Friday, January 20, 2012

Unvanishing the Vanishing Dollar

Lots of good stuff going on right now making it difficult for me to blog. However, I wanted to highlight this conversation I had with the Internets about private sector savings and federal deficits.

Yglesias: ""A path to an increased national savings rate over the long-term that opens with a gigantic increase in public sector debt doesn't make any sense.""

ApeMan: Actually, it does! I don't favor a cut in the capital gains rate for fairness reasons, but in fact public sector deficits are the ONLY source of net financial savings by the private sector.

Private sector saving equals, to the penny, public sector deficit. The only source for net financial saving is money creation by the currency issuer.

This is the piece of information that is preventing you from understanding economics, Matt. You MUST think about it and try to understand it. If you don't the confusion you sow will continue to offset the good work you do. It's really critical.

This is why it's misleading to think of deficit spending as "borrowing." It isn't - not really. It's the creation of net financial assets.

Here's a simple way to think about it in lay terms. The federal government creates a certain number of dollars in a given year. Some of those dollars are accumulated by foreigners - that's the trade deficit. Thus for savings by Americans just to get to zero, the government has to create dollars (deficit spend) equal to the level of the trade deficit. For Americans to actually accumulate net dollars (save money) the government must create a number of dollars GREATER THAN the level of the trade deficit.

The government does not, of course, borrow these dollars from anyone. It just creates them. If it creates fewer net dollars than are sent overseas, Americans wind up with less savings. If it creates more than are sent overseas, Americans wind up with more savings. It's so simple, as I think Galbraith wrote, that the mind recoils from it.

Steve: I don't understand, ApeMan. I thought money is created by people and corporations who borrow from banks.

ApeMan: Money is indeed created by bank loans. However, when a bank loan creates money it also creates a corresponding private sector liability (the note itself), so the total operation nets to zero. Total private savings are unaffected.

When the currency issuer creates a dollar, no corresponding private sector liability is created, so the total operation has a net positive impact on private sector savings.

This sounds complicated but in fact it's quite simple - when you borrow money from your bank, you wind up with two accounts, a deposit account (positive) and a loan account (negative). When you get a check from the federal government, you wind up with one account, a deposit account (positive.)

The government's account with the Fed is debited, of course, but the government's account with the Fed is purely notional - the federal government doesn't have "savings."

In a way it's actually easier to understand if you look at the way it used to work. Banks used to create their own money, such that when you took money out of your bank it would say "Bank of America Note" on it instead of "Federal Reserve Note." Banks had various agreements about honoring each other's notes.

Eventually everything was standardized when the Fed declared that notes issued by legitimate banks would clear "at par" with federal reserve notes, at which point there was no longer any need for individual banks to issue their own notes. That's why now we just use nothing but federal reserve notes.

The only downside is that it's harder to demonstrate conceptually that some money is "bank money" and some money is "state money" since now it all looks and acts the same, regardless of where it originated.

The one key is: bank reserves - and thus savings - are still always state money. That's why deficits are the norm for modern governments. It's a feature of the system, not a bug, and present deficits do not necessitate future tax increases. It's a misconception.

LD: Why would 'net private sector savings' be zero?

ApeMan: Imagine I'm the currency issuer. I issue $100 in notes. Now people have $100 in savings. Then at the end of the quarter I tax them back again. Now people have $0 in savings.

LD: That would only be if the tax equaled the entire money supply, but maybe I'm not understanding your argument.

ApeMan: No, the money supply is the total amount of money in existence, not the NET money in existence. Savings is net money. The private sector can't create savings by borrowing, obviously.

To extend the example, I'm the currency issuer and I issue $100 of state money. Bank A now has $100 of reserves and a deposit account in the amount of $100. Now Bank A makes loans in the amount of $100, so now Bank A still has $100 of reserves but it has $200 in deposits ($100 in bank money, $100 in state money) and $100 in loans.

The total NET savings in the economy is still $100, no matter how much money Bank A creates by lending.

LD: If I might adjust your example?

Currency issuer issues $1000 at $100 each to 10 banks.

Banks loan out with 10% reserve, implying a total money supply of $9000. Let's say the banks make 5%, for a total profit of $450.

On tax day, Gov'mint takes 10%, $45, and spends $45.

First, you assume money supply=tax rate or government expenditure. Second, even if the net savings is '$100', or $1000 in my scenario, this is not dramatically affected by the tax imposition such that "money injected into the economy by the federal treasury would be taxed back out again"

ApeMan: Right but you're confusing yourself by equating "savings" with "money." Savings is NET money, not total money. Total money is only slightly affected by taxation because most money is bank money. But ALL net money is state money.

The easiest way to see it is to look at the POV of the customer of the bank. He can take out loans in any amount the bank will allow, but his net position will still be zero unless and until he gets a check from some outside entity. if you aggregate the entire private sector together, obviously the only remaining outside entity is the currency issuer.