Solving the Paradox of Monetary Profits

flattr this!

The Economics E-Journal

    The Economics E-Journal is a relatively new journal that implements several new approaches to academic publishing:

    • It is open access and free. Most academic journals are restricted to subscribers or those with access to academic libraries that subscribe, which excludes the general public from access to intellectual endeavour.
    • Anyone paper submitted to the journal is permanently available. Normally only papers that have been refereed and accepted for publication can be accessed.
    • Anyone can comment on a paper, and comments and the number of downloads goes some way to influencing whether a paper is published in the journal proper.

    Papers are still refereed as in a standard journal, and those that are accepted by the referees are published in the journal section of the webpage.

    The paper below was submitted to the journal at the invitation of the editors for a special edition on "Man­ag­ing Finan­cial Insta­bil­ity in Cap­i­tal­ist Economies“. It took some time to get through the ref­er­ee­ing process, but the paper is finally avail­able online (I was crit­i­cal of some of the feed­back I received—there are in my opin­ion some teething prob­lems still to be sur­mounted in bal­anc­ing the range of peo­ple that can com­ment on papers in this jour­nal against the need to have crit­i­cally informed read­ers mak­ing the ulti­mate deci­sion. How­ever the final paper was also much improved by the inter­ac­tions with ref­er­ees and the editors).

    Click here for a PDF ver­sion of this paper ; you can also read it as a web­page below. I’ve changed the theme for my blog recently to get around for­mat­ting has­sles, since the pre­vi­ous theme inserted a page break every time I used italic font!. There were still some for­mat­ting hassles–I had to sub­sti­tute for some Greek char­ac­ters with the Eng­lish spelling of the Greek let­ter for example–but it is bet­ter than with the old theme.

    This post below deserves the moniker “wonk­ish”, but I hope that it is still gen­er­ally read­able.

    Pre­lim­i­nar­ies

    Bruun and Heyn-Johnsen (2009) state the para­dox that eco­nom­ics has failed to pro­vide a sat­is­fac­tory expla­na­tion of how mon­e­tary prof­its are gen­er­ated, even though the gen­er­a­tion of a phys­i­cal sur­plus in pro­duc­tion is an essen­tial com­po­nent of non-neoclassical eco­nom­ics. They empha­sise that our abil­ity to explain phe­nom­ena like the “Great Reces­sion” will be lim­ited while ever we are unable to explain this fun­da­men­tal aspect of capitalism.

    In fact this para­dox can be solved very sim­ply, using insights from Cir­cuit The­ory Graziani (1990). Graziani’s bril­liant ini­tial propo­si­tion was that a credit econ­omy must be using a non-commodity as money, since the alter­na­tive of “an econ­omy using as money a com­mod­ity com­ing out of a reg­u­lar process of pro­duc­tion, can­not be dis­tin­guished from a barter econ­omy” Graziani (1995: 518). From the fact that an intrin­si­cally val­ue­less token is nonethe­less accepted as full pay­ment in the exchange of goods, Graziani derived the con­clu­sion that:

    any mon­e­tary pay­ment must there­fore be a tri­an­gu­lar trans­ac­tion, involv­ing at least three agents, the payer, the payee, and the bank… Since in a mon­e­tary econ­omy money pay­ments go nec­es­sar­ily through a third agent, the third agent being one that spe­cialises in the activ­ity of pro­duc­ing means of pay­ment (in mod­ern times a bank), banks and firms must be con­sid­ered as two dis­tinct kinds of agents (Graziani 1995: 518–519).

    Unfor­tu­nately, attempts by Graziani and sub­se­quent Cir­cuitist authors to develop a viable math­e­mat­i­cal model of the cre­ation of mon­e­tary prof­its in a pure credit econ­omy have to date been a failure—a sit­u­a­tion well expressed in Rochon’s lament “How does M become M+?” (Rochon 2005: 125). This fail­ure was not due to any weak­ness in the under­ly­ing vision of a pure credit econ­omy, but to con­fu­sions of stocks with flows ema­nat­ing largely from inap­pro­pri­ate math­e­mat­i­cal approaches use by these authors. A sim­ple dynamic mon­e­tary model that uses the bank account as its fun­da­men­tal unit explains how cap­i­tal­ists can and do make a profit. In brief, “M becomes M+” via the price mech­a­nism, which con­verts the sale of the phys­i­cal sur­plus gen­er­ated in pro­duc­tion into money.

    The topic has become clouded by many other issues—from the basis for the value of money itself to the impact of debt repay­ment on the money stock. So that I can focus solely on this issue of how mon­e­tary prof­its are gen­er­ated, I delib­er­ately abstract from these impor­tant but—in this context—tangential issues, as out­lined below.

    There are dis­putes in Post Key­ne­sian mon­e­tary the­ory over the log­i­cal basis for the exis­tence and value of money—notably between Char­tal­ists who assert that tax­a­tion is the basis of money’s value, and some Circuitists—including Graziani (1989)—who assert that its accep­tance in com­plet­ing oblig­a­tions between buyer and seller in an exchange is suf­fi­cient. The math­e­mat­i­cal conun­drum about whether cap­i­tal­ists can make a mon­e­tary profit when the source of their ini­tial cap­i­tal is bor­rowed money exists inde­pen­dently of this philo­soph­i­cal debate. The con­sen­sus to date has been that it is math­e­mat­i­cally impos­si­ble for cap­i­tal­ists in the aggre­gate to make prof­its (see for exam­ple Bellofiore et al. 2000). I abstract from these philo­soph­i­cal and ex origo debates in order to focus sim­ply on the math­e­mat­i­cal issue, to show that this con­sen­sus is false.

    This dis­pute, and the cur­rent con­sen­sus con­clu­sion, also exist within the con­fines of mod­els of a pure credit economy—that is, mod­els that treat money as a non-commodity issued by a pri­vate bank­ing sys­tem, and abstract from the exis­tence of both the State itself, and State or fiat money. The math­e­mat­i­cal issue is there­fore best treated in a model of a pure credit econ­omy, even if a com­plete model of the exist­ing mon­e­tary sys­tem must include both fiat and credit money.

    Finally, there is a dif­fer­ence between mod­ern Post Key­ne­sian the­o­rists and Keynes over what hap­pens to money that is used to repay debt. The con­ven­tion in Cir­cuit lit­er­a­ture is that money used to repay debt is destroyed:

    To the extent that bank debts are repaid, an equal amount of money is destroyed (Graziani 2003: 29–30).

    Money is cre­ated as banks lend-mainly to business-and money is destroyed as bor­row­ers ful­fill their pay­ment com­mit­ments to banks. Money is cre­ated in response to businessmen’s and bankers’ views about prospec­tive prof­its, and money is destroyed as prof­its are real­ized Min­sky (1982: xxi).

    Keynes, on the other hand, spoke of a “revolv­ing fund of credit” which was con­tin­u­ously replen­ished by the repay­ment of debt, which implies that money used to repay debt may be tem­porar­ily taken out of cir­cu­la­tion, but is not destroyed:

    If invest­ment is pro­ceed­ing at a steady rate, the finance (or the com­mit­ments to finance) required can be sup­plied from a revolv­ing fund of a more or less con­stant amount, one entre­pre­neur hav­ing his finance replen­ished for the pur­pose of a pro­jected invest­ment as another exhausts his on pay­ing for his com­pleted invest­ment (Keynes 1937: 247).

    I side with Keynes on this issue, but to avoid com­pli­ca­tions result­ing from this dif­fer­ence of inter­pre­ta­tion, I first con­sider the his­tor­i­cally rel­e­vant exam­ple of a pri­vate bank using paper notes that it itself creates—see Fig­ure 1 for an exam­ple of such a note issued dur­ing the “Free Bank­ing” period in the USA (Dwyer 1996).

