In 1979 President Carter appointed To the federal reserve Paul Volcker. At the time his appointment was seen as part and parcel with Carter's "austerity" program (austerity is generally seen as reducing spending, increasing taxes and being "less accommodating" to private enterprise. Increasing interest rates is what the third point generally means. I will return to this later). In the mainstream economics before the 1970's, a curve called the "Phillips curve" purported to explain that their was a determinate relationship between inflation and unemployment. That is, when the rate of inflation goes up, the rate of unemployment was supposed to go down a certain amount and vice versa. The "stagflation" (ie high levels of unemployment and inflation) of the 1970's completely exploded this view.
In it's place (whether merited or not) Milton Friedman came to prominence with "monetarism". His basic idea was that money is "neutral" in the long run ie it doesn't effect any real variables (like employment, distribution of output etc. see earlier post for a differing view). the basic equation monetarists use to explain this idea is MV=PQ. In this equation M is money (as in cash and bank deposits), V is velocity or how much money circulates in a given period of time, P is the level of prices and Q is the amount of output produced. Milton Friedman argued that velocity was basically constant and in the long run the economy tended towards full employment (the unemployment that did happen was caused by inefficient labor markets ie unemployment insurance and unions). Because of this, it was easy for him to draw the line of causation from money to prices. In other words growth in the "money supply" caused growth in the rate of price increases (look at this earlier post for a more detailed explanation and a reverse the causation argument).
Back to Volcker. He was largely seen as implementing Friedman's agenda. he was to lower, the rate of growth of prices by lowering the rate of growth of money. In practice, this meant a lot of volatility in interest rates (if you target interest rates, you have to accept the level of bank reserves and vice versa).Note also that Friedman declared that labor unions were making labor markets more inefficient and thus restricting output (and creating unemployment). Marxists (and other analysts) such as Doug Henwood argue that the “Volcker shock” was primarily aimed at breaking the power of labor. It's also notable that average people were not involved in this battle ideas. Workers were only a “problem” that needed to be solved.
Tuesday, April 3, 2012
the "volcker shock"
“Humans are inherently Greedy”
Rationality as a justification of social inequality
Rational choice theory is a branch of thinking ever omnipresent in the social sciences. It is especially dominant in economics and many of the adherents in other disciplines have spilled over from economics (e.g Gary Becker, and Freakonomics co-author Steven Levitt). As could be noted by the use of the term “choice” it a theory of human action. The theorists are not attempting to explain the thoughts, feelings and emotions of People. They purport to explain why they do what they do (at least in the “economic” realm). In addition, their conception of rationality is more specific and different then average person’s definition Duncan Foley explains it like this in his piece Rationality and ideology:
Economists, however, have come to define rationality in a much narrower sense. The economist’s rational decision maker optimizes, that is, pursues not just any action that promotes a goal, but the action that best promotes the goal. The economist’s rational decision maker processes information according to the procedures of Bayesian statistics. Furthermore, the goals the economist’s rational decision maker pursues have to be reducible to the direct consumption of material goods and services. This is a “rationality of the belly” (which some people might reasonably regard as being rather irrational).
This may seem absurd on it's face; on a moment's reflection it is easy to recognize that people don't behave like this. The defense however, is easy (but strangely brilliant) and was made over half a century ago by Milton Friedman:
Let the apparent immediate determinant of business behaviour be anything at all—habitual reaction, random chance, or whatnot. Whenever this determinant happens to lead to behaviour consistent with rational and informed maximization of returns, the business will prosper and acquire resources with which to expand; whenever it does not, the business will tend to lose resources and can be kept in existence only by the addition of resources from outside.
What he is essentially saying is that people have no agency. Actors may have differing motivations but as soon as they start to deal with the problems of “scarcity” and the “economy” they will encounter competition and behave “as if” they are rational “utility maximizing” people. The “natural” processes of economies (Duncan Foley suggests that in Neoclassical economics these processes are determined in a Hobbesian/Lockean/Rawlsian “veil of ignorance”). Even when leaving work and production and entering the world of “leisure”, agents have no agency since their preferences are predetermined. Note that since rational, utility maximizing individuals require perfect information, complete markets and definite measurements of all elements of life that provide “utility”, any move away from Capitalism is rejected as almost perverse. Further, redistribution downwards is considered “inefficient” and “supoptimal” because it may result in less total utility being available (this is called pareto optimality). In this view, it is less efficient for a poor person to have 1 dollar then for Donald Trump to have 3. All that matters is that the better off **could** compensate the worse off, even if they never do. In it's purest form, Rational Choice theory is a full throated defense of capitalism that argues against even the mildest forms of redistribution.
Foley, Duncan. "Rationality and Ideology in Economics." World Political Economy Graduate Class. New School For Social Research, New York City. 27 Mar. 2012. Lecture.
Friedman, Milton. "The Methodology of Positive Economics." Essays in Positive Economics. Chicago, IL: University of Chicago, 1953. Print.
