The choice is between increasing or decreasing aggregate demand

By Edward Harrison of Credit Writedowns.

DoctoRx, Rob Parenteau and Marshall Auerback have each written articles here to bring clarity to some issues I first raised at the beginning of the month in my post, “The recession is over but the depression has just begun.”

As I see it, the issue we are debating has to do with how the government responds when large debts in the private sector constrain demand for credit in the face of a severe economic shock and fall in aggregate demand. In short, if private sector debt levels are so high that a recession precipitates private sector credit revulsion, how should government respond?

Frankly, this question is as much philosophical and political as it is economic.  So I want to wait to answer it and first frame the monetary system in a way which reveals the political nature of the question. Afterwards, I hope it is apparent that there is no one answer to this question and that any society’s answer depends on and reveals its priorities as a people. I will try to make some concluding marks about government debts and taxes in a fiat currency system given the analysis Marshall’s post.

Money and the sectors of the economy

Money is a tool, a medium of exchange, which derives its value from its utility in allowing individuals in an economy to trade goods and services. It eliminates the need to barter and make direct exchanges of goods and services in order to trade. Think of any economy as a collection of individuals or groups which trade goods and services with each other and with the outside world in exchange for a money-value of those goods and services. Each transaction is an exchange of a good or service for a equivalent value amount of money.

So, in any country, the flow of goods and services should be a one for one mirror image of the money flows. Now, if you break an economy down into sectors like the government sector, the private sector, and the foreign sector, the same is also true. Two accounting identities flow from this.

  • In any particular time period, the changes in both money value of goods and the changes in the financial balances must sum to zero.  As Rob, illustrated: Household FB + Business FB + Government FB + Foreign FB = 0
  • One sector’s deficit is another sector’s surplus. Think of it this way, if you and I are the only ones in the economy. If I spend more than I earn in, say, one particular month to buy your goods and services, you must have spent less than you earned in that same month to buy my goods and services.

If you take Rob’s formula and combine the two sectors of households and businesses into one sector, the private sector, you are left with Private FB + Government FB + Foreign FB = 0. What this means is that in any given time period, the private sector financial balance is offset by the government and foreign sectors’ balance such that they all sum to zero.

Private sector debts and credit revulsion

Given the framework above, it should be clear that when the private sector has a net surplus, the government and foreign sectors must have a combined net deficit.

So what happens when the economy lapses into recession because of a financial crisis caused in large part by excessive leverage and debt?

The answer is credit revulsion, also known as deleveraging. And this is what we have just seen in the U.S. economy.  Credit revulsion means that the private sector (businesses and households) reduce or are forced to reduce their debt burdens. This change in behavior induces a net surplus in the private sector; the private sector increases savings.

I’m sure you know where this is going. If the private sector moves to a net surplus, the combined government/foreign sectors must axiomatically move to a deficit.

A foreign sector deficit means that we are net exporting i.e. foreigners are buying more stuff from us than we are from them. We are talking money flows here not goods and service: more money coming in than going out (FB deficit) means fewer goods coming in than going out (current account surplus). Since the U.S. is not going to run a current account surplus, I am going to leave this out of the discussion to focus on the real issue: Government.

We can try and reduce private sector savings

So, the result for the U.S. of a private sector which is net saving is government deficits – this what naturally flows from a credit-revulsion induced private sector deleveraging. By saying this, I am stating fact, I am not making a political argument for or against deficit spending.

However, this is where the political/philosophical discussion starts. Two questions come to mind.

  • Do we want the private sector to net save at this point in time?
  • If so, do we want this savings to occur in an environment of more aggregate demand or less?

Policymakers today have answered no to the first question. They have said, “we do not like credit revulsion and our preferred policy choice is to work against it by reducing private-sector savings.” How do they do this? They lower interest rates in such a way that there is less incentive to save. Policymakers are in effect voting to continue the asset-based economic model.

But, there are several problems with this policy decision: it rewards debtors over savers, it prevents deleveraging from occurring, it creates asset bubbles, it keeps zombie companies and overcapacity alive, and it misallocates resources by artificially lengthening time preferences for money. In short, it is poor policy and it will end poorly as well.

Or we can maintain it and decide to either increase or decrease aggregate demand?

If you reject this policy path, you then have two options. In one, aggregate demand is reduced. In the other aggregate demand is increased.  Which option we choose, again, depends on politics.

In a July post, I outlined the choices. (Note the labels ‘surplus’ and ‘deficit’ should really be labeled ‘financial balance.’ For simplification the foreign sector isn’t depicted but one could assume it is aggregated with the government sector.):

In the Minsky world, the increase in net savings in the private sector and reduction of the current account deficit is axiomatic when the government is increasing deficits.  The point is that the private sector net saving and current account deficit must equal the government deficit.  So, when the combined private savings and current account deficit increases, the government’s financial balance must become more negative.

What this implies is this (diagram from Paul Krugman’s post with the unfortunate title “Deficits saved the world”):

Krugman's Financial Balances New

To make the graph easier to follow we start with sector balances at zero i.e. where sector surplus/deficit equals zero for both the private sector including the current account deficit and for the government sector. And just to be clear, points above the line show private sector savings or public sector deficit.

