The Impotence of Monetary Policy

Bernanke's Jackson Hole speech was meant to give some insight into what the Fed might do in coming months. I think it reveals how powerless the Fed is in general, and how little it understands the economy it is meant to oversee.

The prospects for household spending depend to a significant extent on how the jobs situation evolves. But the pace of spending will also depend on the progress that households make in repairing their financial positions... But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.

Agreed. But then here are the policy options he puts forth.

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities

How does changing the term structure of Fed assets help households repair their balance sheet?

A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement.

How does the Fed saying different words help households repair their balance sheet?

A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System

How does lower IOER (already just 0.25%) help households repair their balance sheet? Actually, this seems to make things worse, whereas the others have simply been irrelevant.

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability.

And what mechanisms does the Fed have in place to help it achieve its "medium-term inflation goal" regardless of where that goal is set?

What's happening is that, in a time of over-indebted households and weak aggregate demand, workers are simply losing their jobs and remaining unemployed. While unemployed, they draw Government benefits, and thus maintain some baseline level of consumption, avoiding 1930s style debt deflation. At the same time, this large pool of unemployed workers mean businesses can keep wages down, sell into what Government supported aggregate demand is there, and pocket the rest as profits.

The big lever here is fiscal policy -- announce a payroll tax holiday, and let households actually repair their balance sheets.

UPDATE: In the meantime, low interest rates take income out of the economy. Their net effect is very unclear.

Do Bush's tax cuts help restaurants?

Recently, I wondered where the marginal unit of aggregate demand comes from to guess at what impact raising taxes on the rich might have. In comments, JKH wondered how much marginal AD came from luxury items such as yachts etc.

The top 3% by income in the US make approximately $200,000 to $249,999. Not bad, but not investment banker money either. Two college educated professionals with technical degrees in mid-career, or a single lawyer fairly senior in his firm, or specialist MD, could make that by themselves. The question them becomes, how much does this group eat out at mid-end restaurants?

Bush's tax cuts

One general question about tax cuts is, where does the marginal unit of aggregate demand come from? One argument says that you give it to the poor, as they spend most of their income. Another argument says that you give it to the rich, as they have more discretionary spending, and so control marginal aggregate demand.

Here's some thinking on that topic from Mark Zandi.

In most times, raising taxes on the wealthy by such a modest amount has had little impact on the economy. But these aren’t most times. The well-to-do appear unusually sensitive to changes in their finances, probably because their nest eggs are significantly smaller with the drop in stock and housing prices. Only the top 3 percent of households would have to pay higher taxes if the president got his way, but this rarefied group currently accounts for a fourth of consumer spending. If they pull back, even a bit, the recovery could be derailed.

Consumer spending makes up about 70% of the economy, so that 3% of households generate about 20% of total AD.

The impotence of monetary policy

This post by Krugman sums it up. It's a pity things are even worse than he suspects:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns
subside”? Krugman (1999) and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.

…

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed
skepticism that simple announcements can have any effects on expectations.

OK, so say the BOJ or Fed announce a higher inflation target. Now what? Inflation means higher price levels, and for a price, you need a transaction. Announcing a target does not create a transaction, and therefore, does not influence a price. The BOJ's concerns that their credibility is on the line are right on -- the standard monetary mechanism (overnight interbank interest rates) has no impact on prices.

Unconventional monetary mechanisms, like changing other rates, have no impacts for the same reason. The only thing that has impact are transactions, a transfer of nominal assets from the Govt to the non-Govt sector. And this is fiscal policy, not monetary policy.

RIP: Google Wave

Last year, I remarked that Google Wave reminded me of Lotus Notes. Ouch.

This year, thankfully, it's been killed.

The article lists the usual excuses engineers give to a product they built that fails: "lack of a decent marketing campaign", "ahead of its time", etc. etc. I think the main issue was that it didn't solve a real human problem.

Capital Constraints at the Margin

Macroeconomic Resiliance thinks that new firm entry means that banking, at the sector level, is not capital constrained.