    A paper note model is also con­sis­tent with Graziani’s orig­i­nal paper on the mon­e­tary cir­cuit, where he observed that “A true mon­e­tary econ­omy must there­fore be using a token money, which is nowa­days a paper cur­rency” (Graziani 1989: 3). These banks did not destroy their notes when debts were repaid, but treated their specie as a “revolv­ing fund”, with notes stored until they could be recir­cu­lated in new loans:

    Free banks were rarely able to keep all of their allow­able note issues in cir­cu­la­tion at all times. Ratios of idle notes to total legal cir­cu­la­tion in New York ranged from a low of 4 per­cent in 1852 to a high of 21.6 per­cent dur­ing the panic of 1857. The pro­por­tion of idle notes dipped below 10 per­cent in only three years and hov­ered around 15 per­cent through­out the 1850s (Boden­horn and Hau­pert 1996: 688).

    Though the his­tor­i­cal sta­bil­ity of this period is dis­puted,
    a pri­vate bank­ing sys­tem of this type is not intrin­si­cally unsta­ble, and as I show below, cap­i­tal­ists can make a profit in such a sys­tem, even if their ven­tures are 100% debt-financed.

    Fig­ure 1: Bank of Flo­rence (Nebraska) Dol­lar Note (Smith­son­ian Insti­tu­tion 2010)

    The Basic Model: A Set Quan­tity of Notes

    Con­sider a pri­vate bank which, hav­ing ful­filled the legal require­ments for Free Bank­ing (see Boden­horn 2008: 183–184), cre­ates a stock N of dol­lar notes like those in Fig­ure 1. These notes are ini­tially held by the new bank in its vault. The bank then issues loans to firms, which enables the firm to hire work­ers, who then pro­duce out­put which is sold to work­ers, cap­i­tal­ists and bankers.

    A min­i­mum of 5 classes of accounts are needed to model this sys­tem:

    1. The bank vault (BV), into which the newly-minted notes are first placed
    2. Firm deposit accounts (FD), into which actual trans­fers of loaned dol­lars are made
    3. Work­ers deposit accounts (WD), into which wages are paid by firms
    4. A bank trans­ac­tions account (BT), into and out of which inter­est pay­ments are made
    5. Firm loan accounts (FL), where ledger entries that record the quan­tity of notes that have been lent to firms

    The first four of these are phys­i­cal repos­i­to­ries of notes. The fifth is not a repos­i­tory for notes, but a ledger record­ing the legal claim that the bank has upon those to whom it has lent. Oper­a­tions on it there­fore do not involve mon­e­tary trans­fers, but record the impact of those trans­fers on the indebt­ed­ness of bor­row­ers.

    The basic trans­ac­tions that occur in this model are detailed in Table 1. Seven of these steps involve the phys­i­cal trans­fer of money:

    1. Lend­ing of money from the bank vault to the firms’ deposit accounts (row 1)
      1. Pay­ment of inter­est by firms to the bank’s trans­ac­tions account (row 4)
      2. Pay­ment of inter­est by the bank to firms’ deposit accounts (row 6)
      3. Pay­ment of wages (row 7)
      4. Pay­ment of inter­est on work­ers’ account bal­ances (row 8)
      5. Pay­ment for con­sump­tion of the out­put of firms by bank and work­ers (row 9)
    2. Repay­ment of loans by firms (row 10)

    Four steps are ledger entries only, involv­ing the record­ing of a money trans­fer related to the level of debt:

    1. Record­ing the loans to firms (row 2)
    2. Com­pound­ing the debt at the rate of inter­est on loans (row 3)
    3. Record­ing the pay­ment of inter­est on loans (row 5)
    4. Record­ing the repay­ment of loans (row 11)

    Table 1: Basic Finan­cial Trans­ac­tions in a Free Bank­ing Econ­omy

    Row Trans­ac­tion Type Bank vault (BV) Bank trans­ac­tion (BT) Firm loan (FL) Firm deposit (FD) Worker deposit (WD)
    1 Lend money Money trans­fer

    a

    a

    2 Record loan Ledger entry

    a

    3 Com­pound debt Ledger entry

    b

    4 Pay inter­est Money trans­fer

    c

    –c

    5 Record pay­ment Ledger entry

    –c

    6 Deposit inter­est Money trans­fer

    –d

    d

    7 Wages Money trans­fer

    –e

    e

    8 Deposit inter­est Money trans­fer

    –f

    f

    9 Con­sump­tion Money trans­fer

    –g

    g+h

    –h

    10 Repay loan Money trans­fer

    i

    –i

    11 Record repay­ment Ledger entry

    –i

    Sum of flows

    i–a

    c–d–f–g

    a+b–c–i

    a–c+d–e+g+h–i

    e+f–h

    The finan­cial flows in each col­umn of Table 1 can be summed to describe the dynam­ics of the bank accounts in this model:


    To model this sys­tem, we need to pro­vide val­ues for the oper­a­tions a to i. Table 2 spec­i­fies these, with each oper­a­tion being related to the cur­rent level of the rel­e­vant account—lending from the vault, for exam­ple, is assumed to occur at a con­stant rate “beta“V related to the cur­rent amount of money in the vault at time t, BV(t).

    Table 2: Finan­cial Oper­a­tions

    Flow Descrip­tion
    a Loans to firms at the rate bV times the bal­ance in the vault at time t BV(t) bv.BV(t)
    b The rate of inter­est on loans rL times the level of loans at time t FL(t) rL.FL(t)
    c Pay­ment of inter­est on loans rL.FL(t)
    d Pay­ment of inter­est on firm deposits FD(t) at the rate rD rD.FD(t)
    e Pay­ment of wages by firms at the rate fD times firm deposits at time t FD(t) fD.FD(t)
    f Pay­ment of inter­est on deposits at the rate rD rD.WD(t)
    g Pay­ment for goods by banks at the rate bT times the level of the bank trans­ac­tion account at time t BT(t) bT.BT(t)
    h Pay­ment for goods by work­ers at the rate wD times the level of the bank trans­ac­tion account at time t WD(t) wD.WD(t)
    i Repay­ment of loans at the rate “phi“L
    times the out­stand­ing loan bal­ance at time t FL(t)
    fL.FL(t)

    The full dynamic sys­tem is given by Equa­tion :


    As is eas­ily shown, with real­is­tic para­me­ter val­ues (see Table 3; the val­ues are explained later in the text prior to Table 5, and Table 5 itself) this describes a self-sustaining sys­tem in which all accounts set­tle down to equi­lib­rium val­ues, and in which cap­i­tal­ists earn a mon­e­tary profit.

    Table 3: Para­me­ter Val­ues

    Para­me­ter Value Descrip­tion
    bV ¾ p.a. Rate of out­flow of notes from the vault BV
    rL 5% p.a. Rate of inter­est on loans
    rD 2% p.a. Rate of inter­est on deposits
    fD 2 p.a. Rate of out­flow of notes from FD to pay wages
    bT 1 p.a. Rate of out­flow of notes from BT to pay for bankers consumption
    wD 26 p.a. Rate of out­flow of notes from WD to pay for work­ers consumption
    fL 1/7 p.a. Rate of repay­ment of loans

    Fig­ure 2: Bank Account Bal­ances over Time

    Fig­ure 2 shows the dynam­ics of this sys­tem with an ini­tial stock of N=100 mil­lion dol­lar notes.

