Friday, August 17, 2012

Musings in central banking 3 - Challenge to MMT (continued)

I respond here to Mitch Green's reasons (methodological) for rejecting my challenge to MMT and his invitation to 'try this again, but do so with good assumptions, a realistic model'. I took up his invitation to try again, although without altering assumptions. I show why the challenge is crucial to validate a key claim by MMT and why my model assumptions suffice for that purpose.

Mitch Green:
I reject the whole premise of your argument on the grounds that you're engaging in fallacious reasoning. You set up a hypothetical model of "pure banking" vs. "central banking" which has no bearing on the world in which we actually live. You then issue a challenge to the MMT community to defend its operational description of the modern banking and public finance system, but you refuse to allow any realism in the discussion. Instead, you force them back into this nonsensical pure banking world, which allows no room for real world interaction between the state, the CB and the financial system and ask them again to explain the 'no financial constraint' argument.

I won't play this game. I'm open to a legitimate discussion concerning these issues, but you need to first fully specify your model with warranted assumptions. Here's a hint: you assume the government faces the same underwriting criteria that a household or firm does. This is clearly an unwarranted assumption, as governments do not go to banks for loans. You further assume that CBs control the quantities of reserves. The Volker experiment of the late 70s early 80s has demonstrated this to be an unwarranted assumption, and as such central bankers have given up on quantity targets altogether, and now target rates, which they have demonstrated control over.

So, try this again, but do so with good assumptions, a realistic model, and then perhaps we can talk. 
ECB-Watch
You criticize the two models I specified for lacking realism, that is, the 'operational description of the modern banking and public finance system'.

You're quite right they lack realism, but that isn't the purpose. The purpose is to bring out the salient feature distinguishing what some would call a free market (pure banking),  and one with a central bank.

The first model is not only not realistic but hypothetical. Its raison d'être is to serve as a benchmark against which the central bank model (CB) is compared: if/since the government is revenue constrained under the former—what you call "the government faces the same underwriting criteria that a  household or firm does"—, how/why is it not under the second. MMT has to explain the change  of *property* that arises in the transition from the first to the second model.  That is the challenge.

Note that the two proposed models of CB, DW and OM, agree with one of two of the stated mandates of  the Fed (the other being full employment) and the unique mandate of the ECB. I think you would agree that is a necessary condition. If you see a sufficient condition that isn't met, I'd like to hear it.

About the paragraph "You further assume that CBs...  which they have demonstrated control over.", U are wrong on two counts. First, I stand by the fact that CB *controls* the quantity reserves. They don't *target* the qty of reserves but rather the interbank rate. This is explicitly specified in the CB models. Second, I have made reference to the failed Volcker experiment in the first part of the challenge (remember, this is a multiple posts series): "Monetarist experiment tried and failed".

The discomfort your experience with these 'toy' models is exactly what I intended to provoke and reinforces my doubts about MMT. Its followers discuss monetary operations on the level of complexity  of bond traders and have lost sight of the big picture as result.
Also see: 

16 comments:

  1. UPDATE:

    About : "Note that the two proposed models of CB, DW and OM... would agree that is a necessary condition."

    I should have said: Central banks are designed to be able to set the interbank rate, to a first approximation. The two proposed models, DW and OM, meet this minimal requirement.

    The mandate itself—an inflation target—is assumed to agree with reality. [1].

    [1] "The CB adjusts it—drains or adds liquidity—so as to meet an interbank rate target, itself chosen to meet an inflation target. "

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  2. UPDATE. In response to a private conversation, let me clarify that what I call 'the salient feature distinguishing what some would call a free market (pure banking), and one with a central bank' is described in the second post:

    "In transiting from PB to DW/OM, the CB becomes the monopoly supplier of interbank credit—reserves, and thus can set its price—interbank rate. "

    I think MMTers accept this when they speak of 'monopoly issuer of the currency'.