A popular line of argument blames the lack of bank lending despite the Fed’s extended ZIRP policy on the impaired capital position of the banking sector. For example, one of the central tenets of MMT is the thesis that “banks are capital constrained, not reserve constrained”. Understandably, commentators extrapolate from the importance of bank capital to argue that banks must be somehow recapitalised if the lending channel is to function properly as Michael Pettis does here.

The capital constraint that is an obvious empirical reality for individual banks’ does not imply that bank bailouts are the only way to prevent a collapse of the monetary transmission channel. Although individual banks are capital constrained, the argument that an impairment in capital will induce the bank to turn away profitable lending opportunities assumes that the bank is unable to attract a fresh injection of capital. Again, this is not far from the truth: As I have explained many times on this blog, banks are motivated to minimise capital and given the “liquidity” support extended to them by the central bank during the crisis, they are incentivised to turn away offers for recapitalisation and instead slowly recapitalise by borrowing from the central bank and lending out to low-risk ventures such as T-Bonds or AAA Bonds.

So the bank capital “limitation” that faces individual banks is real, in no small part due to the incestuous nature of their relationship with the central bank. But does this imply that the banking sector as a whole is capital constrained? The financial intermediation channel as a whole is capital constrained only if there is no entry of new firms into the banking sector despite the presence of profitable lending opportunities. Again this is empirically true but I would argue that changing this empirical reality is critical if we want to achieve a resilient financial system.

I would disagree. A bank knows what its cost of capital is. A bank should be able to estimate what the profitability of a new loan should be. Therefore, practically speaking, the constraint is whether the marginal profitability of the loan more than compensates for the marginal cost of capital that needs to be set aside in order to make that loan. So a bank many have plenty of capital but still not make loans if it feels they will not be profitable.

University Websites

A great cartoon by xkcd on University websites.

What's funny is that regular corporate websites looked exactly the same ten years ago. In general, they are better now though.

Blast from the past

Back in 2007, Arnold Kling wrote:

Finally, Zimran Ahmed writes,

I think one inevitable requirement of unwinding the housing bubble market is that housing prices have to come down to fall in line with historic trends. In some areas this means very dramatic decreases -- maybe 40%+ in real terms? I'm not sure what a "deflated housing bubble" would look like if it did not bring prices back to historic norms.

I'm sorry, but unless by "some areas" you mean areas the size of a 9-digit zip code, we're not going to see 40 percent declines in house prices.

While all areas certainly have not declined by 40%, some areas considerably larger than a "9-digit zip code" have.

Bush tax cuts and the Quantity Theory of Money

The Bush tax cuts are set to expire, and it doesn't look like the Obama administration will intervene to extend them. I think this is a mistake.

The Quantity Theory of Money states:

where

MV=PQ

M is quantity of money.
V is the velocity of money in final expenditures.
Q is an index of the real value of final expenditures.
P is price

As an example, M might represent currency plus deposits in checking and savings accounts held by the public, Q real output (which equals real expenditure in macroeconomic equilibrium) with P the corresponding price level, and the nominal (money) value of output. In one empirical formulation, velocity was taken to be “the ratio of net national product in current prices to the money stock”.

Thus far, the theory is not particularly controversial, as the equation of exchange is an identity. A theory requires that assumptions be made about the causal relationships among the four variables in this one equation. There are debates about the extent to which each of these variables is dependent upon the others. Without further restrictions, the equation does not require that a change in the money supply would change the value of any or all of P, Q, or . For example, a 10% increase in M could be accompanied by a 10% decrease in V, leaving unchanged. The quantity theory postulates that the primary causal effect is an effect of M on P.

The postulation is wrong. V changes dramatically with propensity to spend, or not spend. Not spending is the same as "saving".

Those with low incomes have very little discretion in their ability to spend or not spend. They need to spend most of their income every week just to get by. Those with high incomes have more discretion in their ability to spend or not spend. Their savings rates are much higher. Moreover, if you look at after tax consumption, you'll find that inequality is much lower than pre-tax income. This is due to transfer payments, progressive taxes, and the difference in saving.

The Bush tax cuts operate at the Federal income level, and therefore can only impact those with high incomes, as Federal Income taxes are primarily paid by high income households. Therefore, an increase in the tax rate at that segment may have the largest impact on their propensity to save, and therefore V.