    The equi­lib­rium val­ues of the accounts can be solved for sym­bol­i­cally in this con­stant money stock model:


    From Account Bal­ances to Incomes

    The equi­lib­rium yearly wages of work­ers (and gross inter­est earn­ings by bankers) can be cal­cu­lated from Equa­tion , and they in part explain why, in con­trast to the con­ven­tional belief amongst Cir­cuitist writ­ers, cap­i­tal­ists can bor­row money, pay inter­est, and still make a profit. Though only $100 mil­lion worth of notes were cre­ated, the cir­cu­la­tion of those notes gen­er­ates work­ers’ wages of $151 mil­lion per annum (given the para­me­ter val­ues used in this sim­u­la­tion), 1.5 times the size of the value of the notes in the econ­omy (see Fig­ure 3):


    This indi­cates the source of the Cir­cuitist conun­drums: the stock of money has been con­fused with the flow of eco­nomic activ­ity that money can finance over time. A stock—the ini­tial amount of notes cre­ated in this model—has been con­fused

    Fig­ure 3: Wages and Gross Inter­est

    with a flow—the eco­nomic turnover in notes per year. In fact, for a wide range of val­ues for the para­me­ter ?D, the flows ini­ti­ated by the money bor­rowed by the firms over a year exceed the size of the loan itself.

    This is pos­si­ble because the stock of money can cir­cu­late sev­eral times in one year—something that Marx accu­rately enun­ci­ated over a cen­tury ago in Vol­ume II of Cap­i­tal (though his numer­i­cal exam­ple is extremely large):

    “Let the period of turnover be 5 weeks, the work­ing period 4 weeks… In a year of 50 weeks … Cap­i­tal I of £2,000, con­stantly employed in the work­ing period, is there­fore turned over 12½ times. 12½ times 2,000 makes £25,000″ (Marx and Engels 1885, Chap­ter 16: The Turnover of Vari­able Cap­i­tal).

    Aggre­gate wages and aggre­gate prof­its there­fore depend in part upon the turnover period between the out­lay of money to finance pro­duc­tion and the sale of that pro­duc­tion. This turnover period can be sub­stan­tially shorter than a year, in which case fD will be sub­stan­tially larger than 1, as I explain below.

    The Mak­ing of Mon­e­tary Profits

    A sec­ond fun­da­men­tal insight from Marx lets us explain what fD is, and simul­ta­ne­ously derive an expres­sion for prof­its: the annual wages bill reflects both the turnover period, and the way in which the sur­plus value gen­er­ated in pro­duc­tion is appor­tioned between cap­i­tal­ists and work­ers. The value of fD there­fore reflects two fac­tors: the share of sur­plus (in Sraffa’s sense) that accrues to work­ers; and the turnover period mea­sured in years—the time between M and M+. Labelling the share going to cap­i­tal­ists as s and the share to work­ers as (1–s), and labelling the turnover period as tS and express­ing it as a frac­tion of a year, I can per­form the sub­sti­tu­tion shown in below:


    Money wages are there­fore:


    Since national income resolves itself into wages and prof­its (inter­est income is a trans­fer between classes, and sums to zero across all classes), we have also iden­ti­fied gross profit:


    Using a value of s= 40%—which cor­re­sponds to his­tor­i­cal norm of 60% of pre-interest income going to work­ers (see Fig­ure 4)—this implies a value for tS of 0.3.

    This means that the turnover period in Marx’s ter­mi­nol­ogy is roughly 16 weeks. This is much longer than in Marx’s numer­i­cal illus­tra­tion above, but still suf­fi­cient to give cap­i­tal­ists prof­its that are sub­stan­tially greater than the ser­vic­ing costs of debt. Fig­ure 5 shows the annual incomes for each class in soci­ety over time; all are pos­i­tive and the equi­lib­rium lev­els (once account lev­els sta­bilise) are $151 mil­lion, $98 mil­lion and $2.5 mil­lion for work­ers, cap­i­tal­ists and bankers respec­tively out of a national income of $252 mil­lion (see Equa­tion ).

    Fig­ure 4: Wages Per­cent­age of US GDP

    Fig­ure 5: Class Incomes after Inter­est Pay­ments


    The value of tauS also deter­mines the veloc­ity of money: the ratio of nom­i­nal GDP to the pro­por­tion of the money stock in cir­cu­la­tion (the equiv­a­lent of M3–M0 in mon­e­tary sta­tis­tics, since in this pure credit model there is no fiat money), which is 3 given the para­me­ters used in this sim­u­la­tion. This is within the highly volatile range sug­gested by his­tor­i­cal data (see Fig­ure 6).

    Table 4 sum­marises the equi­lib­rium val­ues for account bal­ances, gross and net incomes in this hypo­thet­i­cal pure credit econ­omy.

    Fig­ure 6: US GDP to Money Sup­ply Ratios

    Table 4: Equi­lib­rium Account Bal­ances, Gross and Net Incomes

    Account bal­ances Class incomes Net incomes
    Bank vault 16 N/A N/A
    Firm loans 84 N/A N/A
    Firms 75.6081 100.811 (prof­its) 98.123
    Work­ers 5.8205 151.216 (wages) 151.333
    Bankers 2.5714 4.2 (debt servicing) 2.571
    Totals 84 (in Deposits) 252.027+4.2 252.027

    We can also derive a sym­bolic expres­sion for the equi­lib­rium level of profits

    pe:


    This allows us to spec­ify the gen­eral con­di­tions under which equi­lib­rium mon­e­tary prof­its will exceed zero, given the exis­tence of a phys­i­cal sur­plus from pro­duc­tion. They are far from oner­ous: the rate at which the bank trans­ac­tion account turns over each year has to exceed the rate of inter­est on loans and the rate at which the work­ers’ deposit account turns over has to exceed the rate of inter­est on deposits . Rea­son­able val­ues for these para­me­ters eas­ily meet these con­di­tions, as detailed below.

    Other Para­me­ters and Time Lags

    The para­me­ters rL and rD are nom­i­nal inter­est rates, and their val­ues are roughly in line with his­tor­i­cal norms at times of low-inflation; that leaves the para­me­ters bV, fL, fD and bT to account for.

    The val­ues for “phi“V and fL respec­tively spec­ify how rapidly the bal­ance in the vault is turned over, and how rapidly loans are repaid, and were cho­sen so that the equi­lib­rium value of BV would be roughly the value noted by Boden­horn and Hau­pert (1996: 688) of 15% of avail­able notes:


    The para­me­ters “omega“D and “beta“T sig­nify how rapidly work­ers and bankers respec­tively spend their bank bal­ances on the out­put pro­duced by firms: work­ers are assumed to turnover their accounts 26 times a year—which cor­re­sponds to work­ers liv­ing from fort­nightly pay­cheque to pay­cheque, with only mod­est sav­ings. Bankers are assumed to turnover their account just once a year, reflect­ing their much higher per capita incomes.

    In the remain­der of the paper, all para­me­ters are expressed using the sys­tems engi­neer­ing con­cept of a time con­stant, which gives the fun­da­men­tal fre­quency of a process. In every case, the time con­stant is the inverse of the para­me­ter used thus far; for instance, the value of 26 for wD cor­re­sponds to work­ers’ con­sump­tion hav­ing a fun­da­men­tal fre­quency of 1/26th of a year, or two weeks.