    I got yet another comment on Twitter expressing perplexity about pure banking (PB):

    "Or where do you imagine the money in your PB come from?"

    That tells me some MMTers didn't learn from the ground up and it may be that by skipping steps they've unknowingly made leaps of faith.

    The Pure Banking model is not my invention, is based on Section 5. 'A pure credit economy, with two sets of banks' of Marc Lavoie's 'Primer on endogeneous money' (2000).

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    Replies
    1. It doesn't matter what the source of the analysis is, though, the question stands: where do you imagine that money in your PB system comes from? How is it that a bank emerges in a non-monetary subsistence economy? You can't appeal to history for that, since in history, banks emerged in monetary economies.

      And I don't follow how you imagine that reading Marc Lavoie's primary on endogenous money in 2000 is some kind of pre-requisite for learning MMT from the ground up. Davidson was assigning endogenous money literature in the early 90's when I was going to grad school, and Mitchel was working in it in the late 90's when I was at the University of Newcastle.

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    2. It's a long time, perhaps a refresher is in order.

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  3. http://www.nakedcapitalism.com/2012/08/philip-pilkington-divine-mathematics-neoclassical-economics-as-spiritual-meditation.html


    ;)

    This is why he said he won't play your game.

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  4. UPDATE Mitch Green (NEP/UKMC) has rejected the challenge for good:

    "grownups don't play children's games. Your's is no challlenge, for reasons I already suggested". https://twitter.com/MitchGreenNEP/status/237876580989419521

    I am sorry to read that, after obliging to his request to clarify the challenge.

    Marc Lavoie has a paper (see above) in which he builds the modern banking system from the ground up. I took two snapshots of his demonstration, pure banking [1] and a system where the central bank controls the IB rate. I have put aside features such as banknotes and securitization that would distract from the matter under consideration. I should be congratulated by Mitch Green, rather than dismissed, for making it look a 'child's game'.

    Government and non bank private actors are perfectly interchangeable with regard to borrowing in the pure banking model: borrowing is revenue constrained—I assume MMT does not dispute that. As any loan officer would tell you, there is a cap on
    borrowing in proportion to the loan applicant's projected revenue stream. To think interchangeability evaporates by putting the central bank in charge of the banking system is counter intuitive. Yet, MMT makes that leap in claiming 'government is not revenue constrained'.

    The challenge to MMT is to go back to my snapshots of Lavoie's model(s) and provide a *concise and clear demonstration* of how this change in property comes about. That's quite open ended: Mitch Green shouldn't feel cornered.

    People are getting smarter about sectoral balances and the (absence) of money multiplier. Therefore MMT is losing its preeminence in these areas. MMTers would be well advised not to let themselves become defined by a claim that lacks convincing foundations.

    Let's close these lines by remembering Mitch Green as the fellow from NEP/UKMC who made the novice's mistake of contesting that CB controls reserves and imputed me the opposite of the view I explicitly expressed, in the first post of this challenge, on the 'Volcker experiment'.

    [1] I should have called it 'free banking', by analogy to 'free markets', because there is no central bank in it. Changing the name now is going to cause confusion so I'm sticking to 'pure banking'.

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    1. But you mischaracterize Marc Lavoie's work: he does not build a modern monetary system from the ground up, since he does not start at the ground. He rather builds a modern monetary system starting from a just-so story, but a different just-so story than the one conventionally used in mainstream monetary theory.

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    2. Note that the reason that the government is not revenue constrained in Marc Lavoie's second stage is that the government at that stage has neither a budget nor tax receipts. Since it engages in no actions that require revenue and engages in no actions to raise revenue, it certainly cannot be considered to be revenue constrained.

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    3. I have no idea what Bruce McFarling means by a "just-so story", but here's how Lavoie sees it:

      "The purpose of this chapter is to help teachers in presenting the main features of a modern financial system."

