corn with his $100 of income.
  4. Suppose Laborers wish to save half of their income. Then $500 will be available to purchase 800 units of corn. Market will clear at $0.625 per unit of corn. Each employed laborer will still get 80 units of corn. Laborer savings of $500 will be exactly offset by the Farmers loss of $500.

In all these scenarios, we note that Farmer Profit + Laborer Savings = ZERO = Government Injections.

Keynesian unemployment scenarios arise if the Farmers make losses and decide to produce less in the next period. A plausible scenario arises if we put a maximum bound on the consumption of corn. Suppose 20 units of corn is the maximum possible consumption for one person for one period. Suppose Farmers consume 20 units, and put the remaining 80 units for sale on the market

  1. Total aggregate demand for corn is 200 units. With 800 units available for sale, price would decline to virtually zero in D&S equilibrium.
  2. As a solution to excess production, farmers may decide to BURN 600 units of the overproduction. Now the supply is 200 and laborers have $1000 in wage income to purchase it. The price will be $5 per unit, and all laborers will get exactly 20 units of corn.
  3. Continuing from F above, the next period, the farmers may decide to cut back production to only 400 units, noting that they ended up with excess production of 600 units which they had to destroy. Instead of full-time labor at $100, they might hire part-time labor at $40 in order to produce only 40 units of corn each. Now 30 laborers are unemployed, and 10 laborers are under-employed. The supply of corn in the market is 200, and $400 is available to purchase it. So the price of corn will be $2 per unit, and each employed laborer will purchase 20 units with his income of $40. Since the wage bill is $400 and the revenue from sales of corn is also $400, profits of farmers are ZERO, as expected, since there are no injections.

This last case is exactly the scenario where lack of effective aggregate demand leads to unemployment and under-employment. Now consider this same scenario as in G, but introduce a Government. The Government announce a social welfare plan. All unemployed laborers will receive $50 as social security payments from the government. Government will spend $50 each on the 30 unemployed laborers running a budget deficit of $1500. Now let us consider what happens

  1. Anticipating greater demand, Farmers hire full-time laborers and pay them $100 each to produce Aggregate Supply of 1000 units of corn. They self-consume 200 units and bring 800 units to the market. Now there are $1000 of wage income plus $1500 of welfare payments available to purchase this corn. At the price of $3.125 per unit of corn, $2500 will purchase 800 units and clear the market. At this price, $100 will buy 32 units, while $50 will buy 16 units. So, the unemployed laborers can get 16 units and the employed can buy 32 units.

According to our assumptions of 20 units maximum consumption of corn, this is not a feasible outcome. So a different feasible scenario is as follows.

  1. Employed laborers decide to save half of their income. Now $500 is available from the employed while $1500 is welfare so total of $2000 is available to purchase 800 units. Market clears at $2.50 per unit of corn. All laborers, employed and unemployed, consume 20 units of corn.

It is this last scenario which shows the magic of MMT. The government spends $1500 out of no-where – no taxes in present or future – no Ricardian equivalence. This deficit spending allows a private sector surplus of exactly the same amount, with $500 in savings of the employed laborers, and $1000 in profits of the farmers. As per Keynesian prescriptions, this spending generates additional aggregate demand which brings the economy to full employment. The surplus generated is enough to feed the unemployed workers – forever – That is, the government can continue to make this deficit spending forever, keeping the economy at full employment, without worrying about sustainability of the budget deficit.

Note that in standard MMT models, value of money is created by taxation. Here we are thinking of a village which is out of the government tax net. The value of money is created by the ability of villagers to go to nearby city and purchase city goods with the money.

A  BIGGER point in context of this model is the following. Human understanding of abstract concepts is based on translating these concepts to concrete forms. Models helps us to do that by simplifying reality, and enabling us to see the abstractions in action. Thus the MMT idea that Government Injections = Firm Profits + Household Savings is an abstraction until it is  illustrated via a concrete model, such as the one above, where it appear with much greater clarity. BUT the model by itself is not enough either, because it just shows one instance and not the general principle. UNDERSTANDING requires operating at BOTH levels at the same time — understanding the abstractions, and understanding the form that these take in concrete representations, like models. This point is brought out in the following 16 minute mini-discussion





