Monetary Realism

Understanding The Modern Monetary System…

The Accounting Quest of Steve Keen

Economics stands before a summit whose existence it is largely oblivious to. It can’t see the mountain because of a self-imposed fog. It sneers in the general direction of the summit, without really understanding what it is sneering at.

One great exception to this is the book:

‘Monetary Economics’ by Wynne Godley and Marc Lavoie

These authors have scaled the summit in question. They have demonstrated skills that are too rare in economic thinking – first, they are very knowledgeable in the detailed logic of financial and macro level accounting, and second, they understand the fundamental importance of accounting to economics. The idea of accounting “closure” resonates throughout the book. It is at its core the simple idea that balance sheets connect to each other through double-entry bookkeeping over space/time, with the facility of consistent income and flow of funds accounting as the required linkages for change. It acknowledges and uses the powerful logic that accounting is not just a rear view measurement device – it is also a constraint on all forward looking projections of economic outcomes – meaning that it is an important condition in the substance and shape of good economic analysis. If economics were to become fully congruent with real world observation, such a book would be viewed as ground breaking for the precision with which it weeds out some notable mainstream economic fallacies. And that might help pave the way for what should be a more cohesive fusion of accounting, finance, and economics as a connected and interdependent set of disciplines.

There is no short cut to head-on recognition of the importance of accounting to economics. There is no rationale for departing from the correct logic and method of double-entry bookkeeping as it exists – no reason to “spice it up” with creative but anomalous departures from what it actually is. Double-entry bookkeeping is not “a work in progress”. It is what it is. The neo-classical concepts of exogenous money and the money multiplier and loanable funds and ISLM and supply/demand equilibrium are part of the fog within which mainstream has constructed some economic imagery that is in fundamental conflict with the facts of accounting logic and real world financial measurement. This is all documented pretty cogently in ‘Monetary Economics’.

Another economist, Steve Keen, is attempting to scale the same summit from a different angle, although he writes reluctantly about having until recently “avoided the dry and dusty topic of double-entry bookkeeping”. Steve has written a post on quantitative easing, with an admirable bent towards the importance of accounting in that context:

Steve Keen: Is QE Quantitatively Irrelevant?

He says, “I’m open to correction that I’ve wrongly characterised what banks do or how QE works here.”

I think there is definitely a range of mischaracterizations in Keen’s post about how the banking system responds to QE in both operations and accounting.  So I’m going to offer some comments, as invited. While his construction departs from the actual case, I do have respect for the general direction of his pursuit.

As backdrop, there is a systematic tendency in the blogosphere and elsewhere to misrepresent the impact of QE in a particular way in terms of the related macroeconomic flow of funds. Keen has made this sort of error. Most descriptions will erroneously treat the macro flow as if banks were the original portfolio source of the bonds that are being sold to the Fed, obtaining reserves in exchange. This is not the case. A cursory scan of Fed flow of funds statistics will confirm that commercial banks are relatively small holders of bonds in their portfolios, especially Treasury bonds. The vast proportion of bonds that are sold to the Fed in QE originate from non-bank portfolios. The functional role of banking in this context is to act in effect as a broker of bonds between these portfolios and the Fed. Many descriptions of QE instead erroneously suggest the strong presence of a bank principal function in which bonds from bank portfolios are simply exchanged for reserves. In fact, for the most part, while the banking system has received reserve credit for bonds sold to the Fed, it has also passed on credits to the accounts of non-bank customers who have sold their bonds to the banks. This is integral to the overall QE flow of bonds.

It is also the case that many writers when explaining bank reserve operations have a propensity to overlook the banking system’s critical role as the original distributor of Treasury bonds to non-banks. Most bonds issued end up in the portfolios of non-banks, not banks. The QE function that is the subject here may be viewed as a “reverse distribution” version of that flow, or a gathering up of bonds that are sold to the Fed (although not back to Treasury) mostly from non-bank end holders. In both cases, commentators often overlook the end points of the flows that define the true macroeconomic distribution effect of such Treasury bond flows.

Given this acknowledgement of the full span of the QE bond transfer, it must accordingly be the case that the Fed’s activity in outright purchases of bonds in QE is most often associated with banking system reserve creation AND bank deposit liability creation, since for the most part it is non-bank portfolios that are ultimately affected by these bonds transactions.