      As for "he does not build a modern monetary system from the ground up" here's what Lavoie writes in the same paper:

      "T-accounts [...] will be presented in a systematic way, starting from the simplest pure credit economy [...] Complications will be
      gradually introduced, such as [...] central bank"

      I assumed Lavoie's description of the "modern financial system" was accepted by MMTers. If Bruce's view is representative of MMT I now have to ask point bank: 'does MMT rejects Lavoie's models, and how specifically?'

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    4. "Note that the reason that the government is not revenue constrained in Marc Lavoie's second stage is that the government at that stage has neither a budget nor tax receipts."

      The paragraph where I claim that I borrowed from Lavoie is different from that about gorverment. In the latter I simply point out that government is but one customer of banks and it is common knowledge customers are 'revenue constrained' ('As any loan officer would tell you...').

      The same paper, however, contrasts the post-chartalist view of government with the neo-chartalist view. The first (the one I call 'common knowledge') see government as akin to private firms: 'firms need to borrow from banks to make expenditures'. The second, which I assume is MMT's is described as 'the Treasury is best seen as drawing cheques from its account at the central bank, and selling bonds to the central bank in order to replenish its bank account at the central bank.'

      Lavoie settles the comparison as follows:

      "Will the situation be any different if Treasury bills issued to pay for government expenditures or deficits are sold directly to the central bank, as the neo-chartalists would generally put it? The answer
      is no, ultimately it will not."

      Although I didn't intend to take up the challenge myself, rather let MMTers do it (recall I said 'open ended'), if one starts from the premise the first view implies government is revenue constrained, Lavoie's equivalence would suggest it is also revenue constrained in the neo-chartalist view of money. In other words, MMT's claim government is not revenue constrained is false. It's only a suggestion, not my final belief. The challenge remains open for anyone to take it up.

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    5. Now, let me susbtantiate

      "The paragraph where I claim that I borrowed from Lavoie is different from that about gorverment."

      :

      ECB-Watch:

      "A loans the customer $X and immediately instructs bank B to credit the grocer's account by $X. [Let's] understand what goes on in the background [...] The transfer from the customer's deposit to that of the grocer
      therefore results in a decrease by $X of A's liability. How is it balanced? [...] If A held no deposit at B, the latter would create a loan/deposit of $X in A's name and immediately transfer $X from the deposit to that of the grocer. The size of B's balance sheet would increase by X. In the end, A borrowed $X from B and lent as much to the customer, which is also balanced. "

      Lavoie (labels D and B were renamed to B and A):

      "Let us assume that there are two banks [...] At the end of each day, Bank [B] realizes that the cheques drawn by its customers in favour of the customers of Bank [A] are in an amount that exceeds the cheques drawn the other way. [...] If Bank [B] consents to grant loans to Bank [A], the accounts will balance. [...] "

      ECB-Watch:

      "If deposit rate is zero, for A and B to both be in business, B must lend to A at a rate inferior than that at which A lends to the customer."

      Lavoie:

      "The two banks A and B need only make sure that they agree on a rate of interest that will be profitable to both of them. In other words, the interbank interest rate, i.e., the rate of interest charged by Bank B to Bank A on the amounts due must be somewhere in between the rate of interest on deposits, which Bank B is paying to its depositors, and the rate of interest on loans, which Bank A is charging to its borrowers."

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    6. "The purpose of this chapter is to help teachers in presenting the main features of a modern financial system."

      This is intent, not approach.

      "As for "he does not build a modern monetary system from the ground up" here's what Lavoie writes in the same paper:

      "T-accounts [...] will be presented in a systematic way, starting from the simplest pure credit economy [...] Complications will be
      gradually introduced, such as [...] central bank""

      Which says that rather than building the system from the ground up, he is building the system by starting with a highly simplified and artificial system and adding features that are present in real world system in an effort to arrive a system that describes the real world system.

