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WEA Discussion Forum: Trade Wars
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The current WEA Discussion Forum on Trade Wars is being opened today.
Many relevant questions are at stake:
Can China actually replace the US as the economic leader in the world?
If not, what will prevent it? If so, what is required for …?
How can the US prevent this shift from happening?
Will free trade still be promoted strongly through multilateral agencies?
Does the global winner keep the hegemony as its prize?
Or are we in a new situation of shared/partial hegemonies?
What are the consequences to the world economy and the future of neoliberalism?
You can read the following interesting papers and engage in this Discussion Forum
period: October 19th till December 5th, 2020
website: https://tradewars2020.weaconferences.net/papers/
1.The current correlation of forces in the struggle for global economic hegemony
by Juan Vázquez Rojo
2. The War on Trade and its Theoretical Implications
by Oscar Ugarteche
3. The interplays of US, China and their intellectual monopolies
by Cecilia Rikap and Ariel Slipak
by Eduardo Martínez-Ávila
5. America’s Trade Deficits: Blame U.S. Policies – Starting with Tax Laws
by Kenneth E. Austin
Political Economy
This is a sequence of posts on “New Directions in Macroeconomics“, which discusses the numerous directions of research which must be incorporated to create a viable Macroeconomics for the 21st Century. We have previously discussed “Post-Keynesian Economics“, and “Modern Monetary Theory“. This post discusses the necessity of re-incorporating politics into economics.
Once we recognize the importance of history and institutions, it becomes clear that economic problems cannot be separated from politics and society. The interplay of class interests, and their relative power, is of essential importance in understanding political and economic structures of society. Current commitment to methodological individualism has blinded economists to these aspects, and left them unable to explain burning issues like the rapid rise of income inequality in the wake of financial de-regulation. There are many different perspectives from which the inter-relationships between politics and economics can be analyzed.
Marxist Perspective: Although the Marxian prediction of the demise of Capitalism has proven wrong, the methodology and tools he developed yield deep insights not available within the orthodoxy. Moore (2015) shows that dynamics of capitalism require ever increasing exploitation of all available resources. However, with the imminent exhaustion of planetary resources on a global scale, capitalism, appears to have reached its final frontier. A key Marxian insight is that exploitation is enabled by an ideology which creates an appearance of fairness, necessity, desirability, and attractiveness of the capitalist economic system. For an illustration of how modern economic theory fulfills this role, see ET1%:Blindfolds Created by Economics. Unlike orthodox macroeconomics, Marxist theory is well suited to understanding the global nature of capitalism; for key references, see Burnham (2001). Marxist analysis is also very helpful in understanding increasing inequality and exploitation, which is responsible for the inherent instability, and repeated crises, of the capitalist economy. Harvey (2017) is a useful introduction to contemporary understanding of Marxist theory, together with a critique of orthodoxy (see Video Lecture: https://www.youtube.com/watch?v=gBazR59SZXk ).
The Great Transformation: Polanyi’s famous book (see Summary of the Great Transformation) provides a deep analysis of the transformation in England from a traditional society to a market society. As he shows, emergence of the market mechanism created conforming changes in politics, society, and our attitudes towards the planet and people. Polanyi shows how social transformations work through collective efforts of classes, which are embodied in the form of institutions. However, he does not take classes and institutions as exogenously given. Rather, he shows how social transformation can create or destroy classes, and also institutions, in accordance with shifting balance of powers created by a complex of forces which act from within or without. Three major methodological principles used by Polanyi for the study of social change are articulated in The Methodology of Polanyi’s Great Transformation. All three run counter to received wisdom in contemporary economic methodology, and therefore furnish new foundations for an alternative 21st Century approach to economics.
The New Political Economy: Many have come to realize the impossibility of understanding economic crises of the past century without taking into account the political and historical context, as well as a deep analysis of the institutional structures. See for example “There is no economics without politics” by Admati (2019). This has led to the emergence of a new eclectic approach to the study of close connections between politics and the economy. The recently established Department of Political Economy at Kings College London provides as raison d’etre: “In a world characterized by financial uncertainty, ecological insecurity and value conflict, the links between political and economic processes are ever more apparent and the need for a multifaceted appreciation of how they operate, has never been greater.” As an illustrative example, Lemann (2019) provides an account of how economic theories, combined with political power, reshaped institutions and policies to dramatically change the social, political, and economic landscape over the past century. Combining political, institutional, and historical methods leads to deep insights into the workings of our economic system not available within the orthodoxy. A comprehensive and thorough book-length treatment is provided in a draft textbook on Political Economy by Daron Acmeoglu (2020).
END OF SECTION. To read the full paper, with complete references, see: International Econometric Review, Vol 12 No. 1 or SSRN Version.
Modern Monetary Theory
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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