Thus, it is incorrect to suggest as Keen does that QE has no effect on the broad money supply. But the effect that it does have occurs through a mechanism that has nothing to do with the erroneous textbook “multiplier” explanation of deposit expansion. Rather, it reflects the more or less immediate bank deposit liability impact that occurs in conjunction with QE reserve expansion. Because most of the bond flow into the Fed does not originate ultimately from bank held bond portfolios, it must be the case that reserve expansion is offset elsewhere on bank balance sheets. The first instance of such an offset is on the liability side of banking, simply because ultimate sellers of bonds are receiving money credits for those bonds.

This dynamic may not be so obvious in the observation of macro statistics during the financial crisis and the overall period of QE. That is because the bank deposit liability effect of reserve expansion during QE has occurred against a backdrop of general deleveraging of bank balance sheets. Thus, cumulative QE has not necessarily shown up at all times in equal amounts of additionally robust net growth in bank deposit liabilities. Loan repayments in the process of deleveraging and other balance sheet processes such as bank recapitalizations, have had the effect of reducing some bank deposit balances in a way that might not have been the case in the absence of a financial crisis.

In fact, the effect of QE has been to provide the banking system with a considerable replenishment of deposit liabilities that would otherwise have been lost or at least grown more slowly in the counterfactual case without QE. The counterfactual case in the midst of the financial crisis would likely have involved an initial vicious deleveraging of the size of the banking system balance sheet, where absent the injection of QE reserves on the asset side, there might well have been a more damaging outright contraction of deposits on the liability side.

When depicting QE in his computer program ‘Minsky’, Keen introduces a strange form of repo accounting on bank balance sheets. This accounting is incorrect. It simply does not exist in the real world – not as a direct feature of QE transactions in the way he has described. The most detailed dissection of such a complex accounting distortion would be more complicated than is warranted here. But here are some of the basic points concerning what he seems to have constructed:

First, as noted, most of the QE bonds are sourced ultimately from non-banks, so repos appearing as bank liabilities would not be an issue even if the accounting were correct, which it is not.

Second, the Fed purchases bonds outright in QE. There is no repo activity as a direct feature of such purchases. There is no repo commitment on the part of the Fed to sell bonds back to those who provided them to the Fed, and such repos do not show up in either the micro or macro level accounting for QE bond purchases by the Fed. In fact, the Fed will decide if and when it wishes to sell back its QE bonds to the private sector as a function of a QE “exit” strategy. Moreover, many of the bonds may end up being matured on the Fed’s balance sheet instead of being sold back. So it will be the Fed’s option to sell in the case of both the occurrence and the timing of any such exit transactions. There is no legal or economic obligation, as is the case with actual repo transactions. Thus, the repo entries that are presumed in Keen’s presentation are quite erroneous as a reflection of reality. And he has compounded this accounting error with respect to the repo entry on commercial bank balance sheets by first creating a repo liability as the offset to an increase in QE created reserves (which is wrong), and then forgetting that under his own assumptions there is first a decline in bank holdings of bonds due to the QE sale of bonds from bank trading inventories into the Fed, which requires a single accounting entry as an asset reduction in its own right. Triple entry accounting doesn’t work.

In fact the accounting and operations that correspond in a correct way to what actually happens in QE are very straightforward, involving the transfer of outright ownership of bonds, the creation of bank reserve credits, and in most cases the creation of deposit liability credits, as described above. To insert a convoluted imaginary repo sequence in the midst of this quite normal bookkeeping is simply to distort the case of actual operations and accounting treatment for QE.

(It is worthwhile noting that the operations of the Fed in a normal, non-QE environment include the outright purchase of bonds in conjunction with the secular growth in banknote liabilities on the Fed’s balance sheet. Commercial bank customers who go to their banks to get banknotes pay for them with commercial bank debits to their deposit accounts. Banks pay for their purchase of those banknotes from the Fed with central bank debits to their reserve accounts. This typically creates a shortage of reserves in the system (i.e. in pre-crisis, pre-QE monetary mode). The Fed, in order to control interest rate levels, re-injects reserves into the banking system by purchasing bonds. The end result is that assets and liabilities on the Fed’s balance sheet expand together – newly acquired bonds along with newly issued banknotes. Given that the location of most of the end-sellers of bonds in the case of banknote expansion is the same as it is for QE (non-bank portfolios), it is also the case that the Fed’s purchase of bonds in the case of banknote liability expansion tends to replenish the deposit liabilities that were extinguished as a result of the original purchase of banknotes by the public.)