This is the second part of Lecture 9 in Advanced Macro II, Spring 2019, at PIDE by Dr. Asad Zaman. The first part (L09A: Why Minsky Matters) covers the first 27m of the YouTube lecture linked below. The second part, L09B, starts 27:22m is about 1hr long:


A 1500 word summary/outline of the key points covered in L09B is given below:

Krugman fails to understand Minsky

On the one hand, Minsky has been transformed from an eclectic outcast to a darling of the mainstream after the crisis. On the other hand, Krugman and others have failed to appreciate the central insights of Minsky, just as they did with Keynes. While Keynes had completely rejected mainstream theories on solid grounds, Hicks and Samuelson constructed a neoclassical synthesis which conceded the short-run to Keynes on the basis of short run wage rigidities, but kept the fundamentals of mainstream theories intact. Similarly, today mainstream economists like Krugman admit to being at fault in not predicting the GFC, but blame it on external factors, rather than central weaknesses in mainstream theories. Three external factors which account for the failure of economists to “see it coming” are:

  1. The GFC was Black Swan Event. A period of stability led to under-estimation of risks and a discounting of the probabilities of crisis.
  2. The Fed kept interest rates low for too long. This allowed massive credit creation, which led to bubbles
  3. Rise of Shadow Banking Industry went un-noticed. The unregulated financial sector created a crisis by making high leverage gambles, using derivatives as insurance.

Accordingly, mainstream economists propose three solutions, none of which require re-thinking traditional Macroeconomics.

  1. We should pay more attention to the possibility of black swan events, and allow for distributions with fat tails in our stock market models.
  2. We should pay more attention to monetary policy
  3. We should do more regulation of shadow banking (Macro-Prudential Regulations)

In fact, this analysis fails to understand the central insights of Minsky. The mainstream, deluded by theories of intermediation, does not understand the central role of private sector credit creation in generating crises. Even more important, Minsky attacks the central religious belief in “equilibrium”. While Krugman believes that market forces are stabilizing, Minsky promotes the heresy that “equilibria” are inherently unstable. In modern financial economies, the very stability of the equilibria generates the forces which de-stabilize the economy.  Very briefly, stability encourages risk taking behavior, which increases until a crisis occurs. This view is truly deeply heretical because it attacks the founding pillars (optimization/equilibrium) of mainstream orthodoxy.

Mainstream Views on Money

The standard story of money, taught worldwide in conventional textbooks, is that the Central Bank controls the High Powered Reserves, and the total money supply is determined as a simple multiple – M = kR, where M is money supply, k is the money multiplier, and R is the High Powered Reserves. Monetarists argue that the Money supply has no effect on the real economy except for determining prices. Accordingly, Friedman recommended the simple monetary policy rule that the Central Bank should aim for 6% per annum growth in the money supply. Setting a fixed target, and achieving it would anchor expectations about future money and prices, allowing inter-temporal trade without frictions created by uncertainty. Attempt by Central Banks to follow this policy proved to be a complete failure. The reason is that the process of credit creation by private banks is not under the control of the Central Bank. This depends on the investment climate and business expectations. Central Banks would routinely fail to meet announced policy targets, since the money supply depended on factors outside their control. This failure would damage credibility of the central bank, further weakening the impact of monetary policy.

This failure of the Friedman rule led to the use of Minsky’s preferred and recommended policy: the use of the overnite discount rate (and not reserves) for monetary policy. In addition, Minsky recommended the elimination of the interbank borrowing of reserves. The theory behind the creation of the inter-bank market was that this allows extra liquidity to the banks. However, Minsky thought that reserves should only be borrowed from the Central Bank, because this will allow the Central Bank to monitor the quality of loans being offered as collateral. The inter-bank borrowing market allows a general decline in quality of loans, as occurred prior to the GFC. Had Minsky’s idea been implemented, it would have been possible for the Central Bank to forestall the crisis by refusing to accept high risk mortagages as collateral for borrowing of reserves. The Fed would have been aware of risky debt portfolios accumulating in the Private Banks, because that is used as collateral for reserves.

