Stock-flow consistent macro models

http://bilbo.economicoutlook.net/blog/?p=4870

Many readers keep calling for my views on Austrian economics. Apparently when pushing the modern monetary view they get hit with a barrage of Austrian school criticism along the lines that statism is dread and that by privatising everything you will improve the human condition. My first thought when I get E-mails like this is to wonder where my readers hang out in their spare time! I wasnt aware that the Austrian school was anything more than a cobbled together bunch about as large as the modern monetary school (laughing). Anyway, I am taking the request seriously and as a start I present some background some modern monetary armaments. We are going to war. The Austrians claim that they predicted the crisis etc is nothing more than recognition that their major hypothesis is that anytime the government is involved in the economy eventually things turn sour. So eventually, given that economic activity cycles, you are going to be correct. However, their understanding of the way the fiat monetary system operates is nonexistent. More on the another time. For now, this blog introduces what is called stock-flow consistent macroeconomic accounting structures. It is based on a paper I wrote last year with James Juniper called There is no financial crisis so deep that cannot be dealt with by public spending. It is at the pointy end of my blogs and wont appeal to all. But if you really want to start understanding the quality of modern monetary theory then stock-flow accounting is a good place to start. What this framework allows you to understand is why the prevailing orthodoxy in macroeconomics has failed. The framework shows you that the mainstream belief that markets self-equilibrate at levels that are remotely socially acceptable is erroneous. Markets do not self-regulate in ways that avoid major financial upheavals and these crises have profound impacts on the real economy. In particular, the body of literature that is built upon the belief that fiscal policy should only be a passive support to an inflation targeting monetary policy is shown to be highly damaging to the long-term growth prospects of modern monetary economies. The current crisis confirms that the only way that the non-government sector can save is for the government sector to run continual budget deficits. The stock-flow framework allows you to understand why this fiscal conduct is non-inflationary and, if managed properly, exerts downwards pressure on nominal interest rates and underpins full employment. To understand how the modern monetary economy operates we need to take a step back into national accounting. First, a modern monetary system has three essential features:

A floating exchange rate, which frees monetary policy from the need to defend foreign exchange reserves). A sovereign government which has a monopoly over the provision its own, fiat currency.

Under a fiat currency system, the monetary unit defined by the government has no intrinsic worth. It cannot be legally converted by government, for example, into gold as it was under the gold standard. The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.

Within a modern monetary economy, as a matter of national accounting, the sovereign government deficit (surplus) equals the non-government surplus (deficit). The failure to recognise this relationship is the major oversight of neo-liberal (and Austrian) analysis. In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. The sovereign government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment. Additionally, and contrary to neo-liberal (and Austrian) rhetoric, the systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings. The decreasing levels of net private savings which are manifest in the public surpluses increasingly leverage the private sector. The deteriorating debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity. So you have to trace the private indebtedness back to the conduct of the government sector. The analogy neo-liberals (and Austrians) draw between private household budgets and the government budget is false. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained. With that in mind, modern monetary theorists develop a theory of unemployment based on the conduct of fiscal policy (compare that the Austrians who emphasise excessive real wages). In a fiat monetary system, unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income. Involuntary unemployment is idle labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save. This is a fundamental mistake that neo-liberals (and Austrians make).

Stocks, Flows and Loanable Funds

Economics is the science of confusing stocks with flows. Michal Kalecki What is the market of loanable funds? It is supposed to be the market that equilibrates the demand for savings with the demand for investment. But if such a market existed, it would be a market for flows, not stocks. However the bond market is a market of stocks. The capital market is a market for stocks. Both bonds and capital persist across periods and can be re-sold. Everyone who owns a bond (or who owns capital) is a potential supplier of bonds or capital at some rate. Everyone is also a potential demander of bonds or capital at some rate. As the interest rate changes, some suppliers become demanders, so that at equilibrium, supply (of the stock) is equal to the demand (for the stock). This is the equilibrating process for stocks that can be re-sold by their current owner in any period. But lending and investment are the derivatives of these quantities with respect to time they are flows. Can the interest rate equilibrate both flows and stocks? A flow of investment say capital goods producing firms or borrowing leaves the current period stock of capital or bonds unchanged, but the growth rate of these stocks changes. In future periods, there will be a greater stock of capital or bonds as a result of an increase in the flow of investment or borrowing. And we can imagine that there might be a demand for a flow of savings or a demand for a flow of lending. As a simple example, suppose that all bonds are consols to avoid issues with changes to the quantity of bonds due to bond repayment. The equivalent assumption for capital would be no depreciation. In that case, let capital will be be the total quantity of bonds or capital. Then the growth rate of bonds or .

If the rate, is such that the quantity of bonds demanded is the quantity of bonds supplied:

So that

or

Similarly,

Where

are the interest-elasticities of supply and demand (for the stock). , so dividing both equations yields:

At the market clearing rate, we have

Therefore the interest rate that equilibrates stocks will only equilibrate flows in one of three special cases: 1. Supply and demand for flows is zero ( ) 2. The interest-elasticities are zero ( ) 3. Flows are stocks. I.e. all capital depreciates to zero instantly and all bonds are repaid instantly. None of these assumptions hold in any economy. Nor is plausible to believe that they should hold in simple models. Therefore the interest rate can only equilibrate the level (stock) of bonds or capital so that at that rate, agents are just as likely to buy the capital from someone else as they are to sell it to someone else. But interest rates cannot clear flows they cannot clear lending and borrowing, savings and investment. The flows will be whatever is profitable at the rate, which may not be what is demanded at that rate.