In reference to the issue of repo in general, we should emphasize that repo is obviously an important institutional element in the macro flow of funds. But it is not central to the Fed’s balance sheet when viewed in quantitative (stock) terms – in either regular or QE monetary environments. In fact, Fed system repos – which provide funds to the system and which would be the natural location of any Fed repo activity directly associated with QE asset expansion, currently track at roughly $ zero, due to the massive QE reserve liquidity position of the banking system, and the corresponding absence of any material requirement for Fed repo activity (in quantitative stock terms) for purposes of fine tuning system reserve levels. The fact that the Fed now pays interest on outsized excess reserve balances that have been created by QE means that such repo activity is no longer a critical adjustment mechanism for excess reserve management as is the case in normal non-QE environments. But we should hasten to add that even in non-QE environments, the outstanding balance sheet stock of Fed repos is not a material presence when compared to the stock of outright held bonds and corresponding banknotes issued, as described above.

Third, we turn to what must now be noted as an accounting error of extreme proportions – which is that it is certainly not the case that the Fed draws on its equity account when it acquires assets. The Fed creates reserve liabilities as a result of the payments process that is used in the acquisition of assets. The phrase “loans create deposits”, which has become popularized in the endogenous money view of commercial banks, applies equally to the Fed in its own case of asset acquisition and reserve creation. The equity account is not touched in such a transaction, just as it is not touched when a commercial bank makes a loan and credits a deposit to the borrower’s account.

This type of accounting error is symptomatic of a misunderstanding of how an equity account works in the more universal context of double entry bookkeeping. The balance sheet equity account is where income accounting intersects with balance sheet and flow of funds accounting. At the margin, revenues and expenses on the income statement have incremental and decremental impacts on equity, respectively. These effects are summed up in periodic income accounting, resulting in a cumulative credit or debit to equity, depending on whether the result is a profit or loss for the period.

That said, the vast bulk of financial flows captured in flow of funds accounting (the purpose of which is to account for changes in the composition of balance sheets) has no direct effect on the equity account. Again, for example, the mere act of commercial bank lending and deposit creation, or Fed bond acquisition and reserve/deposit creation, is captured (as a flow) only in flow of funds accounting. This type of transaction does not touch the income statement directly and therefore does not touch the equity account directly. The blogosphere (including some economists), in seeking to understand the nature of macro flows, shows an occasional propensity to confuse these two basic, different accounting modes – income accounting and non-income flow of funds accounting. This is too lengthy a topic to pursue in more detail here, but some of us have pointed to this sort of error on a fairly regular basis in the past.

By way of contrast, the Fed does spend from equity (at the margin, via the income statement) when it pays for its own types of accounting expenses – salaries, purchase of regular goods and services in running its daily operations, and even payment of interest on reserves. These items are recorded as expenses on the income statement of the Fed.

And we should remember more generally of course that interest revenue and expense on the banking assets and liabilities that are first recorded in flow of funds and balance sheet accounting are then recorded as subsequent effects through income and equity accounting.

Steve Keen also notes his objective to establish a new definition for aggregate demand by equating it to income plus the change in debt. This entails embedded accounting confusion. Notwithstanding the evidence of impressive historic correlations and causal connections between changes in debt and economic outcomes, it is nevertheless incorrect to add income and flow of funds (i.e. a change in debt in this case) in any expression deemed to be an equation or an identity. Such an expression at best can serve as a regression function, in this case relating current period income to prior period income plus the change in debt. It includes accounting variables that are simply incompatible in an additive sense for an actual equation to hold, either during a single period of time or at a single point in continuous time. Income and changes in debt are orthogonal accounting measures. Flow of funds accounting where the balance sheet equity account is not involved (e.g. increases in debt) cannot intertwine indiscriminately with income accounting in any fashion that could be considered stock/flow consistent. Moreover, there is the problem that changes in debt may well be a source of finance used, not for spending as captured in NIPA, but for asset acquisition as captured only in the flow of funds accounts. This component of the use of funds in the economy has nothing directly to do with income accounting. Finally, the notion that there can be such a strict relationship in terms of income and the change in debt overlooks the fact that aggregate demand can fluctuate at times due to changes in money velocity, without necessarily involving changes in debt. In either case, it is potential and actual spending rather than a change in financial stocks or the utilization of existing stocks (i.e. money) that is inherent in the idea of aggregate demand.

I should note again that ‘Monetary Economics” by Godley and Lavoie is crystal clear and comprehensive in its appreciation of the differences between these two accounting modes, and of the importance of that distinction to the understanding of stock/flow consistent projections or scenarios for future economic activity.