This recession is primarily caused by a fall in V that has not been made up by an increase in M. Fed actions have changed the composition of M, but not its quantity. The increase in quantity has come from fiscal deficits.

Debt is not a transfer

In this post, Interfluidity talks about how the real sticky price in the world isn't labor, it's debt. This is correct, and is at the heart of Fisher's debt-deflation theory. Fisher's an interesting guy, because after losing all his money during the Great Depression, he actually changed his mind about how the economy works.

In the comments, Nick Rowe jumps in with the standard economic position on debt:

Suppose that last year, I borrowed from you, and promised to pay you $100 this year. Sure, that $100 is “sticky”. But it’s not a price. Last year it was a price (the price we negotiated when you gave me the loan), but it’s not a price this year. It’s not a price like the price of labour or the price of cars. The price of labour or the price of cars affects how much labour or cars we decide to buy or sell at that price. And if those price are sticky and get out of whack that can create excess demand or supply of labour or cars. But that $100 I owe you is a transfer payment. It’s like a welfare payment or social security check. The decision it affected has already been made, last year. It cannot any longer create excess demand or supply, though it could have done last year, if it had been sticky last year. What it does do is transfer resources from me to you. It affects the distribution of wealth. It’s not a measure of the scarcity of goods that people are currently deciding to buy or sell.

This position is incorrect. First, an outstanding loan is not a "transfer". When a bank makes a loan, money is not "transferred" from party A to party B. The loan is made ex nihilo by the bank crediting an asset and liability at the same time, expanding its balance sheet to both create the receivable and the deposit. It is only if the loan is defaulted on that it becomes a transfer, a transfer from the bank's equity holders to the loan recipient. Macroeconomics does not model debt, and therefore does not model the economy in a useful or realistic way.

Second, distribution of wealth very much impacts forward looking decisions, and it impacts the scarcity of goods that people are trying to buy or sell. For example, if a number of loans default, and wealth is distributed from bank equity holders to loan recipients, then the banks are undercapitalized and will not extend new credit. Moreover, bank investors will revise downward their estimation of a bank's skill in making good loans, and will increase the cost of capital if they do decide to make additional investments. All of this impacts the price of credit explicitly, and are entirely distributional outcomes.

Thirdly, willingness to pay decisions in micro are always subject to budget constraints. Wealth distribution impacts this directly again. Only in macro does the amount of money you have play no role in your willingness to spend.

Don't believe the NYTimes -- Los Altos edition

From the NYTimes:

The vast majority of owners in these upscale communities are still paying the mortgage, of course. But they appear to be cutting back in other ways. The once-thriving Los Altos downtown is pocked with more than a dozen empty storefronts in a six-block stretch.

The Los Altos downtown consists of about six blocks, and would never be described as "thriving". "Sleepy" is more apt.

Lost in Translation

I can't remember if I first read Tim Park's "Italian Neighbours" when I first moved to Italy, or while I was already there. I do know that I read the depressing "Europa" years later where the happy family Park described in his earlier books had clearly vanished. Europa was depressing, indulgent, and dull. It was nominated for a Booker. I would skip it.

Anyway, I was interested to see a New York Review of Books article by Parks on the translation of foreign language books into English, or rather, the lack of it. Park notes that the translated works, instead of highlighting cultural difference, all represent the same, internationalist, progressive, literary worldview

It seems to me rather that as we tackle intriguing stories from Latvia and Lithuania, Bosnia and Macedonia, we are struck by how familiar these voices are, how reassuringly similar in outlook to one another and ourselves....

It is as if literary fiction didn't so much reflect other cultures, obliging us to immerse ourselves in the exotic, but rather brought back news of shortcomings and injustices to an international community that could be relied upon to sympathize. These writers seem more like excellent foreign correspondents than foreigners. Across the globe, the literary frame of mind is growing more homogeneous.

He is quite correct. To hear truly novel voices today (pardon the pun) you need to go back in time and read classics in other languages, ideally from the 18th Century or earlier. Certainly pre-world war 2.

It is best to read 18th century books judged classics pre-world war 2, but not after. Kipling, for example, truly seems to be from Mars.

