by Michael Pettis has a post about endogenous money in which he challenges the idea that banks and governments can create demand from “thin air”. This is a concept that has grown in great popularity over the years thanks in large part to internet discourse, but it’s also become quite confused at times due to differing views on endogenous money. Pettis does a nice job covering much of that confusion which stems from the way Steve Keen has depicted the ideas over the years. I like Keen and he’s doing good work in moving Post-Keynesian ideas forward, but let’s just say that there is A LOT of push-back and criticism within the Post-Keynesian community about how he’s defining his ideas and doing his accounting (see here, here, here, here, here, here or here for instance). There is a lot to like in Pettis’ post. Specifically, I think the discussion on accounting identities is critical since accounting identities are, well, just identities. Saying something like “spending = income” is just a tautology. It doesn’t tell you anything about how these actions impact the economy. I mean, I could be spending on building a bomb that will destroy the person I spent the income to. If we’re the only two people in the economy well, do the math on how that will likely impact our economy. You get the (silly) point (hopefully). There was one section that needs clarification though.
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Michael Pettis has a post about endogenous money in which he challenges the idea that banks and governments can create demand from “thin air”. This is a concept that has grown in great popularity over the years thanks in large part to internet discourse, but it’s also become quite confused at times due to differing views on endogenous money. Pettis does a nice job covering much of that confusion which stems from the way Steve Keen has depicted the ideas over the years. I like Keen and he’s doing good work in moving Post-Keynesian ideas forward, but let’s just say that there is A LOT of push-back and criticism within the Post-Keynesian community about how he’s defining his ideas and doing his accounting (see here, here, here, here, here, here or here for instance).
There is a lot to like in Pettis’ post. Specifically, I think the discussion on accounting identities is critical since accounting identities are, well, just identities. Saying something like “spending = income” is just a tautology. It doesn’t tell you anything about how these actions impact the economy. I mean, I could be spending on building a bomb that will destroy the person I spent the income to. If we’re the only two people in the economy well, do the math on how that will likely impact our economy. You get the (silly) point (hopefully).
There was one section that needs clarification though. Pettis writes:
A lot of people seem to think that this means the state can create demand out of thin air, and so demand created by the state can be added to existing demand with no other change, including no increase in savings. If savings and investment had previously balanced, according to this argument, and the state creates new demand, either this new demand is in the form of investment, in which case investment becomes greater than savings, or the new demand is in the form of consumption, in which case savings is reduced (savings is the obverse of consumption), and so once again investment exceeds savings.
This isn’t quite right. What Post-Keynesians usually emphasize is that the government can endogenously expand its balance sheet by running a budget deficit. In doing so it is adding net financial assets to the private sector. For instance, if the government sells a bond worth $100 to Peter to finance spending to Paul then the government is spending $100 into the economy that Peter did not want to spend. But Peter is not worse off. Peter has $100 in bonds AND Paul has $100 in income. This adds to private sector net financial assets by $100 because the liability of the bond is held outside of the private sector. Gross savings and gross financial assets have not increased, but the whole point here is to emphasize that the government is making the private sector better off IN NET FINANCIAL TERMS than it otherwise would have been by simply expanding its balance sheet and creating the bond out of thin air.*
Now, is this necessarily good? Of course not. As I said above, Paul might use his $100 in income to build a bomb that kills Peter and the government. That certainly wouldn’t be a positive economic outcome for this economy. But that’s a whole different matter. The fact is, the government can expand its balance sheet out of thin air to create financial assets and in doing so it increases net financial assets and private sector savings. In theory, this should lead to greater spending than we might have otherwise had. But it depends on many other factors as Pettis notes. The key point here is that Pettis is not being very careful when he says:
[The banks and government] never simply create demand “out of thin air”, as many analysts seem to think, and doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.
This misunderstands the way the accounting identities are being utilized in the Post-Keynesian framework and I am afraid Pettis is falling victim to his own narrow definitions of “savings” and “investment” within the context of his own views on the accounting identities.
* – If we were to alter this debt creation from “thin air” to a discussion about banking the sectoral accounting has to be placed in the right perspective again. For instance, much of private sector investment is funded via loans so we could say, since investment adds to savings, that debt created from thin air can help to finance the creation of savings via investment.