There are other errors in how Keen combines his interpretation of repo accounting with some odd suggestions about equity account effects. The repo margin he anticipates (incorrectly in this case) could not in any case become an ex ante entry in the equity account. As a general rule, neither the Fed nor commercial banks are permitted to capitalize net interest margins attributable to their balance sheet positions in assets and liabilities. Interest margins are accrued to the income statement over time, and thence to the equity account (after allowing for other expenses) as they are earned. This again is another dimension of standard micro financial and macro level NIPA accounting, in which it is important to distinguish between marked-to-market asset values and what is known as accrual accounting for income and expenditures. Repos even when accounted for correctly earn an interest margin on an accrual basis. And even if repos were applicable in this case, accrual of earnings to banking equity actually decreases the money supply. It does not increase it. This is true of all equity accounting in the banking system. Money effectively converts from deposit liabilities to bank equity as bank profits are generated and credited to the equity account. This is the result of interest being charged to borrowers (who pay the interest from their deposit accounts) being greater than interest being paid to depositors.

Next, whether or not banks increase the money supply by expanding their balance sheets through the acquisition of equity securities is a rather random take on bank balance sheet management as it may be affected by QE. We should understand the broader truth of the basic (post Keynesian) insight that banks don’t lend reserves. Neither does the banking system transform reserves in any technical way into holdings of equity securities when acquiring such securities from non-banks. Both lending and securities purchases are flow of funds decisions that in themselves do not require system reserves, but rather are driven by risk assessment combined with bank capital allocation commensurate with that risk. The reserves are for payment purposes, and remain in the banking system when used to make payments. So, to the extent that bank reserves are a non-issue for lending, they are also a non-issue for the purchase of equities, with or without QE. Either of these activities can expand bank balance sheets, including deposit expansion on the liability side, and both require capital management in order to justify them as risk taking activities.

Moreover, in fact the U.S. commercial banking system’s holding of equity securities is minimal – less than $ 100 billion – and there is no evidence to suggest that QE has played any meaningful role in a decision for banks to expand their holding of equities in a material way. This makes eminent sense, in that equity securities are the riskiest financial asset class. Therefore, the fact that bank reserves play no role in either the analysis of risk or the allocation of required capital in making asset mix decisions holds a fortiori when comparing the case of equity security acquisition to bank lending. And, similar to the case for bonds, nearly all of the QE effect on the distribution of equity security holdings (in this case an indirect effect) will have been reflected in the distribution as it is observed mostly in non-bank portfolios.

Also, a repo account is in no way some sort of quasi-reserve position for bank lending, as seems to be suggested in Keen’s construction. One of the puzzling things about Keen’s model is that he seems to have built in a capacity to view banking system lending or buying equities as an alternative to holding reserves. This is very odd, in that it conflicts notably with the normal post Keynesian attitude to the functional role of reserves. The functional requirement for any form of risk taking through balance sheet expansion is capital, not reserves.

There are a few other minor and mostly optical points of error. Double-entry bookkeeping doesn’t record liabilities and equity as negative amounts. That particular sign orientation is used in an “adding up constraint” under a Godley/Lavoie matrix approach. In effect, the balance sheet is represented as a column vector of positive and negative numbers in such an approach, rather than two columns of positive numbers adjacent to each other, which is what is done in actual financial accounting. The purpose of the Godley/Lavoie matrix approach is to capture the fundamental accounting constraint whereby balance sheets must balance, in a way that translates to a vector form that sums to zero in such an “adding up” visualization. That is a convenient mathematical transformation of an actual double-entry bookkeeping visualization. Double-entry bookkeeping incorporates positive signs for assets and liabilities, so that assets equal liabilities plus equity. In particular, increases in equity (such as retained earnings) do not show up as a negative number in double-entry bookkeeping.

Finally, the Fed’s equity account in reality does not reflect “the value of its charter”. It is a standard financial account. It is the cumulative result of original capital injections and any retained income effects (which will be small due to remittance of Fed profits to Treasury). In fact, the equity account is where losses would be absorbed, should they occur, just as is the case with a commercial bank. That said, this “charter value” idea is a small point that is arguably not so important in the context of using a simplified model for the Fed balance sheet. Nevertheless, the factual operation of the equity account in the context of balance sheet, income and flow of funds accounting is an important general point of understanding.