(A brief aside: I believe Italy requires all foreign films to be translated into the Italian. This provides work for Italian (voice) actors. Kind of like Rhode Island and its petrol pump attendants.)

Financial "reform" bill a dud

Yves is merciless about the Obama administration's financial "reform" bill:

I want the word “reform” back. Between health care “reform” and financial services “reform,” Obama, his operatives, and media cheerleaders are trying to depict both initiatives as being far more salutary and far-reaching than they are.

So what does the bill accomplish? It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.

The only two measures I see as genuine accomplishments, the Audit the Fed provisions, and the creation of a consumer financial product bureau, do not address systemic risks. And the consumer protection authority was substantially watered down. Recall a crucial provision, that banks be required to offer plain vanilla variants of products, was axed early on. In addition, the agency, initially envisioned as independent, will now be housed in the Fed, which has never taken any interest in consumers (witness its failure to enforce the Home Owners Equity Protection Act, a rule which would have limited subprime lending) and has a long standing hands-off posture towards its charges.

Most of the rest is mere window dressing.

I have a lower opinion of the bill than Yves, since I don't like the consumer protection agency. I see that as to households what the bond rating agencies are to corporations -- third parties with no skin in the game whose job it is to keep you "safe" by making credit decisions for you. Not only did the ratings agencies fail, they actually made things worse by enabling bad credit to pass as triple-A. A loan is not a product, it is a combination of a financial instrument and a borrower, and treating it as if it were a product, "good" or "bad" by itself, misses the fundamental nature of a credit transaction, which is a promise between a lender and borrower.

I also don't like the "audit the Fed" provision. What are they going to do? Send Bernanke to jail? Which leaves nothing in the "good" column.

So Lost

I am so late in reviewing Lost, but heck, I reviewed Easy Rider a couple of weeks ago. Anyway, I watched Lost from beginning to end over about 4 months. Reactions:

The word for "laundry" and "landscape" come from the same root. "Landscape" is what you get when you take wilderness (land which has not been "cleaned") and you "clean" it. The resulting "landscape" is synonymous with "civilization".

By contrast, wilderness is wild and unclean. It is dangerous and mysterious, wonderful and terrible things can happen out there at any moment. You might be eaten by a wolf. You might find a Gingerbread cottage and be eaten by a witch. You might fall in love with the first living thing you see upon awakening. Characters who live at the interface between civilization and the wilderness, like woodsmen, are dark, mysterious individuals.

The island, in Lost was the very personification of this old notion of "wilderness". It was filled with magic, mystery, and danger. When the show focused on the effect Wilderness had on normal people, it was interesting. When the show focused on the mechanics of the Wilderness itself, it was terrible. I want to know how the island works as much as I want to know about the mitichlorians in Puck's "love-in-idleness" juice. But that was what we got.

The entire story arc dealing with Jacob and his brother, the source below the island, etc. left me cold. The characters ultimately were not interesting because backstory alone does not create interesting characters. I tired of Sawyer's scowls, Jack's disbelief, Kate's heels, and Hugo's amiable shrugs. Locke was the most interesting to me, until he became the smoke guy. I also liked Ben Linus for most of the series, and Mr Eko. The flash-sideways effect sort of worked because it promised to highlight the impact the island had on the characters. But that payoff never really came.

The first season remains fantastic. The rest of it is addictive and not-annoying if you can watch them back to back on DVD. Most of the disappointment comes from how well it began.

The Case for Austerity

I support larger stimulus and greater deficits. This is because the private sector is still overleveraged, and wants to increase its net financial assets. The deleveraging process is reducing aggregate demand, and getting to a debt level that the sector can service out of income via default will bring with it massively higher unemployment, and thus real output losses. Our current 10% unemployment rate is already too high, and the real output losses acute. So, let's stimulate through higher deficits.

Let me now try to make a case for Austerity.

The credit crises exposed distribution that seems unfair to the electorate. Or at least grossly inefficient. For example, the financial sector is remunerated multiple times above the non-financial private sector, and yet, once you factor in the cost of bailouts, seems to net destroy wealth. This seems unfair, or at least, grossly inefficient. Much of the Obama administration's stimulus has benefited the financial sector directly, supporting and extending this practise.