The money induced inequalities in income (more accurately, output) distribution
In our modern capitalist society, a major inequality results from the very nature of production for monetary profit and the hiring of workers. Marx distinguished production for exchange from production for monetary profit using the equations M-C-M' and C-M-C. Workers ( or in proto/non/precapitalist money using societies, peasants) first and foremost are looking to acquire the basic necessities of life. Generally, this means selling the only reproducible asset they have, their labor power. Workers are paid a wage that is denominated in money. Then they use that same money to purchase what they need from firms.
Here, production is fundamentally broken from consumption. Workers only acquire the output they produce by purchasing it at the market and capitalists are producing, not to satisfy consumption but to accumulate money that will partially be used to consume on the market later. Under capitalism, people spend much of their time either producing or consuming, but these activities are never directly connected.
Normally at this point, Marxists go into explanations of how this leads to the exploitation of workers and how all profit comes from surplus value produced by workers. This may or may not be a valid argument, but it is not the focus of this post. Rather, I would like to direct this post towards the analysis of Michal Kalecki, a polish (Marxian trained) economist and widely seen as an independent (conemporary) developer of John Maynard Keynes's analysis. As is noted above, workers are paid a monetary wage. This means they aren't guaranteed any set standard of living (for the moment I will ignore inflation adjusted contracts, since those are no where near the norm). It also means that the pricing and production decisions of firms as a whole determine the output workers receive, no matter how high or low their nominal wages are.
If worker's for example, form a union and push for higher and higher wages (assuming their productivity stays constant), capitalists as a whole could grant them their wage increases but then raise prices to preserve their profit margin. This is quite a dangerous result for many reasons, not least of which it shows that firms have vast control over the living standards and power of workers, but workers (even when they push back) are only able to achieve limited gains for themselves. For Neoclassical economists, this is unacceptable. It is partially why the concept of competition (specifically “perfect” competition) is so central for them. The process of competition between firms helps them strip firms of their agency and social control. It also leads to the easy defense that any undue power corporations have over our lives is a result of a “lack of competition” that is often attributed to state intervention. Even when they spend their time modeling the economy more realistically (using “imperfect” competition) competition is supposed to exert massive control over firms and if it doesn't, the solution suggests itself (deregulate and break up firms). Interestingly Marxists also rely on competition reducing capitalist agency, but for different effects. Rather then equalizing the power dynamic, it is supposed to make it more brutal since any capitalist which didn't try to expand production, invest and squeeze workers would be destroyed.
Mankiw, Nicholas Gregory. Principles of Economics. Mason, OH: Thomson South-Western, 2011. Print.
Marx, Karl. Capital: A Critique of Political Economy. London: Penguin in Association with New Left Review, 1981. Print.
How do banks create money?
This is one of those questions that make me squirm when I have to answer it on the spot, for a lot of reasons. First, money is an intimate topic to people’s lives. They owe people and institutions money, their savings are in money; money is just an integral part of everyday experience. Explaining the nature of money to someone can be a difficult experience, especially when they understand the answer.
Second, there’s the fact that multiple explanations of how banks create money exist. Not only that but neoclassical economics proposes one view that dominates the academic and political discourse (neoclassical economics is broadly the economic point of view that has dominated economics for the last 140 years, with perhaps a brief interlude during the “Keynesian” revolution). In the neoclassical view banks are only able to lend money after depositors have put their cash into a bank. Since governments sometimes require banks to hold a certain amount of money aside (in the U.S it’s 10%), the idea is that the rest of their “excess” reserves are available for lending. This theory plus the US’s 10% reserve requirement has led to one of neoclassical economics’s most appealing teaching example. I think it is valuable to quote N. Gregory Mankiw's principles of economics textbook at length here because he's a very clear writer and his book dominates the textbook market (not to mention it gives me a chance to remind people that his students walked out of his class in protest of it's content last semester here: www.thecrimson.harvard.edu/article/2011/11/2/mankiw-walkout-economics-10 )
"Let's suppose that First National has a reserve ratio of 1/10, or 10 percent. This just means that it keeps 10 percent of its deposits in reserve and loans out the rest... First National still has $100 in liabilities because making the loans did not alter the bank's obligation to it's depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people taking out the loans, but they are assets of the bank making the loans because the borrowers will later repay the bank.)
...Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits in the bank. Yet when the First National makes these loans, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money.