I’ve already noted where I’d look for the highest standard of coherent accounting in the context of full macroeconomic modeling (Godley/Lavoie). Their book ‘Monetary Economics’ presents an integrated accounting and economic framework, featuring a rich supply of income and balance sheet simulations covering various types of economic behavior, where the outcomes are in full accordance with the actual accounting facts of the monetary system. I notice that Keen’s presentation includes something he calls the “Godley Matrix”. I tend to doubt that Godley would have employed the type of accounting that Keen is attempting to develop, an inference I come to naturally from reading the Godley/Lavoie book.

Steve did invite input regarding his method, and I’ve provided some here. More power to him in his pursuit of a robust post Keynesian oriented accounting emphasis, in the interest of advancing facts that need to prevail over neo-classical misconceptions that only obscure a factual view of the monetary system at work. But I suggest in the strongest way that the raw material to get such an effort on a solid footing already exists in an accounting framework that is well established in practice at both micro and macro levels.


A common reaction of mainstream economics to the suggestion that it has stumbled in the case of solid macro accounting requirements for some of its theory is for it to become rather snooty about the role of “the accountant” as a professional activity separate from economics. This is the sneering I referred to earlier. Such a purportedly “sophisticated”, self-elevating view avoids the substantive issue of how in various identified cases economic theory is simply not compatible with real world macro accounting closure requirements. Again, I refer the reader to Godley/Lavoie’s ‘Monetary Economics’ in order to get a sense of the full scale and meaning of this phenomenon.

Like Steve Keen, I am not, and never have been, an accountant.

Given a normal aversion to the excessive use of metaphors, I’ve refrained from expanding on the image of “the summit” with such bells and whistles as death zones, frozen bodies, reckless tourists, “into thin air”, and wise Sherpas. That would require an accounting extension of its own kind – which admittedly is quite tempting.



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  • Nick Edmonds

    Not to say it’s wrong to say something like “the policy rate is exogenous”; it’s just we mean it’s better to think of it that way.

  • JKH

    No – not wrong at all.

    In fact, that’s clean origin of it.

    Just that following that trunk split – rate versus reserve balances – the rest of the tree gets a little tangled when attempting to clarify how the exo/endo distinction manifests itself.

  • Ramanan

    Totally agree with you that it is moot.

    But the initiation part may have a history. So consider a purchase of foreign exchange by the central bank. It creates settlement balances in the accounts of member banks. In neoclassical literature, the discussion is then presented as two things: non-sterilized and sterilized – as if the central bank has a choice in initiating. So it is as if there are only two possibilities: central bank initiation or central bank doing nothing. But banks themselves may get rid of the excess reserves by contacting the central bank and the central bank may sell T-bills.

    I however don’t know the context in which initiation is used in QE. The Fed announces dates and quantities in advance and does a reverse auction. So I don’t know what the initiation from the other side is about.

  • JKH

    Exercising brain cells here in preparation for revisting GL – which has very interesting things to say about endogeneity – such as you point out on sterilization illusion.

    QE reverse auction? Don’t follow it that closely, but its an extension of OMO in terms of actual execution isn’t it? I.e. notwithstanding a pre-announced program, the Fed picks its spots and bids its price? Anyway, the choice to swap bonds for money is the seller’s – at a price – as is the choice to swap money for bonds by the Fed. The end-seller may not even be certain his bonds are the ones that are going into the Fed.

  • JKH

    And putting this all back into context, SK has some things to learn about QE and the creation of deposits through flow of funds – before asserting differential equations that are stock/flow inconsistent.

  • JKH


    Check out brilliant insight:

    Guess WM never thought about the Fed paying interest on reserves

    Or, more to the point, that paying a zero interest rate on reserves is a actually a choice, rather than a force of nature.

    Exogenous even.


  • Art Patten

    “Guess WM never thought about the Fed paying interest on reserves
    Or, more to the point, that paying a zero interest rate on reserves is a actually a choice, rather than a force of nature.”

    You’re kidding, right?

  • JKH

    His “natural rate is zero” argument is logically premised on there being no alternative to paying zero interest on reserves. That’s obviously false – not only as evident in what actually happened in QE, but also as evident in various monetarist proposals for negative interest rates on reserves. Zero is just another rate, between positive and negative. How is that kidding?

  • stone

    I took Warren Mosler to mean that the risk free interest rate represents an artificial scarcity that central banks choose to impose rather than being some manifestation of the innate value of deferring consumption that stems from the innate human psyche above and beyond any institutional influence (is that what “micro foundations” are supposed to be?).