Public sector unions such as the SEIU and the teachers union, especially in California, have lavish benefits and retirement packages that they can juke to increase to obscene levels. At the same time, they enjoy extreme job security in a system that does not seem to reward competence or productivity. In California, young promising teachers are fired while teachers on probation (and therefore, not teaching) get paid full salaries for years. Again, this seems unjust, or at least, grossly inefficient.

And Greece has a large public sector, which draws the best and the brightest for its generous compensation and job security, while the Germans work hard, save, and export all the fruits of their labor so they can save some more. The Germans tighten their belts, while the Greeks strike so they can keep retiring at 60. This may seem unjust, or at least grossly inefficient, to the Germans.

And, at ground zero, irresponsible homeowners took on massive loans they could not afford, which inflated the price of housing leaving the prudent "priced out forever". An ocean of tax breaks, bailouts, hand outs, ZIRP, etc. have all focused on helping the irresponsible homeowner, keeping house prices high, and the prudent stuck on the sidelines.

All of these situations are political, and as Rahm noted, you need a great crises to tackle them. So far, stimulus has taken the form of extending and further entrenching the inefficiency and malinvestment. All of this has real cost, in badly allocated resources, lost opportunity, and a further corrosion of the polity (such as it is). If this be "stimulus", the Austerians might say, then maybe it is time to "purge the rot from the system".

If stimulus took the form of flat rate, per capita transfers, then we could purge the rot while protecting employment. But unfortunately, academic macroeconomics does not understand that Government deficits fund net private savings, and so it managed aggregate demand for savings through unemployment and not through appropriate fiscal policy.

Bernanke cannot do Accounting

Bernanke demonstrates the squalid state of Economic Theory:

debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. Bernanke (1995, p. 17)

Voila -- Bernanke does not understand the difference between assets (which really is just a transfer, ie the Internet bubble) and debt.

Banks do not loan out deposits. Savings do not get given, by banks, to borrowers. Investing in a mutual fund, there the fund manager doles out your cash to a company, is nothing like putting your money in a bank, where the bank manager certainly does not dole our your money to a borrower.

Banks create loans by expanding their balance sheets. The money is created as an asset and a liability, simultaneously. Therefore, debt deflation is not a simple transfer, where balance sheets stay the same size, but a contraction, where balance sheets shrink as assets and liabilities are both written down.

We are two years into this crises, and the basic mechanism for bank lending remains opaque to the Chairman of the Federal Reserve.

Religion, the University, and Economics

I don't have anything to say about the conclusions or politics of this individual (whom I suspect is this person) but I did want to call attention to one dynamic she highlights:

Ed schools don’t get much respect within the university, and even less in the political arena. But they are the gatekeepers of elite credentials within the education community. These credentials don’t matter so much for teaching jobs per se, but do matter for educational policy jobs and doctoral program applications that come after teachers "do their two" in public schools and move on to jobs in which they can influence policy.

It’s much easier to move from teaching to an education think tank or a doctoral program if you’ve got a degree and credential from, say, Columbia Teacher’s College than if your degree has the local state diploma mill stamp. Elite ed schools use the one area where they reign supreme to withhold legitimacy from dissenters.

I think this explains why the University system seems to be so much less capable today of revealing truth than it was back when the Academy was distinct from the Government. So we have an Economics discipline that does not understand double entry bookkeeping.

To what end?

It should be obvious to the most casual observer that the financial industry is not part of the private sector. The charter it gets from the Federal Reserve, and the role it shares in the payment system with the US Treasury, means that it is a public/private partnership.

Access to reserve accounts at the Fed mean that banks can print money, just as the Government can. The reason they exist at all is so the State can have investment decisions made by the private sector, with private capital being in first-loss position before (ultimately) public capital. The actions of the Geither, Summers, and Obama perverted the role of the financial sector by putting public capital in first loss position before private capital.

The public/private nature of the financial industry also means that regulation should be focused more on the "why should we allow it" rather than the "why shouldn't we allow it"? just as, when setting up a new Government department, we should ask "why" rather than "why not?"

