Do “net financial assets” matter?

I’ve just read Steve Waldman’s post on “net financial assets” and am connecting it up with Michael Pettis’ excellent discussion. (See also Cullen Roche’s comment on the issue.)

Steve discusses the decomposition of financial positions on which MMT is based. He points out that the term “net financial assets” is used for the “private sector domestic financial position” which refers exclusively to the aggregate netted financial position of both households and firms and explicitly excludes “real” savings such as any housing stock that is fully paid up. By definition, if the “private sector domestic financial position” is positive, then it must be the case that on net the private sector holds claims on either the government or on foreign entities. Of course, the value of such claims depends entirely on the credibility of the underlying promises — this is the essential characteristic that distinguishes a claim to a financial asset from a claim to a real asset.

For Steve, there is a tradeoff between holding financial claims and holding real claims, and a principal reason for holding financial claims is to offset the risk of the real claims. Thus, Steve goes on to claim that to the degree that such a positive private sector financial position is due to claims on government, the government is using its credibility to provide a kind of insurance against real economy risk.

This is where I think Steve both gets what happened in 2008 right, and gets the big picture of the relationship between the financial and the real, and between the private sector and the public sector wrong. Steve is completely correct that in 2008 the issue of public sector liabilities played a huge insurance and stabilization role.  But Steve extends his argument to the claim that: “The domestic private sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the state.”

The key point I want to make in this post is this: the financial and the real are so interdependent that they cannot actually be divorced. The same is true of the private and the public sectors. Financial activity and real activity, public sector activity and private sector activity are all just windows into a single, highly-integrated economy. Thus, I would argue that it is equally correct to state that: “The domestic public sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the private sector.”

That financial activity and real activity are two sides of the same coin is most obvious when one considers that the credibility of private sector financial liabilities depends fundamentally on the performance of the real economy. But it is equally true that the credibility of public sector liabilities (when measured in real terms) depends fundamentally on the robustness of the real economy as well. Those countries that have very highly rated debt did not achieve this status ex nihilo, but because of the historical performance of their economies and the robustness of their private sectors.

Thus, it is entirely correct that the public sector can temporarily step in to provide insurance for the private sector when it is struggling, but the view that it is the public sector that is the primary provider of insurance fails to capture the genuine interdependence that lies at the heart of a modern economy.

Indeed, Steve recognizes the danger of framing the financial and the real and the public and the private in this way in his last paragraph, where he acknowledges that this publicly-issued insurance is in fact provided in real terms at the expense of a segment of the private sector — the segment that does not hold the claims on government.

Michael Pettis on Creating Money out of Thin Air

Now let’s turn to Michael Pettis (whom I’ve never met, so I’ll call him by his last name). Pettis has long stood out as an economist with a uniquely strong understanding of the relationship between the financial and the real. He argues that “When banks or governments create demand, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other, equally easily specified, cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand out of thin air, as many analysts seem to think, because doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.”

His two cases are a full employment economy (without growth) and an economy with an output gap. He argues that it is only in the latter case that the funding provided by banks (or government) can have an effect on output. In a comment to Pettis’ post I observed that his first case fails to take into account Schumpeter’s theory of growth. An economy is at full employment only for a given technology. Once there is a technical innovation, the full employment level of output will increase. Schumpeter’s theory was that the role of banking in the economy was to fund such innovation. Thus, there is a third case in which bank finance in a full employment economy does not just transfer resources to a different activity, but transfers them to an innovative activity that fundamentally alters the full employment level of output. Thus, it is not only when the economy is performing below potential that bank funding can create the production that makes savings equal to investment. When banks fund fundamental technological innovation, it is “as if” the original economy were functioning below potential (which of course if we hold technology constant at the higher level, was in fact the case — but this deprives the concept of “potential GDP” of its meaning entirely.)

Schumpeter was well aware that the same bank funding mechanisms that finance fundamental technological innovation, also finance technological failures and a vast amount of other business activity. Indeed, he argued that even though the banking system was needed to finance innovation and growth, the consequences of the decision making process by which banks performed this role included both business cycles and — when banking system performed badly — depressions.

In short, there is very good reason to believe that even in a “full-employment” economy when banks create debt, some fraction of that process creates additional demand. The problem is that the fraction in question depends entirely on the institutional structure of the banking system and its ability to direct financing into genuine innovation. It’s far from clear that this fraction will exhibit any stability over time.

How Did We Get Here: The Fault Lies in Our Models

So why do economists fall into the trap of treating the financial and the real as separable phenomena? Why do macroeconomists of all persuasion look for solutions in the so-called public sector?