  • Ramanan

    He should also try a new business of making shredders and post a video on that. How he got interested in it and things like that.

    The worst evidence about his theory of taxes paid in cash being immediately shredded by the tax man is him having met a person who shreds cash!!!

  • JKH

    natural rate of zero is premised on goosing the system with reserves, not paying interest on them, and letting rates go to zero

    again it misses the logic that not paying interest is a choice to pay an interest rate of zero

    and its based totally on the institutional feature of bank reserves in the first place, which is a function of the architecture for a competitive banking system

    if the system consisted of one nationalized bank, there’d be no bank reserves, and the state would be faced with the choice of what rate to pay on bank deposits – as a function of monetary policy

  • JKH


  • Ramanan

    “You’re kidding, right?”

    Mosler’s contention – and in which he thinks is what sets his Mosler Monetary Theory apart from anything else – was that the government is in a supreme position that it has an open line of credit at the central bank – as if there is no law preventing it – and the only reason it issues bonds is to prevent interest rates from falling to zero. 2008 arrives and it is clear that it was not right. The Treasury continues to issue bonds in spite of the fact that with the Fed paying interest on reserves and with a floor system short term rates can fall to the floor. If what he said was true that the “purpose”, or the sole purpose was to prevent interest rates from falling to zero, then the US Treasury could simply have stopped issuing bonds as soon as the Fed started paying interest on reserves.

    It is true that the government is in a supreme position in the money creation process but Moslerism is full of overkills to drive this point.

  • Art Patten

    Mosler/Forstater: “If the central bank has a positive target for the overnight lending rate, either the central bank must pay interest on reserves or otherwise provide an interest-bearing alternative to non-interest-bearing reserve accounts…Our main point is, in nations that include the USA, Japan, and others where interest is not paid on central bank reserves, the “penalty” for deficit spending and not issuing securities is not (apart from various self-imposed constraints) “bounced” government checks but a zero percent interbank rate”

    WTF is wrong with you guys? MR = Mosler Rejection (at all costs)?

  • Steve Roth

    @Cullen: “The question is whether the central bank determines the supply of broad money.”

    @Ramanan: “Wasn’t talking of the monetary base!”

    Right. I went somewhat off that rail.

    But when the Fed buys bonds from nonbanks it is certainlyaffecting the broad money supply (increasing bank deposits, [hence banks’ balance sheets, {hence Fed reserves}]).

    But the real point: is that increase in the broad money supply significant or material? Back to my previous semi-specious comment: QE only increases the broad money supply because the broad money supply is defined as not including treasuries. So the Fed swaps defined “money” for “non-money.”

    Does the real/nonbank sector have more “money” post-QE? Does it cause any wealth effect beyond the one we know about: driving up bond (hence equity) prices due to greater flow demand? (Much less any monetarist-style hot potato?)

    You could argue a la the FT Alphaville crowed that because reserves can’t be collateral-chained like bonds can (right?), there’s less “bank money” post-QE, compared to a non-QE counterfactual.

  • Art Patten

    Unbelievable. The guy, who doesn’t have a mean bone in his body as far as I can tell, realizes 20 years later that PR matters far more than he ever imagined. At the end of it all, an industry outlet interviews him about an innovative but ultimately failed venture. And that makes him what, a media whore? Is this still about Randy calling Cullen a retard, or what?

    F&#%ing ridiculous. All of it.

  • Steve Roth

    1. I don’t think it’s about who initiates a transaction, but about the Fed being willing to outbid the market. It’s not driven by profit motive. Banks are. So it can “force” the banking system to buy or sell.

    2. Been wondering for a while: when we talk about exo/endo, is it simply different (and arguably obscure) language for arguing about causes and effects?

  • Ramanan

    I am not sure of this FT Alphaville thing about collateral collateral collateral.

    A lot of vague analysis there. It is true that the repo markets observed the financial crisis more clearly than others … as if they were in the front seat of a concert … I really don’t know what FT Alphaville’s story is for recent times.

    QE does increase the broad money supply when the Fed buys the bonds. In a sense – as JKH mentioned – the counterfactual is no QE and you dismiss arguments about observed data because in the absence of it, broad money may have reduced.

    Hot potato process is to be distinguished from wealth effects of QE. The Wealth effect happens via capital gains which adds to the stock of wealth of households but the Monetarist hot potato process is supposed to happen at the flow level but in reality it doesn’t happen. Monetarists confuse income and money.