Here is an excellent discussion on high-frequency trading which illustrates this point. The Exchanges -- shockingly in my opinion -- sell information that can be used to front-run trades. Kid Dynamite takes the "why not" perspective:

someone will always have the data first, and someone will always have the data before you. It's a fact of, well, data transmission.

Again, the important fact is that this data is open to anyone who is willing to make the investment in it - not just a secret cool kids club that requires you to work for a specific blue blooded Wall Street firm. Anyone can do it - if they are willing to invest in the business.

Rajiv takes the "why" counter-perspective:

Generally speaking, stability in financial markets depends on the extent to which trading is based on fundamental information about the securities that are changing hands. If too great a proportion of total volume is driven by strategies that try to extract information from market data, the data itself becomes less informative over time and severe disruptions can arise. Banning specific classes of algorithms is unlikely to provide a lasting solution to the problem unless the advantage is shifted decisively and persistently in favor of strategies that feed information to the market instead of extracting it from technical data.

He also notes that HFT does not add liquidity, in fact it destabilizes it (as the "flash crash" showed) and it may not be profitable, as tail risk may destroy all profits just as the credit crash of 2008 consumed all the profits made from 2000-2008, if not more.

If the financial sector was purely private, I would take Kid Dynamite's "why not?" position. As it's a public/private partnership, I am taking Rajiv's "why?" position, just as I would any other Government program.

The Cleanest Race

I love this crazy interview about North and South Korea, in part because Myers looks a little like Karl Lagerfeld. I'd love to see a Japanese interpretation of Japan, both politically and economically, from their housing crash to today

Accounting for Loans, deposits, and equity

winterspeak reader TH asks:

There's just one part of introductory MMT that I can't quite figure out: why, if loans create deposits, can a banking system have a loans-to-deposits ratio other than 1? Do some loans somehow not
create deposits in equivalent amounts?

Bank loans, of course, are not the only thing that creates deposits. Deficit spending creates deposits with their being no private sector loan associated with that.

Non-bank elements of the private sector can also, of course, extend credit -- for example, by issuing bonds. Here, the borrower expands its balance sheet just like before, but the non-bank borrower does not, he just changes the composition of his assets.

Here are some related threads that happened to be going on elsewhere. First, from Mosler:

“He seems correct to me — can you take us through t-tables to show how deposits increase when private credit is extended in this way?how deposits increase when private credit is extended in this way?”

Deposits don’t need to increase as a result of this. That’s orthogonal, unless you are defining “credit” to be solely deposits, in which case you need another word for equity, bonds, money market mutual funds, and commercial paper. As well as repos and other credit-market instruments I must have missed. :P It’s good to stick to standard usage, as all of these are considered to be “credit market instruments”, and an increase in any of these corresponds to an increase in “credit”.

I think, if you want to only talk about deposits, then say “deposits”, or “bank credit”, if you prefer.

Just as with bank loans, the supply of credit market issues expands and contracts as return prospects change, and as a result, the quantity of deficit spending increases and decreases, causing the quantity of cash-flow surpluses to increase and decrease (which helps or hurts the thirsts of savers for more and more and more financial assets :P)

Any liquid IOU takes on the characteristics of money or “credit-money”, and the stock of these IOUs contribute to the stock of financial assets held by households. If the issuer of the credit market instrument is outside the household sector — say in the business sector, which would be typical for corporate bonds or equities, then an increase in these assets causes an increase in household net financial assets.

“So, the firm has a larger balance sheet, but the household has a balance sheet the same size.”

Yup. The borrower’s balance sheet is key. The borrower incurs a liability — to repay the loan, or to repay a bond — as well as an asset — a deposit, or money market fund, however he decides to park his short term assets while he goes about deficit spending.

But the point is that the borrower does not hang onto his asset. The loan is used to buy a house or car, and the bond is sold to expand industrial production. So the borrower then turns around and spends the asset (technically, he sells it for cash, pays the cash to someone else, and that person buys some financial asset with the cash — maybe a deposit, maybe a money market fund, maybe a bond — who knows?).

The bank borrower pays the homebuilder or the car maker, who in turn supplies wages and capital income to *someone* in the household sector, increasing that person’s financial assets. In the same way, the bond-seller turns around and invests in productive capacity by paying employees and parts suppliers, etc, and that ends up also increasing the wages and capital income of some households.

