Tuesday, February 1, 2022

Excerpts from "Monetary Economics" (Godley & Lavoie)

 From pgs. 48-52, these were just too good not to share (emphasis added):

"In the mainstream framework, money is sometimes said to fall from the sky, thrown out of an helicopter, as in the famous parable by Milton Friedman. In that mainstream framework, which is highly popular in mainstream intermediate macroeconomic textbooks, money is a given stock, which seems to appear from nowhere, and which has no counterpart in the rest of the economy. Despite changes in the real economy, and presumably in financial flows, the stock of money is assumed to remain at all time constant. The quadruple-entry system shows that such a conception of money is meaningless."

So well said, and the root of inspiration for "hard money" types, including goldbugs and Bitcoin HODLers. They fail, like most people do (including money managers), at grasping the concept of money and debt being one in the same.

"From a flow-of-funds standpoint, increased deposits are thus a source of funds while increased loans are a use of funds for the banks. For some, this terminology seems to reinforce the mainstream belief, associated with the loanable funds approach, that banks provide loans insofar as they have the financial resources to do so; in other words, banks make loans only when they have prior access to deposits...On the contrary, a key feature of the banking system is its ability to create deposits ex nihilo. More precisely, when agents in the economy are willing to increase their liabilities, banks can increase the size of both sides of their balance sheet, by granting loans and simultaneously creating deposits...It may be that, in flow-of-funds terminology, money deposits is the source of funds allowing the use of bank loans. But the cause of this increase in deposits and loans is the willingness to contract an additional liability and the desire of the borrower, here the production firm, to expand its expenditures."

Like I wrote about in an earlier piece, banks are the most misunderstood businesses in the world.

"Firms only draw on their lines of credit when they are required to make payments. In the second step of the circuit, the deposits of the firms are transferred by cheques or electronic payment to workers who provided their labour to the firms. The moment these funds are transferred, they constitute households' income. Before a single unit is spent on consumer goods, the entire amount of the bank deposits constitutes savings by households, and these are equal to the new loans granted to production firms."

At the risk of repeating myself: banks DO NOT use deposits to fund loans; LOANS CREATE DEPOSITS.

"The key factor is that, as households increase their consumption, their money balances fall and so do the outstanding amount of loans owed by the firms. Similarly, as households get rid of their money balances to purchase newly issued equities by firms, the latter are again able to reduce their outstanding loans. In other words, at the start of the circuit, the new loans required by the firms are exactly equal to the new deposits obtained by households. Then, as households decide to get rid of their money balances, the outstanding loans of firms diminish pari passu, as long as firms use the proceeds to pay back loans instead of using the proceeds to beef up their money balances or their other liquid financial assets. Although determined by apparently independent mechanisms, the supply of loans to firms and the holdings of deposits by households (and firms) cannot but be equal, as they are at the beginning of the circuit."

This is an important point, because many people who have been skeptical of the viability of Silicon Valley "tech unicorns" totally missed this. There are two ways for a firm to stay solvent (i.e. not default on its existing debt): funding obligations either using cash generated from internal operations/asset sales or raising new outside capital. Remember: US fiscal budget deficits create non-government surpluses, and the US government has run fiscal deficits every year since 2001. The budget deficits we ran over the last decade or so by themselves weren't a problem; the problems were in other public policy decisions that influenced where that newly created government money flowed to. If we had better design, and those newly created dollars actually flowed to people who spent their money on useful goods and services, that would have generated higher sales and profits for firms. With higher sales and profits, the firms could have paid higher wages to employees, who would in turn buy more goods and services, and perhaps have a stronger credit profile to borrow money to fund a mortgage or new car. This would have been especially helpful after the GFC.

Instead, many of these newly created dollars flowed towards, among other groups, VC funds. Recall that VC funds collect deposits from households and purchase equities of early-stage companies. These funds raised over half a trillion of capital in the 2010s. The new equity capital helps pay back old debts, keeping the companies solvent as they burn through cash. The funds raised were also largely put towards marketing rents paid to Google and Facebook. So, the money was trapped in this (un)virtuous cycle, whereby VC's would collude together and mark up each other's books, and all the money would flow to GOOG and FB, who's shareholders became rich and themselves launched careers as VC's, further continuing the cycle.

How could this happen? Lax regulations, particularly antitrust and corporate fraud enforcement, combined with powerful network effects associated with internet-based commerce, created a massive tailwind for Silicon Valley "tech" companies. These companies burned billions of cash, as they didn't have to be profitable thanks to their privileged access to the government's newly printed money. Take for example Uber Technologies (UBER), who as of its latest quarterly filing has an accumulated deficit of $23 billion in its shareholder equity account. That is an astonishingly terrible fundamental economic performance. And yet, UBER's current market cap is over 3x that accumulated deficit figure. It's hard to call this "capitalism" when it's just uber-rich, politically connected people lighting government money on fire and causing taxi shortages for the public to deal with.

"The mere holding of the money paid out as wages has a loan as its exact counterpart. When the household sector buys something from the production sector, this destroys money and loans by an equal amount. While the loan-granting activity created an efflux of money into the economy, the purchase of goods by households creates a reflux - the destruction of money. Thus, any series of transactions can be conceived as the creation, circulation, and destruction of money."

Circle of life. Money is created, circulates around, then dies upon return to its Creator (i.e. the government).

"These extra reserves do not mean however that a multiple of money deposits will be created, as the standard money multiplier has it. If banks do not find any credit-worthy borrower - and the fact that they now have additional reserves implies in no way that additional credit-worthy borrowers will be forthcoming - they always have the choice to purchase government bills...if the central bank is to keep the interest rate at its target level, the central bank must sell to the banks (and to households) the bills that they look for, and by so doing, the central bank will absorb the money balances that neither the banks nor the households wish to hold."

This is what most people got wrong with QE. I distinctly remember a portfolio manager at Tudor explaining to me that QE "deposited cash" into the banks so that they could be spent into the economy. Unfortunately, that's not how it works. Banks don't lend out deposits (or reserves). They create deposits when they make loans. Stuffing banks' balance sheets with reserves has no effect on lending activity, but it has other effects as discussed in a prior post. Public policy failures have resulted in fewer people with sufficient credit to get a loan from a bank. At the same time, banks need a source of income to fund interest expense on deposits, so they purchase Treasuries instead. Weak demand for credit further forces banks to lower their rates, creating a bid for Treasuries. 

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