The Financial Instability Hypothesis

One of the key contributions of Minsky, which advances on Keynes, is the recognition that the Business Cycle is caused by Pro-cyclical Credit Creation. In booming economy, there is a huge demand for credit, and everybody is lending, substantially expanding the supply of credit to the economy. Financial assets are used as basis for loans, and easy availability of credit can lead to rise in the prices of these assets, creating a bubble. When all banks are lending, accepting high-risk assets as collateral, no one bank can afford to get left behind, because they would lose market shares. When the music is playing, everyone must dance. BUT, when music stops, you are caught holding assets no one wants. In more prosaic terms, pro-cyclical lending exacerbates the cycle.

To explain the business cycle, Minsky offers us a pair of related theories. The first is the Keynesian theory of Investment as the driver of the business cycle. The second is Minsky’s contribution, the Financial Theory of Investment. These are explained further below.

Keynesian Theory of Investment: What differentiates Keynesian views from modern macro is the idea that investment is driven by “animal spirits” – expectations about the future which are not ‘anchored’ by any past events (and hence not ‘rational’).  This corresponds to the Keynesian view that the future is DEEPLY and INHERENTLY uncertain. Because it is COMPLETELY unpredictable – rational expectations cannot exist. If all investors are optimistic, this will create a self-fulfilling prophecy, and similarly for pessimism. Random fluctuations in investor sentiments can lead to an upswing maintained for sufficiently long to lead to creation of extra credit. Now the pro-cyclical behavior of financial institutions further fuels the fire, providing extra credit with high leverage, high risk, weak collaterals. Then the Central Bank Responds to the increasing aggregate demand by raising interest rates. In the expansion phase, firms have short term debt which is to be rolled over. Now this becomes more costly than anticipated and creates losses, possibly bankruptcies. This leads to a minor downswing which is further exacerbated by financial response created by tightening credit, and reducing money supply.

Minsky’s Typology of Finance: In this context, it is useful to learn the Minsky Classification of financing:

  1. Hedge Finance (not related to Hedge Funds): earnings enough to repay interest and principal.
  2. Speculative Finance (earnings sufficient for interest payments, but not for principal)
  3. Ponzi Finance (earnings not even sufficient for interest – more borrowing to pay off interest)

Speculative Finance is based on the speculation that asset values will increase in the future, allowing repayment of the principal – for example, this could happen in market where property values are rising rapidly. However, if incomes decrease or interest rates increase, then speculative finance can turn into Ponzi finance, where one has to borrow to make interest payments. This is problematic because loans may not be available, leading to bankruptcies. Many households took Ponzi financing to purchase houses in 2000-2007, speculating that rising house prices would cover their costs. To some extent, Lenders lend to protect past loan, but they will cut losses at some point by going for loan default and collecting collateral.

Causes of Crisis: As the expansion continues, financial fragility continues to increase, as riskier loans are extended, with more leveraging. There are multiple sources which can create a crisis which bursts the bubble:

  • income flows turn out to be lower than expected,
  • interest rates rise,
  • lenders curtail lending,
  • prominent firm or bank defaults on payment commitments.

When leveraging is high, then one failed payment has a multiplied impact on contraction of credit, and this can rapidly multiply defaults throughout the system, leading to a financial crisis. A financial crisis collapses the economy via the following mechanisms:

  1. Debtors cut back spending to make payments
  2. This leads to fall in Aggregated Demand, hence fall in income, jobs, wages
  3. To make loan payments,Asset are sold, which leads to fall in asset prices.

In extreme cases, this can lead to the Debt-Deflation seen by Irving Fisher in the aftermath of the Great Depression. Because of asset price collapse, and defaults by financial institutions, wealth is wiped out. Inability to make payments leads to widespread bankruptcies. Output and employment collapse. Debt increases further from efforts to pay it off.

Minsky’s Policy Recommendation: It was thought that the development of the inter-bank Funds market would facilitate credit creation. Minsky argued AGAINST this. It is not true that banks first acquire reserves and then they make loans. Rather, Banks make loans and then borrow reserves to meet reserve requirements. The Inter-bank market weakens the REGULATORY capacity of the central bank, it does not create additional capacity for lending. If the Central Bank is the sole source for reserve funds, it can monitor the quality of assets being used for collateral throughout the system, and thereby control systemic risks much more efficiently.

Course Website: bit.do/az4macro – contains lectures for both Adv Macro I and II.