In both cases, investment is self-funding, and the “savings” of the fortunate workers or capital owners whose financial assets increased as a result of the deficit spending ends up being the accounting record of borrowing — whether that borrowing takes the form of selling bonds or borrowing from a bank.

As an aside, you can look at the various forms of credit market borrowing in table F.4 in Z.1. Hope that helps

Also, an oldy but goodie from JKH regarding equity (comment 188):

This is a response to Mahaish’s questions # 134 and # 151. It is a macro accounting explanation of the concept and measurement of household net worth, in the context of the Chartalist accounting model. It is not intended to address issues beyond that.

The top-down Chartalist sector balance sheet decomposition is that of government and non-government sectors. Although this breakdown could be applied globally, one typically would choose a particular national balance sheet to model, and then anchor the model with the corresponding government sector.

So let’s take the United States and the US government.

The entire United States balance sheet can then be modelled according to government and non government sectors.

The non government sector decomposes further into the private sector and the foreign sector. We can alternatively refer to the private sector as the domestic private sector, or the domestic non government sector.

The private sector decomposes further into the household sector and the non household sector. The non household sector is mostly incorporated and unincorporated business, including financial institutions.

The US household sector balance sheet as at June 30, 2009:

(Numbers rounded)

Total assets $ 67 trillion
Tangible assets 25 trillion
Financial assets 42 trillion

Liabilities 14 trillion
Mortgages 10.5 trillion
Consumer Credit/other 3.5 trillion

Net Worth $ 53 trillion

Household tangible assets of $ 25 trillion include about $ 20 trillion in real estate and $ 5 trillion in consumer durable goods.

Against financial assets of $ 42 trillion we net $ 14 trillion of liabilities (which are of course financial) to arrive at:

Household Net Financial Assets $ 28 trillion

This household net financial asset total is significantly larger than the total level of non government net financial assets for all sectors. The conceptual and numerical difference is explained below.

Any household financial asset that is not a direct obligation of the government must by definition be the obligation of another non government entity.

E.g. a corporate bond held by the household sector is the liability of the corporate sector.

Therefore, although the corporate bond contributes to both the gross and the net financial asset position of the household, it does not contribute to the net financial asset position of the entire non government sector, due to cancellation of the household asset against its corresponding representation as a non government liability.

This relationship holds for all financial claims of non government entities on other non government entities.

Importantly, this includes equity financial claims. This can seem a bit counterintuitive. Equity claims represented in the usual way on a balance sheet are not categorized as liabilities. However, the essential double entry book keeping characteristic is that they are on the right hand side of the balance sheet. The right hand equity entry directly offsets the corresponding asset entry on the balance sheet of the equity claim holder.

E.g. common stock held by the household sector is that sector’s financial asset. It is not technically a liability of the corporate sector. Nevertheless, it is a financial claim issued by the corporate sector in the sense that the owner of the stock has the right to benefit from all cash flows and valuation effects that accrue directly to the stock (dividends and marked to market stock price changes). This benefit reflects a comprehensive valuation of the operation of the issuer, including its deployment of real assets, its use of liabilities, and its ability to generate profits, etc. The point is that even though common stock is not categorized as a balance sheet liability, it is a financial claim issued by the corporate sector and a financial asset held in this case by the household sector. Common stock and equity claims in general are treated as a financial asset of the holder and a financial obligation of the issuer (cash flow and marked to market evaluated), and because of that essentially net to zero when consolidating the net financial asset position of the non government sector. The residual as a result of this equity netting includes the real assets of the issuer that are instrumental to the generation of such gross equity value. Depending on the objective of a given measurement exercise, those real assets obviously can also be valued separately from their representation as value embedded in the liability and equity structure of the issuer’s balance sheet. They are excluded from direct representation in the measure of net household worth because their implicit valuation has already been transmitted via the direct debt and equity valuation of the enterprise.