The answer to the first question is almost certainly the heavy reliance of the economics profession on “market-clearing” based models. In models with market-clearing everybody buys and sells at the same time and liquidity frictions are eliminated by assumption. Of course, one of the most important economic roles played by financial assets is to address the problem of liquidity frictions. As a result, economists are generally trained to be blind to the connections between the financial and the real. People like Michael Pettis and proponents of MMT are trying to remove the blindfold. They are, however, attempting to do so without the benefit of formal models of liquidity frictions. This is a mistake, because the economics profession now has models of liquidity frictions. The future lies in the marriage of Schumpeter and Minsky’s intuition with New Monetarist models.

The answer to the second question is that we have a whole generation of macroeconomic policy-makers who think that the principal macroeconomic economic debate lies between Keynesians and Monetarists, when in fact both of these schools assume that the government is the insurer of last resort. The only distinction between these schools is whether the insurance is provided by fiscal or by monetary means. (To understand why our economies are struggling right now one need only understand how the assumption that the government is the fundamental source of liquidity has completely undermined the quality of our financial regulation.)

The concept of liquidity as a fundamentally private sector phenomenon that both drives the process of growth and periodically requires a little support from the government (e.g. giving the private sector time to weather a financial panic without the government actually bearing a penny of the losses) has been entirely lost. Only the future can tell us the price of this intellectual amnesia.


9 thoughts on “Do “net financial assets” matter?”

  1. Hi Carolyn,

    I like how you try to reconciliate all this. Thanks!

    You write: “By definition, if the “private sector domestic financial position” is positive, then it must be the case that on net the private sector holds claims on either the government or on foreign entities. Of course, the value of such claims depends entirely on the credibility of the underlying promises”

    You’re right. To me it seems that a question we have all failed to ask is this: What is the underlying promise when we talk about a claim on the government?

    My answer is that the (implicit if not explicit) promise is that taxpayers and some other private agents will end up crediting the “government account” (if it doesn’t physically exist, we can nevertheless imagine it) — an account which the government debits when it spends. * The claim is not on the government (an abstract entity) but on the people — mainly personified by “the taxpayer”. Therefore the “net financial assets” of the private sector are an illusion.

    As you say: The value of such claims depends entirely on the credibility of the underlying promises. If the underlying promise can be tracked to the private sector, then no claim on the public sector alone, without this link to private sector, can have value. (Yes, Government IOUs are fungible, and thus each one of them will have some value as long as we expect that there are some private sector liabilities behind them. But if we expect that for every, say, $1000 worth of Gov IOUs we can only expect that there exists $500 worth of future “taxpayer liabilities”, then the real value of these Gov IOUs is half of what it would be if we could expect/assume $1000 worth of taxpayer liabilities.)

    Does this make any sense?

    * For a more detailed explanation, click my name and see the last three posts in my blog.

    1. Hi Peter,

      I think that your basic intuition is correct, but I also think that you frame the connection between the public and private perhaps a little to strongly. In particular this phrase “no claim on the public sector alone, without this link to private sector, can have value” seems to me too strong.

      Governments are able to issue in their own names. Whether they will actually be able to honor those claims depends on the performance of the private sector. However, because governments issue in their own names Past (private sector) performance matters a lot in determining how much governments can borrow and generally it takes a long time for lenders to catch up with the fact that an issuer is beginning to lack the wherewithal to pay its debts.

      Thus, in my view the public-private connection is both very important, and yet very indirect and amorphous. Over the short-run a government with a past history of credibility will be able to issue vast amounts easily. It is really over the long run that economic performance functions as a limit on a government’s ability to issue debt.

      1. Carolyn, I fully agree with you.

        What I said was not supposed to imply anything about the “government’s ability to issue debt”. What I said, or at least wanted to say, was that there are no “financial assets” in a closed economy which don’t have a connection to a private liability, or obligation. A “very indirect and amorphous” connection is still a connection.

        Based on this, I question the MMT claim that “Government IOUs” are “net financial assets” for the private sector. It can be true if we view Government as fully separate (not only legally) from the People (=private sector). But this is not how I think we should view Government.

        Let’s say that we nevertheless try to view the Government like MMT suggests. How can we then explain how these “financial assets” acquire any value? As far as I know, the MMT position is that these financial assets (“IOUs”) have value because the Government accepts them as a payment for taxes and other fees. But this is just another way to say that they have value because there is a private sector liability behind them. And, as far as I know, MMT, too, acknowledges this private sector liability in form of a tax obligation because it argues that only a Government *Deficit* creates these “net financial assets” for the private sector. We, who have not managed to divorce the Government fully from the People, would of course recognize this Deficit as (mostly) a Taxpayer liability. (This could explain why some “anti-establishment people” see much potential in MMT: it matches their Weltanschauung which tells them that the government is formed by crooks? I consider myself non-partisan.)