  1. We start where the red circle is.
  2. When an economic shock hits which precipitates a massive deleveraging, the entire demand curve shifts to the left to a new lower GDP level, everything else being equal. Thus, deleveraging equals recession. And we now see the private sector curve hitting the public sector curve where the blue circle is. The private sector is now saving and the public sector is in deficit. That is where we are today.
  3. However, to bring things back to neutral i.e. where sector surplus/deficit equals zero for both sectors, one could cut government spending dramatically.  That shifts the entire government curve to the red line on the left, leaving us where the green circle is: in a deep, deep depression. Krugman calls this the Great Depression outcome.

The cult of zero imbalances

In the depression post which kicked off this debate, I said “I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively.” Consider me a card-carrying member of the cult of zero imbalances. My preference is to see a neutral state where the sectors are balanced as the average long-term outcome. We may deviate from a zero imbalance state over the short-term, but we should be working toward it over the longer-term.

However, in the interim, what we want is to get back to that red circle in the chart and higher GDP and stay away from the green circle and lower GDP – also known as depression.  The difference between these two is government deficit spending.

Depressions are downward economic spirals. And when I invoke the term spiral, you should not be thinking of some stable equilibrium like the Great Moderation, Goldilocks economy, Nash equilibrium or some other close facsimile of economic Nirvana. You should be thinking war, famine and pestilence because those are the events which are historically associated with periods of high deflation and depression.

For me, the choice is clear.

The key is liquidation of overcapacity

While the picture I presented above represents a single point in time, what we want to know is how we get back to the green circle over time. In the depressionary example, we contract immediately and violently as aggregate demand is reduced in both the public and private sectors. The result is a liquidation of overcapacity and a depression. In the pro-growth example, aggregate demand is boosted by government spending whilst the private sector deleverages. In this scenario, liquidation of overcapacity also occurs if the government allows it to do so.

And this is the key: to the degree that government deficit spending is used as a vehicle for channeling funds to so-called systemically important businesses to prevent them from failing, we are merely kicking the can down the road. With the deleveraging, malinvestment must be purged for the economy to right itself on a sustainable growth path.

Government’s hidden debt?

That brings me to the last point: government debt. The first issue I want to address is unfunded liabilities.  This is something of great concern to many (including myself).  However, when we are talking about debt and credit, it is not particularly relevant. I mention this because of my statement in the original post:

The government plays a crucial role here because of the huge private sector indebtedness.  In the U.S. and the U.K., the public sector is not nearly as indebted.

A lot of people want to bolt the unfunded liabilities onto government debt to make the government’s debts appear larger than they actually are.  But when talking about the credit system, we have to be careful and distinguish between obligations and actual debt – related but different terms.

In a period of credit revulsion, the key issue is the overall credit in the system. At issue is a debtor’s inability to meet large existing obligations such that the debtor defaults, the obligation is written down, and the overall credit in the system contracts by the amount of capital that has been allocated to that writedown. The issue is credit writedowns and how they suck capital out of the system, reducing credit and leading to a potential deflationary spiral. It has absolutely nothing to do with unfunded obligations.

The governments unfunded liabilities for social security and healthcare are akin to General Motors’ unfunded pension liabilities. GM’s unfunded liabilities are germane to a credit crisis only to the degree they flow through the income statement and, thus, require credit financing in real time.

Government and its money

The difference between GM and the federal government is vast, however. General Motors is a private organization which must fund its obligations by selling products.  To quote Ben Bernanke’s now infamous words:

the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

The U.S. government has monopoly control of the currency and no other entity can print money as a medium of exchange in the United States (see my post “The origin of the U.S. dollar as legal tender and its link to Depression” for how this came to be.)  When anyone else attempts to print money, it is called counterfeiting. In saying this, I am stating fact, I am not making a political argument for or against legal tender laws.

This is a problem for states – which cannot print their own money – and for Eurozone countries – which also cannot print their own money (as I laid out in my post, “Depressionary bust in Ireland is echoed in California”) – but it is not a problem for the U.S. government. If the U.S. government so chooses, it can ‘fund’ any purchase with additional money it prints. It is not constrained in the same way private sector actors or even states and local municipalities are.

It is disingenuous for economic pundits like Marc Faber to suggest the U.S. is going to go bust. The United States will not literally be declared insolvent as long as it issues debt in its own currency. Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

Inflation is another issue altogether.  When the economy is operating at potential, money printing leads to consumer price inflation. But this is not the case right now, there is an enormous output gap that is not going to be closed anytime soon.  So the government can print all the money it wants and buy all the Treasuries it wants; none of this will lead to consumer price inflation in the short run except via dollar depreciation and import prices. Again, I have to remind you that in saying this, I am stating fact, I am not making a political argument for or against quantitative easing.

I should point out that the output gap is why money printing is leading to an asset price bubble both in the U.S. and globally and one reason we should reject QE even in the absence of consumer price inflation (this line was added because the initial comments suggested readers thought I am advocating quantitative easing when I am not).