The household sector, in addition to holding direct financial claims in such forms as bonds and stocks, also holds financial assets in the form of mutual funds, pension funds, life insurance, and unincorporated business equity. Again, these positions are all represented as obligations of the issuer, and therefore all net out on consolidation with the household sector’s corresponding assets in the calculation of non government net financial assets. From the asset perspective alone, they constitute a large component in the gross financial asset position of the household sector.

One could similarly work through the balance sheets of the non household domestic private sector (incorporated and unincorporated business, including financial institutions) and the foreign sector. The business sector has a substantial net negative financial asset position, reflecting the corresponding net tangible or real asset position referred to above. The foreign sector has a positive net financial asset position, reflecting the result of a cumulative US current account deficit, with certain balance sheet items valued on a marked to market basis.

If one then nets the net financial asset positions of all these sectors against each other, the result will be an aggregate net financial asset position equal to the government net liability position, as per the Chartalist overview. Financial claims between non government entities net to zero. But government to non government financial claims don’t. The primary reason for this is that governments tend to issue more claims to non government than vice versa. The latter direction is quite possible of course. That is what has happened to a limited degree in the case of the US Federal Reserve accumulating private sector credit assets, and in the case of the US Treasury injecting TARP capital into the banking system. But such unusual US government financial asset activity has been mostly offset at the same time by the issuance of additional excess reserve base money by the Fed and additional bonds by the US Treasury. Beyond that is the aspect of outstanding and expanding US Treasury debt that reflects the more typical creation of net government liabilities due to government deficit spending. It is this latter net mismatch that results in the corresponding vertical net financial asset accumulation of the non government sector.

Two concluding points:

First, the net worth of US households was calculated at $ 53 trillion as at June 30, 2009. This includes “real” assets of $25 trillion and net financial assets of $ 28 trillion.

This net financial asset measure of $ 28 trillion is one of deceptively wide scope.

One may ask where the real assets of business can be found in this calculation. Where is the measure of plant and equipment investment value in the United States? Where is the left hand side of the business balance sheet?

The answer already alluded to above is that the real assets of businesses are reflected implicitly in the value of their financial obligations, which are included comprehensively in the value of household and foreign sector gross financial assets. This includes as well business liabilities and issued equity claims that are held indirectly through such household financial assets as mutual funds and pension. All business assets are reflected in this way. This is double entry book keeping hard at work.

Second, although this describes the connection between non government net financial assets and household net financial assets, one must delve deep into the various sector gross positions in order to extract the exact location of government issued liabilities held as assets by the non government sector. It’s there. You just have to look for where the government bonds are, as well as Federal Reserve currency, and finally central bank reserve balances.

(BTW, those who are interested in the consolidated treasury/central bank government position can find expert commentary from the various Chartalist oriented economist bloggers, including Scott Fullwiler, Randall Wray, Warren Mosler, and of course Bill Mitchell. But in summary, the net balance between government and non government includes the gross effect of central bank reserve balances issued to the banking system, central bank currency issued to the non government sector, and treasury debt issued to the non government sector.)

The bonds in particular are all over the place. For example, foreign central banks own trillions of US treasury bonds and bills, most prominently in China and Japan. Those central bank bond holdings are part of the gross US financial assets held by the foreign sector. In turn, the foreign sector in total has a net positive financial asset position with the US as counterparty (again the result of the cumulative US current account deficit).

The foreign sector thus includes a net asset position with the US government sector, embedded within its larger gross financial asset position with the US, and in conjunction with its total net financial asset position with the US. When one recognizes that the net horizontal asset position of the non government sector must sum to zero, one can then attempt to identity the location of the net vertical asset positions embedded in each defined horizontal sector. The foreign sector clearly has a net positive vertical position according to its bond holdings and some currency. The household sector actually has a modest vertical position relative to its size, consisting of bonds and currency. The rest of the vertical position exists in the non household private sector. Ironically, although this sector has a large net negative financial asset position, most of the net positive vertical position can be found in the gross assets of financial institutions and pension/life insurance investment funds. Against this would be netted the effect of Fed Reserve private sector credit and Treasury TARP funds. Thus, one may decompose sectors according to their positions in net financial assets, as well as their positions in net government assets. The sum in both cases will be the same, according to the overarching Chartalist axiom of aggregate net financial asset equivalence, with the government deficit equal to the non government surplus.