My last post on Behavioural Economics arose some interesting questions about the rationality of the neoliberal governance of the self and its relation to the current research about psychology and cognitive theories. (https://rwer.wordpress.com/2019/03/20/beyond-behavioral-economics-the-self-governance-of-nudging/#comment-150149)

The neoliberal governance of self-care (or neoliberal governance of the self) relies on Dual Process Cognitive Theories (DPTs), especially the one elaborated by Daniel Kahneman. According to him, the distinction between Econs and Humans rejects the concept of homo oeconomicus of the neoclassical theory.  The human brain functions in ways that refer to a distinction between two kinds of thinking: automatic  and reflective (rational), and Kahneman called these ways of thinking System 1 and System 2, respectively. His Dual Process Cognitive Theory tries to explain why human beings actually systematically deviate from rational decisions.

Considering the normativity perspective in behavioural economics, nudges are social norms that  aim to foster “better” choices, “happiness” and freedom of choice. Nowadays, nudges are part of the neoliberal governance. As Thaler and Sunstein say: nudges are everywhere.

The political rationality of neoliberalism is that the strategy of rendering individual subjects “responsible” entails shifting to them the responsibility for social risks such as illness, unemployment, retirement plans, etc.. Therefore, there is a call for “personal responsibility” and “self-care”.  In other words, the political rationality of neoliberalism calls for  the relevance of System 2. However, on behalf of the human cognitive biases, people need a helping hand of the government to be rational and exercise self-control.

It is worth remembering Cass Sunstein and  Richard Thaler´s words:

Equipped with an understanding of behavioral findings of bounded rationality and bounded self-control, libertarian paternalists should attempt to steer people’s choices in welfare-promoting directions without eliminating freedom of choice. It is also possible to show how a libertarian paternalist might select among the possible options and to assess how much choice to offer.

Indeed, the understanding of the Libertarian Paternalism of Thaler and Sunstein  involves implicit forms of power and processes of subjectivation.

Advanced Macroeconomics II – Spring 2019 – PIDE – Dr. Asad Zaman. Course Website: https://bit.do/az4macro . Lecture 9 is provides an introduction to L Randall Wray “Why Minsky Matters”. This post [L09A] covers the first portion (00-27:22m) of the lecture linked in the YouTube Video Below:

AM2 L09A – first half of lecture 9 compares the Global Financial Crisis to the Great Depression, similarities in origins and differences in responses.

  1. Why did No One See It Coming?

We start by posing the question “Why did no one see it coming?” which the Queen of England asked at the London School of Economics. To answer, we must consider the evolution of macroeconomic thought. This involves the rejection of Keynes, the rise of monetarism of Friedman, the extremism of Lucas, New Monetary Consensus of Bernanke, Efficient Markets of Fama, Laissez-Faire approach to financial regulation. The book starts with a beautiful description of the problem, eminently worth adding to my collection of “Quotes Critical of Economics”:

What passed for macroeconomics on the verge of the global financial collapse had little to do with reality. The world modeled by mainstream economics bore no relation to our economy. It was based on rational expectations in which everyone bets right, at least within a random error, and maximizes anything and everything while living in a world without financial institutions. There are no bubbles, no speculation, no crashes, and no crises in these models. And everyone always pays all debts due on time.

In short, expecting the queen’s economists to foresee the crisis would be like putting flat-earthers in charge of navigation for NASA and expecting them to accurately predict points of reentry and landing of the space shuttle. The same can be said of the U.S. president’s Council of Economic Advisers (CEA)—who actually had served as little more than cheerleaders for the theory that so ill-served policy makers.

  1. Minsky: Stability is De-Stabilizing!

According to Minsky, the degree that the economy achieves what looks to be robust and stable growth, this is setting up the conditions in which a crash becomes ever more likely. It is the stability that changes behaviors, policy making, and business opportunities so that the instability results. Examining the history of financial crises furnishes empirical evidence for this thesis: Crashes are often preceded by long period of stability.

The Great Depression: Back in 1929, the most famous American economist, Irving Fisher, announced that the stock market had achieved a “permanent plateau,” having banished the possibility of a market crash. In the late 1960s, Keynesian economists such as Paul Samuelson announced that policy makers had learned how to “fine-tune” the economy so that neither inflation nor recession would ever again rear their ugly heads. In the mid-1990s, Chairman Greenspan argued that the “new economy” reflected in the NASDAQ equities boom had created conditions conducive to high growth without inflation. In 2004, Chairman Bernanke announced that the era of “the Great Moderation” had arrived so that recessions would be mild and financial fluctuations attenuated.