      Your "challenge" ignores the fact that your PB system is drawn from a step in Lavoie's development that does not yet accommodate government spending and revenues. So you are challenging people to show that in a system with no government spending and revenue, government is not revenue-constrained.

      But in that artificial system, it CANNOT BE revenue constrained, since it has no revenue to constrain it.

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    7. Lavoie: "Will the situation be any different if Treasury bills issued to pay for government expenditures or deficits are sold directly to the central bank, as the neo-chartalists would generally put it? The answer
      is no, ultimately it will not."

      This is after the central bank has been added to his formal system. The question cannot be asked before then, since before that point, in the formal system, there is no government spending and government receipts, since in the real world system that he is moving toward, those both involve the Central Bank.

      Not all real world monetary systems in history have been Reserve Bank systems, but none of them have ever been PB systems as defined by Lavoie. Asking whether government is revenue-constrained in the PB system is a category mistake, since the PB system is not yet a system which can exist in the real world.

      The PB is, of course, not a benchmark system. It is a pedagogical system which addresses the teaching challenge that one cannot understand how a system works as a system without an understanding of the complete system, and the modern system is complex enough that its difficulty to find a place to start. So rather than start out with the complete real world system, he starts out with a highly abstracted system that exhibits a few features of the real world system, and then adds additional element to elaborate the system, until he reaches a system that he argues is an effective model of the actual real world system.

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    8. So, basically your challenge is: "after forming a simplified abstract model of the monetary system, stripping out the mechanisms by which government spending and revenue actually interacts with the monetary system, I challenge you to show how government spending and taxation interacts with the monetary system."

      Did you imagine that Lavoie is lying when he describes the sequencing of the system elaboration? "Complications will be gradually introduced, such as competing private banks, a central bank and its reserve requirements,and then, at a later stage, the State with its financial requirements and its issues of government bonds. (1)"

      Or that he makes the following assumptions in his initial one bank model for no reason? "Whatever the case may be, we assume that the State has no budget, and hence that it spends nothing and taxes nothing. (1)"

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  5. "intent, not approach."

    Well, actually, he didn't say 'intent' but 'purpose', and you're fabricating a controversy out of thin air. Same with this:

    "Which says that rather than building the system from the ground up, he is building the system by starting with a highly simplified and artificial system and adding features that are present in real world system in an effort to arrive a system that describes the real world system."

    You and Mitch are incapable of abstract reasoning. A model does not have to have a correspondence in the real world at present to be considered coherent. Call it an 'alternate reality' if that helps. It is the reality that would prevail if the EndTheFed had its way.

    "Your "challenge" ignores the fact that your PB system is drawn from a step in Lavoie's development that does not yet accommodate government spending and revenues. "

    R U saying there's a bank but no customers? The government is but one customer. It's ironic that you accuse my choice of model(s) not to conform to reality, but my street smart reference to loan officer assessing a loan in relation the application's revenue stream—is completely dismissed. You can think on your feet.

    Feel free to add a government that spends and tax as per your definitions, as long as it's clear and concise, in the pure banking model. For the nth time, the challenge is open ended. Stop pretending it is not.

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  6. Also have a look at my post at Tumblr: 'Whelan CB liability is just notional'

    http://ecb-watch.tumblr.com/post/30339717095/whelan-cb-liability-is-just-notional

    Excerpt:

    "Let me try to demystify even more the issue, at the risk of introducing very imperfect analogies. Say ‘reserve’ is sugar and ‘credit in the economy’ is lemonade. In the beginning, free markets reign, firms grow sugar they need to manufacture lemonade they sell to the general population.

    Analogy to ‘interbank free market’:

    When firms have an overstock of sugar, they sell it to those that are in short supply.

    Analogy to Federal reserve controlled interbank rate:

    The ‘Federal Sugar Act’ is introduced whereby a government body has monopoly of sugar production. It can now set the price of sugar and, through it, influence the price of lemonade. "

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