    Table 5: Time Con­stants in the Model

    Para­me­ter and value Time con­stant and value Mean­ing
    bV = ¾ tV = 4/3 years Banks lend their reserve hold­ings of notes every 15 months
    fL= 1/7 tL= 7 years Firms repay their loans every 7 years
    wD = 26 tW= 1/26 years Work­ers spend their sav­ings every 2 weeks
    bT = 1 tB= 1 year Bankers spend their sav­ings every 1 year
    tP= 1 year Time con­stant in price set­ting (intro­duced in Equation )
    t M= 15 years Banks dou­ble the money sup­ply every 15 years (intro­duced in Table 7 on page 24)

    Pro­duc­tion, Prices and Mon­e­tary Profits

    Con­sider a sim­ple pro­duc­tion sys­tem in which out­put is pro­por­tional to the labour input L with con­stant labour pro­duc­tiv­ity a:


    Labour employed in turn equals the mon­e­tary flow of wages divided by the nom­i­nal wage rate W:


    Prices then link this phys­i­cal out­put sub­sys­tem to the finan­cial model above. In equi­lib­rium, it must be the case that the phys­i­cal flow of goods pro­duced equals the mon­e­tary demand for them divided by the price level. We can there­fore derive that in equi­lib­rium, the price level will be a markup on the mon­e­tary wage, where the markup reflects the rate of sur­plus as defined in this paper.

    To answer Rochon’s vital ques­tion, M becomes M+ (that is, mon­e­tary prof­its are realised) via a price-system markup on the phys­i­cal sur­plus pro­duced in the fac­tory sys­tem. This markup can be derived sim­ply by con­sid­er­ing demand and sup­ply fac­tors in equi­lib­rium. The flow of demand is the sum of wages and prof­its (since inter­est pay­ments are a trans­fer and do not con­tribute to the value of output—despite Wall Street’s bleat­ings to the con­trary). The mon­e­tary value of demand is thus:


    The phys­i­cal units demanded equals this mon­e­tary demand divided by the price level:


    In equi­lib­rium this phys­i­cal demand will equal the phys­i­cal out­put of the econ­omy:


    Solv­ing for the equi­lib­rium price Pe yields:


    The markup is thus the inverse of work­ers’ share of the sur­plus gen­er­ated in pro­duc­tion. Cir­cuit the­ory there­fore pro­vides a mon­e­tary expres­sion of Marx’s the­ory of sur­plus value, as it was always intended to do.

    With these phys­i­cal and price vari­ables added to the sys­tem, we are now able to con­firm that profit as derived from the finan­cial flows table cor­re­sponds to profit as the dif­fer­ence between the mon­e­tary value of out­put and the wage bill (in this sim­ple single-sectoral model).

    Table 6: Para­me­ters and Vari­ables for Phys­i­cal Pro­duc­tion Sub­sys­tem

    Vari­able, para­me­ter or ini­tial condition Def­i­n­i­tion Value
    a Labour pro­duc­tiv­ity a = Q/L 2
    W Nom­i­nal wage 1
    Pe Equi­lib­rium price 0.833
    P0 Ini­tial price 1
    Le Equi­lib­rium employment 151.216
    Qe Equi­lib­rium output 302.432

    Using the val­ues given in Table 6, it is eas­ily con­firmed that the equi­lib­rium level of prof­its derived from the finan­cial flows cor­re­sponds to the level derived from the phys­i­cal pro­duc­tion sys­tem:


    The price rela­tion given above applies also only in equi­lib­rium. Out of equi­lib­rium, it is rea­son­able to pos­tu­late a first-order con­ver­gence to this level, where the time con­stant ?P reflects the time it takes firms to revise prices. This implies the fol­low­ing dynamic pric­ing equa­tion:


    A sim­u­la­tion also con­firms that the mon­e­tary flows (demand) and the mon­e­tary value of phys­i­cal flows (sup­ply) con­verge over time (Fig­ure 7).

    This solves the “para­dox” of mon­e­tary prof­its: it was not a para­dox at all, but a con­fu­sion of stocks with flows in pre­vi­ous attempts to under­stand the mon­e­tary cir­cuit of pro­duc­tion.

    Fig­ure 7: Sup­ply, Demand and Price Con­ver­gence

    Analysing the “Great Recession”

    We can now use this frame­work to con­sider one aspect of the cur­rent finan­cial cri­sis: if a “credit crunch” occurs, what is the best way for gov­ern­ment to address it?—by giv­ing fiat money to the banks to lend, or by giv­ing it to the debtors to spend?

    Our cur­rent cri­sis is, of course, more than merely a “credit crunch”—a tem­po­rary break­down in the process of cir­cu­la­tion of credit. It is also arguably a sec­u­lar turn­ing point in debt akin to that of the Great Depres­sion (Keen 2009), as Fig­ure 8 illus­trates. While the model devel­oped here can­not assess this claim, it can assess the dif­fer­en­tial impact of a sud­den injec­tion of fiat money to res­cue an econ­omy that has expe­ri­enced a sud­den drop in the rate of cir­cu­la­tion and cre­ation of pri­vate credit. This is an impor­tant point, since although the scale of gov­ern­ment response to the cri­sis was enor­mous across all affected nations, the nature of that response did vary: notably, the USA focused its atten­tion on boost­ing bank reserves in the belief—as expressed by Pres­i­dent Obama—that the money mul­ti­plier made refi­nanc­ing the banks far more effec­tive than res­cu­ing the bor­row­ers:

    And although there are a lot of Amer­i­cans who under­stand­ably think that gov­ern­ment money would be bet­ter spent going directly to fam­i­lies and busi­nesses instead of banks – “where’s our bailout?,” they ask – the truth is that a dol­lar of cap­i­tal in a bank can actu­ally result in eight or ten dol­lars of loans to fam­i­lies and busi­nesses, a mul­ti­plier effect that can ulti­mately lead to a faster pace of eco­nomic growth (Obama 2009: 3. Empha­sis added).

    Fig­ure 8: Pri­vate Debt to GDP Ratios, USA & Aus­tralia

    The Aus­tralian pol­icy response to the cri­sis, on the other hand, was pith­ily summed up in the advice given by its Trea­sury: “go early, go hard, go house­holds” (Gruen 2008). Though many other fac­tors dif­fer­en­ti­ate these two countries—notably Australia’s posi­tion as a com­mod­ity pro­duc­ing sup­plier to China—the out­comes on unem­ploy­ment imply that the Aus­tralian mea­sures more suc­cess­ful than the Amer­i­can “money mul­ti­plier” approach (see Fig­ure 9).

    The next sec­tion applies this endoge­nous money model to con­sider a dif­fer­en­tial response to a credit crunch in a grow­ing econ­omy: an injec­tion of funds is made into either the Banks’ Vault accounts—simulating the USA’s pol­icy response—or into the Work­ers’ Deposit accounts—simulating the Aus­tralian response.

    Fig­ure 9: Unem­ploy­ment Rates USA and Aus­tralia

    Endoge­nous Money Cre­ation and Eco­nomic Growth

    To model a credit crunch in a grow­ing econ­omy, while oth­er­wise main­tain­ing the struc­ture of the Free Banking/pure credit money model above, I move beyond the lim­i­ta­tions of a pure paper money sys­tem to allow for endoge­nous money cre­ation as described in Moore (1979):

    “In the real world banks extend credit, cre­at­ing deposits in the process, and look for the reserves later” (Holmes 1969, Moore 1979: 53); see also more recently Disy­atat (2010: 7 “loans drive deposits rather than the other way around”).

    In the model, new credit to sus­tain a grow­ing econ­omy is cre­ated by a simul­ta­ne­ous increase in the loan and deposit accounts for the bor­rower. The finan­cial flows in this sys­tem are given in Table 7. The two changes to Free Bank­ing model are the addi­tion of row 12 (and its ledger record­ing in row 13), with the qual­i­ta­tively new oper­a­tion of Money Cre­ation being added to the pre­vi­ous oper­a­tion of Money Trans­fer, and a “Deus Ex Machina” injec­tion of fiat money into either Bank Vault or Worker Deposit accounts one year after a credit crunch.