  • Art Patten

    That’s a little better, but I stand by my BS call @ JKH. That was utter nonsense. (And your paper shredder comment was a low blow.)

  • Steve Roth

    “Guess WM never thought about the Fed paying interest on reserves”

    Right. cf. My comment re: Soft Money Economics. Explanations about OMOs controlling interest rates via the interbank lending market are of purely historical interest. Doesn’t work that way any more, and won’t as long as banks hold (significant) excess reserves. It’s all IOR floor.

  • Ramanan

    “you dismiss arguments” … sorry meant that the observed increase in the money stock measures such as M1, M2 seems to suggest that the Fed’s asset purchase has no effect but balance sheet arithmetic suggests that. So you have to compare it with the counterfactual. More generally there are other mechanisms such as agents reducing their indebtedness to banks when the sell the bonds to the Fed and portfolio rebalance and things such as that.

  • Steve Roth

    Plus the transitory flow-demand effect of current Fed buying, and its choice of what maturities to buy affecting spreads.

  • Cullen Roche


    No one is out to get MMTers. They’re not the victims of a conspiracy theory by MRists. They’re the victims of their own sloppiness at times. Mosler’s shredder analogy is a perfect example of such sloppiness. In trying to promote the idea that “taxes destroy money” Mosler loves to use the shredder example. Except that the only problem is this never really happens in any real sense. Taxes don’t “destroy money”. Taxes are a redistribution of bank inside money. There is a very clear flow of funds that occurs in the system from the time of deposit creation to the time of taxation to the time of govt spending. There are not a series of starts and stops here where banks create money, then the govt destroys the money and then creates it again when they spend. That’s all just MMT creating their own story for how things work. And the shredder comment is a dangerous oversimplification that has actually helped convince a good deal of people that the idea is right. It’s not.

    MMTers aren’t the victims of a “gotcha” campaign by MR. They’re the victims of years of sloppy work and a theory that doesn’t exactly apply to the way the US monetary system works. Other PKers point it out not because we’re out to get them, but because this type of stuff is actually hurting the progress made by other PKers in helping the public understand PK positions. That’s all. It’s not personal and never has been.

  • stone

    I guess that Warren Mosler is taking the default state as being the system being “goosed” with excess reserves and the alternative state of bonds being issued and reserves being drained as being the active choice. To me that makes sense since bonds are an extra piece in the jigsaw so including them seems more active than not including them. Is paying interest on reserves more than just a payment to the banks? Is it much different from say providing all bankers with free rail travel?

  • Art Patten

    Cullen, that’s fine insofar as it goes, but by the same token, JKH shold be properly seen as the victim of his own sloppiness re his assertion about Mosler and IOR. And again, Ramanan’s shredder comment was a lower blow than Mosler deserves. Problems with the shredder argument? Fine. Ripping him for a pretty innocuous video about his interest in cars? Come on, man.

  • Art Patten

    And please, don’t attribute any conspiracy nonsense to me. All I’m doing here is suggesting that people put their ugly sides under wraps. We all know firsthand how ‘well’ that plays outside an inner circle…don’t we?

  • Cullen Roche

    I agree. Personal sniping should be left out of this. We didn’t start MR as a smear campaign against Mosler. In fact, I talk to Warren almost weekly and we’re more than cordial. He knows what we’re doing and he doesn’t take it personally. He disagrees with our position, but he doesn’t take anything personally. And I think that’s the way we should all view this. We’re all just debating ideas about how things work. Getting personal and calling people names just distracts from what we’re actually trying to achieve. So yeah, let’s put the ugly side under wraps. 100% agree.

  • JKH

    somebody should read what they quoted:

    “where interest is not paid on central bank reserves”

    as in – didn’t think about it at the time – and what actually happens when it becomes a live issue

    its not about mean bones

    its about the thesis presented

    no need to get so emotional over facts

  • Steve Roth

    @Ramanan: “More generally there are other mechanisms such as agents reducing their indebtedness to banks when the sell the bonds to the Fed and portfolio rebalance and things such as that.”

    Right. Fed obviously doesn’t “control” the broad money supply, but it certainly affects it. But I think that affect is 1. pretty small and 2. pretty immaterial (at least in the current situation?).

  • Ramanan

    I think it is difficult to prove one way or the other but IMO, the effect on equity prices is quite strong.