        Do you still agree with me?

  2. To be honest, I don’t know MMT that well. My impression based on my limited knowledge is that, like most Keynesian analysis, it is best viewed as an analysis of what we should do in the short-run — which is important.

    I think that in the short run a country can take advantage of the government’s credibility to put in place policies that will at some point need to be reversed in order to maintain long-run stability. In this sense, I don’t have any problem with MMT’s recommendations as I understand them.

    I think that the view that you are promoting is a long-run view — but that you need to be careful not let a focus on the long-run prevent you from choosing the optimal policy in the short-run.

    I realize that your comment is not really focused on policy, but on a more philosophical question. But I’m trained as an economist, so I don’t tend to focus on whether an approach is “right,” but on whether it is useful — and I think that MMT holds a valid place in the policy discourse — but like all theories it needs to be cabined and confined to the limited realm in which it is valid.

    1. I see what you mean.

      You might be happy to hear that I have nothing against the government running a deficit in a downturn and trying to keep as many people as possible employed (assuming it recognizes the limits to this). On the contrary.

      But when it comes to those “philosophical questions” (or can we say “positive science”?), I think we must all demand that any policy recommendation is backed either by good science or intuition, but not by bad science. I am not promoting a long-run view. I am promoting intellectual integrity, and this applies to myself and others.

      MMT explicitly claims that its policy recommendations are backed by science. And it is these scientific claims made by MMT that an economist, or a political philosopher, should in my opinion be concerned with. When you say that you “don’t have any problem with MMT’s recommendations”, that tells us something about your view of the “right policy”, and nothing about you as a scientist.

      If you choose not to study those scientific claims rigorously (this is perfectly fine), then it might be better for you to say that you agree with certain policy recommendations of “citizen Wray” or “citizen Mosler”, or any other MMT writer you might have been reading. I disagree with the scientific claims MMT makes, but I agree that government should run a deficit in downturn and try to keep people employed. In other words: I would never endorse MMT’s scientific claims, but that doesn’t mean that my political opinion clashes totally with most of the writers connected to MMT.

      MMT as a whole is not valid in any realm. Some of its claims are valid and some are invalid. We need to make sure that no one uses invalid scientific claims to back any policy recommendation, regardless of our opinion of the recommendation itself. Don’t you agree?

      1. “MMT explicitly claims that its policy recommendations are backed by science.”

        I am unaware of any such claims. Economics is a social science, and like history is built on models that are always “wrong” in some sense and often unspoken. MMT is drawing attention to some of the unspoken assumptions that drive economic discourse. As far as I am concerned, this is a valuable “scientific” contribution, and the fact that the model being used is just as wrong as every other model ever used by an economist will not stop me from recognizing the positive contribution that MMT brings to the discourse.

        ” We need to make sure that no one uses invalid scientific claims to back any policy recommendation, regardless of our opinion of the recommendation itself. ”

        This would be an excuse to stop all policy-making in the economic realm because there are no controlled experiments in the social sciences — which of course would be silly because not acting is just as much policy-making as acting.

  3. Carolyn, you misunderstood me. Perhaps fault lies with me. Anyway, I did not mean to say that we shouldn’t listen to MMT because the model generally is not flawless. You’re absolutely right in arguing against this.

    What I meant to say is that it seems to me that all the MMT-specific “scientific arguments” (the ones not used by me, or Krugman/some other more orthodox economists) supporting the MMT policy recommendations are badly flawed. One is the “net financial assets of private sector” which I already mentioned, and which they alternatively present as (not a direct quote) “Government IOUs are not really IOUs, as there is no real liability behind them, and so the Gov can issue these freely as long as inflation is kept in control”.

    I, too, welcome the contribution MMT brings to the discourse. They manage to bring out in light certain important and often forgotten aspects of the financial system — although it must be said that these are not in any way original findings. My problem with MMT is that the more original claims they make are controversial and often outright flawed on closer inspection. Despite well-founded criticism, “MMTers” march on and repeat those flawed arguments. This is probably the reason why it has acquired an air of a religion/dogmatism around it. It seems to pull all kinds of politically radical people towards it. I think this is actually somewhat sad, as I appreciate the writings of some of the big names behind MMT, like Randall Wray.

    1. Glad you cleared up the misunderstanding.

      I certainly agree that there is “good” MMT and “bad” MMT, and that the blogosphere is a complex mix of the two.

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