    Again, sim­ply to illus­trate that the sys­tem is viable, a con­stant growth para­me­ter “tau” M has the banks dou­bling the stock of loans every 15 years (see Table 3):


    A credit crunch is sim­u­lated by vary­ing the three cru­cial finan­cial flow para­me­ters tauV, tauL, and tauM at an arbi­trary time in the fol­low­ing sim­u­la­tion (at t=25 years): tauV and tauM are dou­bled and tauL is halved, rep­re­sent­ing banks halv­ing their rates of cir­cu­la­tion and cre­ation of new money and firms try­ing to repay their loans twice as quickly (see Table 8). The gov­ern­ment fiat-money res­cue is mod­elled as a one-year long injec­tion of a total of $100 mil­lion one year after the credit crunch.

    Sev­eral exten­sions to the phys­i­cal side of the model are required to model eco­nomic growth. In the absence of Ponzi spec­u­la­tion (which is the topic of a later

    Table 7: Endoge­nous Money Cre­ation

    Row Trans­ac­tion Type Bank vault (BV) Bank trans-action (BT) Firm loan (FL) Firm deposit (FD) Worker deposit (WD)
    1 Lend money Money trans­fer

    –a

    a

    2 Record loan Ledger entry

    a

    3 Com­pound debt Ledger entry

    b

    4 Pay inter­est Money trans­fer

    c

    –c

    5 Record pay­ment Ledger entry

    –c

    6 Deposit inter­est Money trans­fer

    –d

    d

    7 Wages Money trans­fer

    –e

    e

    8 Deposit inter­est Money trans­fer

    –f

    f

    9 Con­sump­tion Money trans­fer

    –g

    g+h

    –h

    10 Repay loan Money trans­fer

    i

    –i

    11 Record repay­ment Ledger entry

    –i

    12 New money Money cre­ation

    j

    13 Record loan Ledger entry

    j

    14 Gov­ern­ment policy Exoge­nous injec­tion into

    either

    BE or WD

    k

    k

    Sum of flows

    i–a+k

    c–d–f–g

    a+b–c–i+j

    a–c+d–e+g+h–i+j

    e+f–h+k

    ey sup­ply is only war­ranted if eco­nomic growth is occur­ring, which in turn requires a grow­ing pop­u­la­tion and/ or labour pro­duc­tiv­ity. These vari­ables intro­duce the issue of the employ­ment rate, and this in turn raises the pos­si­bil­ity of vari­able money wages in response to the rate of unemployment—a Phillips curve. These addi­tional vari­ables are spec­i­fied in Equation :


    Table 8: Finan­cial Flow Para­me­ters before and after a Credit Crunch

    Pre-credit crunch Post-credit crunch Impact of credit crunch
    tV = 4/3 years tV = 8/3 years Banks lend their reserve hold­ings of notes every 15 months
    tL= 7 years tL= 3.5 years Firms repay their loans every 3.5 years
    t M= 15 years t M= 30 years Banks dou­ble the money sup­ply every 30 years
    k=$100 mil­lion Injected either into bank vault BE or worker deposit WD at year 26, one year after the credit crunch

    The para­me­ter val­ues and func­tional form for this phys­i­cal growth exten­sion are shown in Table 9.

    Fig­ure 10 shows the impact of the credit crunch upon bank accounts: loans and deposits fall while the pro­por­tion of the money sup­ply that is lying idle in bank reserves rises dra­mat­i­cally.

    The US empir­i­cal data to date has dis­played a sim­i­lar pat­tern, though with a much sharper increase in bank reserves as shown in Fig­ure 11.

    A very sim­i­lar pat­tern to the empir­i­cal data is evi­dent in the model when the US pol­icy of increas­ing bank reserves is sim­u­lated (Fig­ure 12).

    The sim­u­la­tion of Aus­tralian household-oriented poli­cies gen­er­ates a very dif­fer­ent dynamic: reserves still rise dra­mat­i­cally dur­ing the credit crunch, but their increase is not fur­ther aug­mented by the pol­icy inter­ven­tion. Instead, firm and worker deposits rise sub­stan­tially (see Fig­ure 13), whereas they fall in the bank-oriented res­cue.

    This higher level of money in cir­cu­la­tion in the household-oriented pol­icy inter­ven­tion is the cause of the dra­matic dif­fer­ence in the out­comes of the two pol­icy inter­ven­tions: the household-oriented approach has a far more imme­di­ate and sub­stan­tial impact upon employ­ment (Fig­ure 14). Con­trary to the expec­ta­tions of Pres­i­dent Obama and his main­stream eco­nomic advis­ers, there is far more “bang for your buck” out of a house­hold res­cue than out of a bank res­cue.

    Table 9: Para­me­ters and Func­tion for Growth Model

    Vari­able or parameter Descrip­tion Value
    alpha Rate of growth of labor productivity 1% p.a.
    beta Rate of growth of population 2% p.a.
    Pop Pop­u­la­tion Ini­tial value = 160
    lambda Employ­ment rate Ini­tial value = 94.5%

    Phillips curve:

    Fig­ure 10: Bank Accounts before and after a Credit Crunch

    Fig­ure 11: Drop in Busi­ness Loans and Dra­matic Rise in Bank Reserves dur­ing Great Reces­sion

    Fig­ure 12: Sim­u­lat­ing US Bank-oriented Pol­icy towards a Credit Crunch

    Fig­ure 13: Sim­u­lat­ing Aus­tralian Household-oriented Pol­icy towards a Credit Crunch

    Fig­ure 14: Com­par­ing Bank-oriented and Household-oriented Poli­cies

    Con­clu­sion

    The para­dox of mon­e­tary prof­its is solved sim­ply by avoid­ing the prob­lem so wit­tily expressed by Kalecki, that eco­nom­ics is “the sci­ence of con­fus­ing stocks with flows” cited in God­ley and Lavoie (2007). With that con­fu­sion removed by work­ing in a frame­work that explic­itly records the flows between bank accounts and the pro­duc­tion and con­sump­tion they drive, it is obvi­ous that Cir­cuit The­ory achieves what it set out to do: to pro­vide a strictly mon­e­tary foun­da­tion for the Marx–Schumpeter–Keynes–Minsky tra­di­tion in eco­nom­ics. As an explic­itly mon­e­tary model, it also pro­vides an excel­lent foun­da­tion for explain­ing the processes that led to the “Great Reces­sion”, and for test­ing pos­si­ble pol­icy responses to it.

    Acknowl­edge­ments

    This work results from a col­lab­o­ra­tive research effort between the United Nations Envi­ron­ment Pro­gram (UNEP) and CSIRO Sus­tain­able Ecosys­tems to estab­lish a regional report on Resource Effi­ciency: Eco­nom­ics and Out­look for Asia?Pacific. I thank 4 anony­mous ref­er­ees, an edi­tor and Trond Andresen (Nor­we­gian Uni­ver­sity of Tech­nol­ogy) for com­ments that greatly improved the final paper.