In every case, there was ample evidence to support the belief that the economy and financial markets were more stable, that the “good times” would continue indefinitely, and that economists had finally gotten it right. In every case, the prognostications were completely wrong. In every case, the “stability is destabilizing” view had it right. In every case, Minsky was vindicated.

Minsky not only saw it coming, but all along the way he warned that “it” (another Great Depression) could happen again. In retrospect, he had identified in “real time” those financial innovations that would eventually create the conditions that led to the GFC—such as securitization, rising debt ratios, layering debts on debts, and leveraged buyouts

  1. Financial Crisis Inquiry Report

The crisis was foreseeable and avoidable. It did not “just happen,” and it had nothing to do with “black swans with fat tails.” It was created by the biggest banks under the noses of our regulators.  This contrasts with what economists at LSE told the Queen – that these things just happen and no one can foresee them – like earthquakes.

According to the report, the GFC represents a dramatic failure of corporate governance and risk management, in large part a result of an unwarranted and unwise focus on trading (actually, gambling) and rapid growth (a good indication of fraud, as William Black argues). Indeed, the biggest banks were aided and abetted by government overseers who not only refused to do their jobs but also continually pushed for deregulation and de-supervision in favor of self-regulation and self-supervision

  1. Dynamite Prize: Friedman, Greenspan, Summers

Instead of helping, economists  (armed with defective economic theories), actually pushed for OPPOSITE policies to those required for stabilization. President Clinton’s Secretary of the Treasury Larry Summers—a nephew of Paul Samuelson and the most prominent Harvard Keynesian of today—famously pushed for deregulation of “derivatives” that played a critical enabling role in creating the financial tsunami that sank the economy. One of the key contributions of Minsky lies in identifying the sources which make the economic system prone to crises. This diagnosis permits the design of appropriate remedies.

  1. Response to GFC 2007 different from response to GD 1929

Monetary and Fiscal Stimulus: Both crises were created by similar kinds of irresponsible behavior by unregulated financial institutions. However, the response to both was dramatically different. A $29 Trillion package was used to bail-out bankrupt financial institutions, and a $1 Trillion government deficit was incurred to pursue expansionary fiscal and monetary policy. This change in response also led to a change in outcomes. Financial collapse of the system was avoided. Although huge numbers became homeless and hungry, the social security programs enacted in the New Deal prevented the worst scenarios of deep massive social misery which followed the Great Depression. HOWEVER, a terrible Recession did follow, where unemployment reached double digit figures, around 25 million.

Recovery? It is claimed that there has been a recovery. Although official unemployment rates came down, much of the improvement is illusory—millions of workers have given up all hope and left the labor force. Even after years of “recovery,” both the homeownership rate (percentage of Americans who own their homes) and the employment rate (percentage of the adult population with jobs) are stuck well below where they were before the GFC. Inequality has actually increased, and all of the gains in the recovery have gone to the very top of the income and wealth distribution.

No Post-Crisis Financial Reforms:  The federal government in Washington did not follow Roosevelt’s example in undertaking a thorough reform of the financial system after GD ’29. The biggest banks are actually even bigger and more dangerous than they were on the eve of the GFC. They’ve resumed many of the same practices that created the GFC. Our public stewards are again allowing this to happen. We didn’t seem to learn much from the GFC. Not only is it true that banking practices have not changed, but is also true that mainstream economics has not changed. Examination of syllabi of universities after the GFC does not reveal any significant changes in terms addition of readings on Minsky, Keynes, and others, who offer deeper insights into the crisis. The same ARCH/GARCH models that failed miserably to assess volatility in the GFC continue to be used. The same DSGE/RBS models in use to make monetary policy continue to be used all over the world.

It seems that we have not learned much from the Global Financial Crisis!

CONTINUED in L09B: Mainstream VS Minsky — goes from 27m to end of lecture (1 hr) — explains how the mainstream misunderstands Minsky, just like they misunderstook Keynes, whose work Minsky builds upon.