The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary economy, where the $100 of reserves generates $1000 of money, the money multiplier is 10. What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/r dollars of money. In our example, R=1/10 so the money multiplier is 10."
| sector | Government | Banks | Debtors (to the bank) | Creditors (to the bank) | ||||
| Parts of balance sheet | assets | liabilities | assets | liabilities | assets | liabilities | assets | liabilities |
| Balance sheet | 0 | $10 (currently held as bank reserves) | $10 reserves. $90 loans | $100 in bank checking account | 0 | $90 loans | $100 in bank checking account | 0 |
I should add that although this is what Mainstream economics puts in their undergraduate textbooks their is a lot academic literature written and published by Neoclassical economists that qualify or even contradict this story. Indeed the most common defense of neoclassical economics is that the critics either don't understand it or are criticizing a "caricature" (aka what appears in the textbooks). The table above is a much more detailed (with the implicit sectors made explicit) exposition of the model Mankiw is presenting. If you learn accounting, you find out very quickly that any financial asset is someone/something else's liability so that they should all sum to zero (The real world contains physical objects that don't have corresponding liabilities so real world balance sheets should sum to positive values).
Notice that in this conception of money creation by banks, the government directly controls the money creation process. If it lowers reserve requirements, excess reserves will appear in the banking system that, according to these theorists, will be lent out, redeposited and lent out again in the “money multiplier” process Mankiw described. If it raises reserve requirements, banks will have to attract more deposits or reduce the amount of loans they are making.
This is a very orthodox theory but it is used in more unorthodox circles to defend various policies. Many liberal critics of big banks have criticized them on the grounds of “not lending” even after the bailouts (this being based on the idea that their holdings of excess reserves are and should be available for “funding investment”). The “move your money” campaign is largely predicated on the idea that moving your deposit limits the ability of big banks to lend money and increases the ability of small banks to. The NEED act (HR 2990) introduced by Dennis Kucinich is largely based on the American Monetary Institute's ideas.
They subscribe to the Neoclassical view of money creation, with the crucial difference that they don't see the “loanable funds” (the deposit and loan concept described by Mankiw) market as an equilibrating system that balances savings and investment in a way beneficial to all. They see it as a system that allows a privileged few to function as a usurious middle man between government, industry and the public (see: monetary.org). For them returning money creation back to the government simply involves raising reserve requirements to 100% .Recall what Mankiw said above:“If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/r dollars of money.” In this case R=1 so each dollar of reserves is just 1 dollar. To AMI, this means that money is only created when governments spend it into existence.
Another view is presented (usually) by the Post-Keynesian school . They look at the correlation between reserves and broader money creation but think that Neoclassical economics has the causation reversed. Rather then banks needing deposits (and thus reserves) to make loans, they see banks making loans which create deposits and then seeking out reserves later. In Neoclassical economics (as alluded to above) savings and investment is balanced through the loanable funds market. The variable that adjusts to balance these two things is the interest rate. If there are more (less) savings being offered as loans then borrowers willing to borrow them, the interest rate is supposed to fall (rise) until equilibrium is reached. Post-Keynesians in contrast envision a central bank with a target interest rate that will intervene to inject reserves when demand for reserves rises to prevent (unplanned) rises in interest rates and withdraw reserves to prevent (unplanned) falls in interest rates. For them the money supply expands and contracts to accommodate the (profitable) financing needs (and desires) of (credit worthy) economic actors including corporations, other financial institutions and households.
I personally subscribe to the Post-Keynesian view. For some Theoretical and empirical defenses of the Post-Keynesian position see Schumpeter's book, Basil Moore's empirical work and definitive book, and a sampling of federal reserve publications cited below. This is enormously relevant to social inequalities. If one accepts the neoclassical view, banks don't have very much agency. they are simply the (well paid) intermediary between savers and borrowers. It is ultimately their actions and reactions that make major changes in the global economy. Rather then the housing bubble being led by madly inventive, criminal bankers, it is supposedly let by investors in search for higher returns and borrowers desire for more and bigger houses. The neoclassical view also leads to the idea that the level of debt doesn't really matter. It also leads to the idea that less radical forms of activism, like moving your money, will bring banking under control, rather then protest, confrontations or even revolution. Social inequality created by finance is ultimately our own fault. If we just became more active and conscious, these ills would shrink enormously. It's not a class conflict, it's a conflict with ourselves.
Works Cited
Delreal, Jose A. "Students Walk Out of Ec 10 in Solidarity with 'Occupy'" The Harvard Crimson. Harvard University. Web. 23 Mar. 2012.
Kydland, Finn E.; Prescott, Edward C., "Business Cycles: Real Facts and a Monetary Myth", Federal Reserve Bank of Minneapolis Quarterly Review 14 (2): 3–18
Holmes, A. R. Operational Constraints on the Stabilization of Money Supply Growth. Controlling Monetary Aggregates. F. E. Morris. Nantucket Island, The Federal Reserve Bank of Boston: (1969) 65-77 .
Mankiw, Nicholas Gregory. Principles of Economics. Mason, OH: Thomson South-Western, 2011. Print.
Moore, Basil J. Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge [England: Cambridge UP, 1988. Print.
Moore, Basil J. "The Endogenous Money Stock." Journal of Post Keynesian Economics 2.1 (1979): 49- 70. Print.
Schumpeter, J. A. The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press. 1934. Print