    Ref­er­ences

    Bhaduri, A. (1969). On the Sig­nif­i­cance of Recent Con­tro­ver­sies on Cap­i­tal The­ory: A Marx­ian View. The Eco­nomic Jour­nal, 79(315): 532–539. http://ideas.repec.org/a/ecj/econjl/v79y1969i315p532-39.html

    Bellofiore, R., Davan­zati, G. F. and Real­fonzo, R. (2000). Marx Inside the Cir­cuit: Dis­ci­pline Device, Wage Bar­gain­ing and Unem­ploy­ment in a Sequen­tial Mon­e­tary Econ­omy. Review of Polit­i­cal Econ­omy, 12(4): 403–417. http://ideas.repec.org/a/taf/revpoe/v12y2000i4p403-417.html

    Boden­horn, H. (2008). Free Bank­ing and Bank Entry in Nineteenth-Century New York. Finan­cial His­tory Review, 15(2): 175–201.
    http://ideas.repec.org/p/nbr/nberwo/10654.html

    Boden­horn, H. and Hau­pert, M. (1996). The Note Issue Para­dox in the Free Bank­ing Era. Jour­nal of Eco­nomic His­tory, 56(3): 687–693. http://www.jstor.org/stable/2123719

    Char­lotte Bruun and Carsten Heyn-Johnsen (2009). The Para­dox of Mon­e­tary Prof­its: An Obsta­cle to Under­stand­ing Finan­cial and Eco­nomic Cri­sis? Eco­nom­ics Dis­cus­sion Papers, No 2009–52.

    http://www.economics-ejournal.org/economics/discussionpapers/2009–52.

    Disy­atat, P. (2010). The bank lend­ing chan­nel revis­ited, BIS Work­ing Papers, 297, Bank of Inter­na­tional Set­tle­ments, Basel. http://www.bis.org/publ/work297.pdf

    Dwyer, G. P., Jr. (1996). Wild­cat Bank­ing, Bank­ing Pan­ics, and Free Bank­ing in the United States’, Fed­eral Reserve Bank of Atlanta Eco­nomic Review, 81(3–6): 1–20. http://www.frbatlanta.org/filelegacydocs/ACFCE.pdf

    God­ley, W. and Lavoie, M. (2007). Mon­e­tary Eco­nom­ics: An Inte­grated Approach to Credit, Money, Income, Pro­duc­tion and Wealth, Hound­mills, U.K. and New York: Pal­grave Macmil­lan. http://www.palgrave.com/products/title.aspx?is=0230500552

    Graziani, A. (1989). The The­ory of the Mon­e­tary Cir­cuit, Thames Papers in Polit­i­cal Econ­omy, Spring: 1–26.

    Graziani, A. (1990). The The­ory of the Mon­e­tary Cir­cuit, Economies et Soci­etes, 24(6): 7–36.

    Graziani, A. (1995). The The­ory of the Mon­e­tary Cir­cuit, in M. Musella and C. Pan­ico (eds), The Money Sup­ply in the Eco­nomic Process: A Post Key­ne­sian Per­spec­tive, 60, Elgar Ref­er­ence Col­lec­tion. Alder­shot, UK: Inter­na­tional Library of Crit­i­cal Writ­ings in Eco­nom­ics. http://www.e-elgar.com/Bookentry_contents.lasso?id=574

    Graziani, A. (2003). The Mon­e­tary The­ory of Pro­duc­tion, Cam­bridge, UK: Cam­bridge Uni­ver­sity Press. http://www.cambridge.org/catalogue/catalogue.asp?isbn=0521812119

    Gruen, N. (2008). Go Early, Go Hard, Go House­holds, vol. 2010, Henry Thorn­ton, Mel­bourne. http://www.henrythornton.com/article.asp?article_id=5482

    Holmes, A. R. (1969). Oper­a­tional Con­traints on the Sta­bi­liza­tion of Money Sup­ply Growth, paper pre­sented to Con­trol­ling Mon­e­tary Aggre­gates, Nan­tucket Island, 1969. http://bosfed.org/economic/conf/conf1/conf1i.pdf

    Keen, S. (2001) Debunk­ing Eco­nom­ics: The Naked Emperor of the Social Sci­ences, Annan­dale Syd­ney & Lon­don UK: Pluto Press Aus­tralia & Zed Books UK. http://www.debunkingeconomics.com/

    Keen, S. (2009) Bail­ing out the Titanic with a Thim­ble, Eco­nomic Analy­sis & Pol­icy, 39(1): 3–24. http://econpapers.repec.org/article/eaparticl/v39_3ay_3a2009_3ai_3a1_3ap_3a3-24.htm

    Keynes, J. M. (1937). Alter­na­tive the­o­ries of the rate of inter­est, Eco­nomic Jour­nal, 47: 241–252. http://www.jstor.org/stable/2225525

    Marx, K. and Engels, F. (1885). Cap­i­tal II, Moscow: Progress Pub­lish­ers. http://www.marxists.org/archive/marx/works/download/Marx_Capital_Vol_2.pdf

    Min­sky, H. P. (1982). Can “It” Hap­pen Again? Essays on Insta­bil­ity and Finance, Armonk, N.Y.: M.E. Sharpe. http://www.amazon.de/Can-Happen-Again-Instability-Finance/dp/087332305X

    Moore, B. J. (1979). The Endoge­nous Money Stock, Jour­nal of Post Key­ne­sian Eco­nom­ics, 2(1): 49–70. http://www.jstor.org/stable/4537511

    Obama, B. (2009). Obama’s Remarks on the Econ­omy, New York Times, New York.
    http://www.nytimes.com/2009/04/14/us/politics/14obama-text.html

    Rochon, L.-P. (2005). The Exis­tence of Mon­e­tary Prof­its within the Mon­e­tary Cir­cuit’, in G. Fontana and R. Real­fonzo (eds), Mon­e­tary The­ory of Pro­duc­tion: Tra­di­tion and Per­spec­tives, Bas­ingstoke: Pal­grave Macmil­lan. http://www.palgrave.com/products/title.aspx?is=140393259X

    Smith­son­ian Insti­tu­tion (2010). National Numis­matic Col­lec­tion (NNC), National Museum of Amer­i­can His­tory, Wash­ing­ton, D.C. http://americanhistory.si.edu/collections/numismatics/

    About Steve Keen

    I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
    Bookmark the permalink.

    68 Responses to Solving the Paradox of Monetary Profits

    1. Tom Shaw says:

      Steve, sorry I should have addressed my ear­lier com­ment to you (August 4, 2011 at 12:33 am — except for the first paragraph).

      Tor­rey, I don’t sub­scribe to the dis­tinc­tions you’re mak­ing regard­ing objec­tive v sub­jec­tive, absolute v rel­a­tive, real v all in the mind, nat­ural v arti­fi­cial. It all depends on the level of abstrac­tion that you’re work­ing at. I think Steve taps into a much bet­ter frame­work when he talks about the fal­lacy of strong reduc­tion­ism (slides 17–18 at that link).

      I also rec­om­mend Leonard Susskind’s thoughts on what is “fun­da­men­tal” (from 1:11:10, but espe­cially from 1:19:10).

    2. kys says:

      Tom Shaw,

      Sorry for my late repsponse.

      By def­i­n­i­tion,

      1. w_D is the rate of out­flow of notes from Worker Deposit W_D to pay for work­ers’ consumption.

      2. b_T is the rate of out­flow of notes from Bank Trans­ac­tion B_T to pay for bankers’ consumption.

      For sim­u­la­tion pur­poses, 26 p.a. & 1 p.a. are assigned to w_D & b_T respec­tively, both of which are real­is­tic. I there­fore do not see any “inter­nal con­tra­dic­tion” like you do.

      In equi­lib­rium, g = b_T * B_T = bankers’ con­sump­tion = bankers’ net income = Bank Trans­ac­tion Account, which means Steve’s reply is accurate.

      As to your assump­tion that g = $x,

      1. The assump­tion does not hold when x > c-d-f because bankers can not plun­der the vault.

      2. When x < c-d-f, bankers save money. Where do they put the money? do you need a new entry “Banker Deposit” that gives bankers inter­ests? do bankers seek to lend out their sav­ings to firms at higher inter­est rates? Do they sim­ply con­sume more when sav­ings reach cer­tain lev­els? Do these con­sid­er­a­tions help in solv­ing the para­dox of mon­e­tary profits?