  • JKH

    And no problem if Wray wants to advertise Mosler’s financial genius together with showing car videos. I didn’t watch the video myself, but he seems to make great cars.

    Apart from that, there are a few people around who have understood for some time that when the central bank supplies reserves earning zero interest in excess of what is demanded, that the market rate heads in the direction of zero. That’s been the working premise of standard OMO for decades.

    So as an extension of that, the entire premise of a zero natural rate becomes pretty questionable, as described in more detail above.

    And this aspect is connected very much to the topic here of the interest rate being exogenous. So that’s the point. Just the facts. I’ll leave to others to assess whether or not that’s sloppy.

    And given that I said nothing derogatory about WM at all, you’re WAY too sensitive about all this, and too eager to victimize a great financial mind and car builder.

  • Steve Roth

    Right. Of course the effect of (temporarily?) boosted equity prices on investment and overall spending/NGDP is much less certain. See my yesterday wealth effect post.

  • Ramanan

    Yes agree.

    Even I had written about this sometime back

    Okay some general opinion without proof: I think the wealth effect is higher than most people think. I however think wealth effect due to capital gains may not have an immediate effect because people think the capital gains may not last. So only when they become confident that the gain is sort of permanent and there is less chance the asset price will fall, will they increase consumption.

  • Steve Roth

    Seems like this would be measurable, which is something that real social/behavioral scientists would do. But you know: empirics are so…messy compared to theory… I’m guessing some have tried to measure this, I just don’t know of it and the mainstream ignores it?

  • Ramanan

    I think they have tried to do some econometric tests and observe something like 0.04 which is actually low.

    I don’t know how they do it but my suspicion is that it is wrong. It is because in a model like G&L, in the equilibrium ultimately reached in *simple* models, propensity to save = 0. But propensity to consume is not 1 and there can be various combinations of propensities to consume out of income and wealth in which there is no saving in such a state.

    Also, higher wealth effect leads to lower public debt. In the extreme with low growth and zero wealth effect, the public debt should be very high which is not the case. Third, fiscal policy works very fast and the time-lag has to do with the wealth effect parameter.

    Something like that – a bit of hand-waving between pure theory and data.

  • Nick Edmonds

    A further complexity with the wealth effect, at least in the UK.

    Households hold very few government bonds directly, and a only smallish share of public equity. The majority of private domestic ownership is in pension funds.

    A wealth effect can still occur from an increase in pension fund values, but it’s likely to be much weaker. There’s a real effect in that higher fund values translate into higher pensions, but that obviously takes a long, long time to come through.

    The effect is also complicated by the fact that gilt yields are used to calculate annuity rates. So although asset values may go up, falling gilt yields depresses quoted pension rates. A fall in people’s expected pensions hardly leads to increased spending.

    The most likely source of a wealth effect in the UK is through the value of housing and, in my opinion, this is small but significant (notwithstanding your pie chart, Steve). However, the link from QE to house prices is an indirect one, given who holds what (funds holds gilts, but not housing; households hold housing, but not gilts).

  • Art Patten

    You should have been a lawyer. Maybe you and Carlos can switch careers? ;)

  • JKH

    Not a bad idea.

    I think Carlos may be quite partial to zero interest rates as well – especially those earned by banks.


  • stone

    Am I right in being under the impression that the fed (and bank of England and bank of Japan) does not now have the capacity to raise short term rates to say 6% for a sustained period. Doing that would entail paying out a massive amount of interest on reserves. Where would they get the money from to pay for that? If they sold of assets such as long term bonds to try and raise the money/drain reserves; the price of those long term bonds would fall so far that even if they were all sold there would still be a glut of reserves.
    If so, then I guess the central banks have lost the capacity to cause a classic “tight money recession” to keep wages down. Now it is down to speculators to cause a commodity price spike recession whenever the economy looks like picking up.

  • Fed Up

    Related to that, would that high of an overnight interest rate cause entities to start redeeming currency for demand deposits?

  • Fed Up

    I thought Keen said income plus change in debt = aggregate demand.

    Could Keen be trying to say something along the lines of Y “minus” financial assets including the MOA/MOE = C + Igoods ?

  • Steve Roth

    @JKH: watching my daughter graduate from u chicago. You will be happy to know that the commencement speaker is…an accountant!

  • JKH

    A good day for you and your daughter!

    But please remember that accounting and economics are both too important to be defaulted into the hands of their respective professions.

  • Michael Sankowski

    Congratulations Steve, that’s a huge accomplishment for her – and for you!