      I look for­ward to a mean­ing­ful discussion.

    3. Tom Shaw says:

      Hi Kys, Steve’s reply is accu­rate in that he recog­nised that this would indeed pro­duce the out­come I noted :)

      The con­tra­dic­tion is sim­ple: w_D and b_T are said to be dif­fer­ent because of dif­fer­ent lev­els of savings/income. This implies that the con­sump­tion coef­fi­cient of a per­son (as reflected in w_D and b_T) is a decreas­ing func­tion of their savings/income. And yet b_T is said to be a con­stant for all val­ues of a banker’s savings/income. Con­tra­dic­tion, Q.E.D.

      Even ignor­ing the inter­nal con­tra­dic­tion, there is no empir­i­cal jus­ti­fi­ca­tion for say­ing that b_T is a con­stant value. I’ve given a real-world exam­ple of some­one whose con­sump­tion has remained rel­a­tively sta­ble once it reached a cer­tain point. It’s cer­tainly a much more real­is­tic propo­si­tion than assum­ing con­sump­tion is lin­early related to the account bal­ance. The truth is prob­a­bly some­where in the mid­dle (maybe g is pro­por­tional to ln(B_T), who knows) but that would still be enough to alter the qual­i­ta­tive outcome.

      Regard­ing your other points, you’re just con­firm­ing the diver­gent nature of the out­come. In your sce­nario 1, the banker goes broke and the sys­tem breaks down. In your sce­nario 2, instead of leav­ing the money in B_T, the banker earns inter­est on it, cap­tures the money sup­ply even faster and the sys­tem breaks down.

    4. kys says:

      Since you like to turn “sec­toral” into “indi­vid­ual”, I guess you must be able to re-model the whole thing. Please do not for­get us when you release your mag­num opus.

      I just won­der if the sys­tem break­down actu­ally means a com­puter break­down or a ner­vous breakdown…

    5. Tom Shaw says:

      Hi Kys, I thought you were after a rea­son­able discussion..

      It’s Steve’s model which turns “sec­toral” into “indi­vid­ual” by posit­ing a sin­gle pri­vate bank — I’m just point­ing out the obvi­ous flaw in the model. I’ve never claimed to be able to model the econ­omy. In fact a cou­ple of com­ments ago I gave my opin­ion that eco­nomic real­ity may well be too com­plex to model from the bottom-up, thus my pref­er­ence for top-down analysis.

    6. kys says:

      But what do you mean by top-down and Bottom-up? I can’t tell the difference.

    7. Tom Shaw says:

      Hi Kys, this is dis­cussed a bit in this pre­sen­ta­tion includ­ing an inter­est­ing con­ver­sa­tion around 23:45. There’s also an arti­cle on Wikipedia.

      The bottom-up approach is to start from smaller, sim­pler com­po­nents and build upwards. For exam­ple, you could the­o­ret­i­cally take your knowl­edge of physics, and based on this derive the rules of chem­istry. Of course this is dif­fi­cult because even though the com­po­nents are sim­ple, the inter­ac­tions may cre­ate emer­gent behav­iour. Small flaws in your assump­tions can cre­ate qual­i­ta­tively dif­fer­ent out­comes. Only recently with super-powerful com­put­ers and extremely accu­rate phys­i­cal under­stand­ing can chem­i­cal prop­er­ties be mod­eled from the bottom-up.

      The top-down approach is to start from a birds-eye view of the whole sys­tem and derive rules from what you see. In prac­tice this is how chem­istry was really devel­oped. Friedman’s “F-Twist” actu­ally makes sense if this is explic­itly your approach. The prob­lem with the top-down approach is that it’s dif­fi­cult to extend your knowl­edge to new situations.

      The tragedy of mod­ern eco­nom­ics is that the flaws of each approach have not been respected. The bottom-up approach failed because, as Steve likes to point out, the all-important assump­tions under­ly­ing keep being for­got­ten or ignored (e.g. SMD con­di­tions or expected util­ity). The top-down approach failed because not enough atten­tion was paid to his­tory (e.g. the great depres­sion) to get a big enough set of empir­i­cal data to analyse. By ignor­ing these flaws, econ­o­mists clearly became way too con­fi­dent in their mod­els, which is why so many were sur­prised by the GFC.

    8. kys says:

      Tom

      This dis­cus­sion is really mean­ing­ful but I’ve got to run now.

      I will talk to you soon in the next debate.

    9. torreybyles says:

      Thanks Tom. I appre­ci­ate your com­ments and will look into the links that you pro­vide. I do like Steve’s fal­lacy of strong reduc­tion, btw.

    10. RJ says:

      I’m not sure from the above if Steve under­stands dou­ble entry book keep­ing or not?

      Or how dou­ble entry book keep­ing relates to the P+L account and bal­ance sheet

      Com­mer­cial banks, cen­tral bank, the trea­sury and com­pa­nies etc MUST post a jour­nal entry for every trans­ac­tion. It is from these jour­nal entries that the P+L account and bal­ance sheet is produced

      Fail­ure to under­stand this results in many econ­o­mists form­ing incor­rect con­clu­sions (as I beleive Steve has in this report. Although I’m open to being con­vinced otherwise).

      Exam­ple from fig­ure Fig­ure 1

      The jour­nal entries are for the BoF

      Action 1 Print notes BoF JE

      Debit Notes asset BoF dol­lars (bank asset)
      Credit Printed money off­set Lia­bil­ity
      This lia­bil­ity reflects a lia­bil­ity the bank has to the hold­ers of these $ notes

      Action 2 BoF issues notes to a customer

      BoF account
      Debit Cus­tomer loan (bank asset / cus­tomer debt lia­bil­ity)
      Credit Cus­tomer cheque account (bank lia­bil­ity / cus­tomer finan­cial asset)

      Cus­tomer accounts
      Debit Bank bal­ance at the BoF
      Credit Lia­bil­ity Bank loan BoF

      Action 3 Cus­tomer with­draws bank notes

      BoF account
      Debit Cus­tomer cheque account (reduce bank lia­bil­ity account)
      Credit Notes BoF dol­lars (reduce hold­ing on notes asset)

      Cus­tomer accounts
      Debit Notes BoF dol­lars
      Credit Lia­bil­ity Bank bal­ance at the BoF (reduce bank bal­ance)
      In effect the credit held at the BoF has been con­verted to a BoF sup­ported $ dol­lar notes

      And the dol­lar notes are sup­ported by debt and noth­ing but debt.

      What if the BoF had gold hold­ings. For me debt still sup­ports the dol­lar notes but gold is used as a safety cover (insur­ance) in case some debt can not be paid back.

      BoF JE
      Debit Gold on hand
      Credit Share­hold­ers funds

      When the full jour­nals are done as above it shows clearly that this statement

      Keynes, on the other hand, spoke of a “revolv­ing fund of credit” which was con­tin­u­ously replen­ished by the repay­ment of debt, which implies that money used to repay debt may be tem­porar­ily taken out of cir­cu­la­tion, but is not destroyed:”

      is incor­rect

      When money is taken out of cir­cu­la­tion to repay debt

      The banks jour­nal entry is

      Debit BoF notes
      Credit Cus­tomer deposit account

      And then

      Debit Cus­tomer deposit account (MONEY IS DESTROYED)
      Credit Cus­tomer loan (bank asset reduced / cus­tomer debt lia­bil­ity reduced)

      So this state­ment below is correct

      Money is cre­ated as banks lend-mainly to business-and money is destroyed as bor­row­ers ful­fill their pay­ment com­mit­ments to banks.”

      The prob­lem occurs because Keynes con­sid­ered notes held in a bank safe as money. It is not.

      If a bank printed a 100 tril­lion note and left it locked in a bank safe. It would have no impact on the money sup­ply at all

      Only when it is released does it impact on the money sup­ply. This is why Notes and coins (cur­rency) in bank vaults do NOT form part of M1 M2 M3 or MZM

      http://en.wikipedia.org/wiki/Money_supply

    11. RJ says:

      Cor­rec­tion

      Action 2 above is

      BoF loans money to a customer

      This arti­cle on money is worth reading

      http://moslereconomics.com/mandatory-readings/what-is-money/

      Money, then, is credit and noth­ing but credit. A’s money is B’s debt to him, and when B pays his debt, A’s money dis­ap­pears. This is the whole the­ory of money.”

      Credit came first and notes and coins later.

      Notes and coins are noth­ing more than a token to allow the easy trans­fer of credit. Notes and coins are exchanged for bank credit (deposits). These tokens can then be exchanged for goods ser­vices or assets. The new holder can then bank these notes and coins in exchange for bank credit

      The jour­nal entries above clearly shows this.

    12. RJ says:

      Keynes, on the other hand, spoke of a “revolv­ing fund of credit” which was con­tin­u­ously replen­ished by the repay­ment of debt, which implies that money used to repay debt may be tem­porar­ily taken out of cir­cu­la­tion, but is not destroyed:”

      Ok

      Which implies”. Does it imply this though.

      If Keynes just called bank held notes and coins a “revolv­ing fund of credit”. Yes debt repay­ment does replen­ish bank held notes and coins. But it does not imply credit is not destroyed. It just means notes and coins are replen­ished in the bank noth­ing more. Credit is destroyed as the jour­nal entries above show

    13. Steve Keen says:

      Hi RJ,

      I think the tech­ni­cally cor­rect def­i­n­i­tion you gave earlier:

      This is why Notes and coins (cur­rency) in bank vaults do NOT form part of M1 M2 M3 or MZM” is not incon­sis­tent with Keynes as you’re read him here:

      ” Yes debt repay­ment does replen­ish bank held notes and coins. But it does not imply credit is not destroyed. It just means notes and coins are replen­ished in the bank noth­ing more. Credit is destroyed as the jour­nal entries above show”

      If one defines credit (or money) as “money in cir­cu­la­tion as defined by M1 M2 M3 or MZM” then yes credit/money is destroyed by debt repay­ment. How­ever the notes and coins are not destroyed, as you note. They can re-enter cir­cu­la­tion later when money is cre­ated once more by addi­tional debt.

      To han­dle this in a dynamic model of the money cre­ation and cir­cu­la­tion process, I am effec­tively work­ing with a broader def­i­n­i­tion of money that includes these “not in cir­cu­la­tion” notes and coins (and other liq­uid assets). This may be the source of the con­flict between me and other Post Key­ne­sians on this–certainly that’s what War­ren Mosler argued in a ver­bal debate some years ago. I argue for my approach and my wider def­i­n­i­tion when mod­el­ling a dynamic process, since to do oth­er­wise implies there is a “sink” (in dynamic sys­tems ter­mi­nol­ogy) through which the notes and coins lit­er­ally are destroyed.

    14. Pingback: The Debtwatch Manifesto | Steve Keen's Debtwatch

    15. Keynes (Arti­cle above) : “If invest­ment is pro­ceed­ing at a steady rate…“
      … “then the Prof­its of the Busi­ness will decline to zero” — Me :
      http://www.youtube.com/watch?v=Bf2LLfM0lKE … so using the CFS the Cur­rent Finan­cial Sys­tem, we may have no phys­i­cal need to increase “Invest­ment” — we might have all the machines we need but the CFS forces an increase to keep the show on the road as it where. So at base the Finan­cial sys­tem does not reflect real­ity and it would be a good idea to design one that does

    16. Steve has failed to estab­lish that there is a “Para­dox of Mon­e­tary Prof­its“
      in the 1st place. A com­pany knows if it has made a profit or loss by look­ing
      at its accounts — not its bank state­ment and the equa­tion for prof­its across he whole econ­omy is :
      Retained Prof­its of Busi­ness = Fixed Assets Of Busi­ness + Gov­ern­ment Debt + House­hold Debt + Foreigner’s Debt
      This can be demon­strated using num­bers for the UK National Accounts :
      http://netexportfinancialsimulation.wordpress.com/2011/07/01/7/

      The step by step, Deb­its and Cred­its, of how it moves from one sit­u­a­tion
      to another through the bank­ing sys­tem you can see in the spread­sheet model financial_scenarios.xls in :
      http://netexportfinancialsimulation.wordpress.com/2011/07/01/nefs-net-export-financial-simulation/

      - There is no Para­dox to solve

    17. EconCCX says:

      Greet­ings All

      Steve, we’ve met. I was one of the lucky geeks who caught your pre­sen­ta­tion in NYC last fall around the impend­ing release of the revised Debunk­ing. We had a lively group con­ver­sa­tion on the way to and at din­ner: MMT vs. cir­cuit the­ory; the exor­bi­tant priv­i­lege; your planned work with Hud­son. The increas­ing and mis­placed con­fi­dence by bor­rower and lender (Min­sky) vs con­trol fraud and principal/agent con­flict (Black). At pre­sen­ta­tion Q&A, I flogged Soddy; you politely responded that you hoped to get to him some day. Thanks, belat­edly, for that great talk, and to Robert (com­menter Robert K?) for hosting.

      I’m quite late to the dis­cus­sion, but hope you’ll still enter­tain a few ques­tions about the Mon­e­tary Prof­its Paradox.

      First is a book­keep­ing ques­tion about a very sim­ple trans­ac­tion. But I think it pro­vides us a win­dow on more com­plex ones:

      A firm main­tains a bank check­ing account with a $10 monthly fee. Sup­pose its bal­ance is $1000 before the fee, and $990 after. Which do you believe most accu­rately describes the out­come of the transaction:

      A) The firm’s bal­ance is reduced by $10; the banks funds are increased by $10. Whether the incre­ment is booked as reserves or prof­its or addi­tional loan­able funds, some account at the bank shows that jour­nal entry, and a $10 gain. Money in the amount of $10 has been trans­ferred from firm to bank, and from aggre­gate firm hold­ings to aggre­gate bank holdings.

      B) The firm’s bal­ance is reduced by $10. That $10 van­ishes com­pletely. It’s on nobody’s account; it sim­ply ceases to exist. That debit to the firm’s account has dimin­ished the universe’s total stock of money. –OR

      C) Some other out­come as yet undescribed.

      Prof. Keen: if you’re able to address this ques­tion, per­haps you could also tell us whether you believe Graziani would agree with your reply. Fel­low com­menters: I hope you’ll kindly take a stab at this as well. I have some terms or premises wrong, no doubt; so I look for­ward to see­ing how oth­ers book and char­ac­ter­ize this transaction.

      Regards
      EconCCX

    18. Bhaskara II says:

      Dou­ble entry jour­nal entries describ­ing the trans­ac­tion from the point of view of each entity would be:

      Firm entity:
      Dr. Fee Expense // Cr. House of Bank (asset account)* $10

      Bank entity:
      Dr. House of Firm (lia­bil­ity deposit account) // Cr. Bank’s Rev­enue or Equity $10

      * house of is an old term that could mean com­pany, bank, fam­ily, etc. Exam­ple “House of Morgan”.

      The firm’s bal­ance is reduced by $10; the banks equity or claim on funds are increased by $10. The incre­ment is booked as the banks’ prof­its. And the incre­ment of the firms expense or reduc­tion in firms’ equity. Money in the amount of $10 has been trans­ferred from firms’ equity to banks’ equity.

    Leave a Reply