I hope this post adds to the debate Marshall, Rob, and DoctoRx have taken on.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Ed

    In what currency was the debt of France denominated in around 1789?

    This is not meant as snark, I’m actually really curious.

      1. Fed Up

        I think you need to include wealth/income inequality along with differences between debt and currency (including the time factor).

      2. Fed Up

        With Private FB + Government FB + Foreign FB, I believe you should break down both private FB and Foreign FB into the lower/middle class and the rich.

        Were the lower/middle class in the high wage countries going further into debt to the domestic rich and foreign rich?

        If the domestic rich and the foreign rich wanted the lower/middle class in the high wage countries to continue to go into debt to the them, did the domestic rich and foreign rich get the gov’ts to do it for them and make sure the debt was not defaulted on?

  2. MyLessThanPrimeBeef

    The Holy Roman Empire was neither Holy, Roman nor an empire.

    The Federal Reserve? Can it be Federal when privately owned? What gold reserve when it can just conjure up money out of thin air?

    Technically, I don’t think the US government can print money. When Congress wanted money in the early 80s, Volker certainly refused it.

  3. Graphite

    It is disingenuous for economic pundits like Marc Faber to suggest the U.S. is going to go bust. The United States will not literally be declared insolvent as long as it issues debt in its own currency.

    Yes, we get it, the point is repeated ad nauseam every single time some Keynesian wants to do some hand-waiving on the deficit.

    These pundits are not stupid or disingenuous, they just recognize that what you are pointing out is distinction without a difference.

    1. Edward Harrison Post author

      If you noticed the terms ‘malinvestment’ and ‘misallocate’ and ‘artificially lengthening time preferences,’ you would realize I am not a Keynesian.

      1. Graphite

        I know, my apologies for I did not mean to suggest that you are (hence the “some Keynesian” phrasing) … only to point out that the “can’t go bust when you print your own money” theme is one frequently repeated by the Keynesian camp.

    2. Graphite

      I wonder, did the Southerners comfort themselves with the knowledge that the Confederate States of America “could not literally go insolvent” as they put their savings into war bonds?

      1. jimbo

        Why yes, Graphite: if the U.S. is conquered by Canada, and the Federal government is dissolved, the U.S. dollar will be worthless. Yes, that illuminates current policy considerations vis a vi the deficit nicely, doesn’t it?

        (In case you’re from the Midwest, that’s what we here in the East call “sarcasm”…)

        1. Dave Raithel

          Yo, Jimbo – we’re sometimes short of time to post timely comments, but we’re not all short on sarcasm. There’d mighta been no Jon Stewart if’n there’d been no Mark Twain.

    1. winterspeak

      Technically no, but in practice, it is. Right now, the Fed sets interest rates, and the Treasury (which is officially a part of the Government) intervenes as it needs to to hit that target.

      If Banks are properly sees as public private partnerships (and I think this is clear to everyone except for bankers, academic economists, and the non-academic economists who love them, that they are) then the Fed is properly seen as part of the Government, and really, a combined Government entity with the Treasury.

  4. selise

    i really love this series. my thanks to all participants.

    one question: will there be someone like steve keen or michael hudson to represent the private debt jubilee position? and if there was no plan for that, may i suggest it?

  5. jimbo

    You are close, Edward, but you are still missing some of the picture. QE is not “printing money”, in the sense that phrase is normally used (i.e. to refer to spending financed by money creation not sterilized by debt issuance – the governement never actually “prints money” except to supply demand from banks). QE is the swap of one asset (reserves) for another (long term debt). It is not a fiscal transfer, and does not create any more demand in the economy.

  6. sangellone

    I used to think like Dr. Harrison. That economic growth was merely striking a proper balance of factors on a chart but it isn’t. Economic growth depends on increasing physical inputs of raw material. Yes, one can become more ‘efficient’ in the use of raw materials and substitute dear ones for less expensive ones as technology allows but, at the end of the day there is one that cannot be fudged and that is energy.

    The more the US tries to rev up its economic engine the more raw material and energy inputs will be required. We didn’t use to much care for there was no real competition around for these resources and we could take them for ourselves. Those days are over. We have scoured the earth for the easy to find stuff and, one by one, the supply curves for mineral after mineral, resource after resource are peaking.

    Under such circumstances trying to boost aggregate demand begins to resemble running harder on a treadmill.

    1. pebird

      Actually, the Chartalist and Modern Monetary Theory folks very strongly state that the constraints on the economy are the limitation of real resources (both materials and labor). It is not just a matter of printing money and throwing it out of helicopters (Ben’s helicopters only hover over Broad Street) – one key point is that fiscal policy is much more important and powerful than monetary policy (which pisses off a lot of neo-classical economists).

      Also, there can be bad deficits as well as good deficits, just as there can be good private lending and poor private lending. Money creation “out of thin air” is needed to increase net financial assets – banks can’t do this – presently (although given what Treasury and the Fed are suggesting, we look to be surrendering this right).

  7. phil mckee

    Here are my thoughts. In your FB sector breakdown you leave out the banking sector which can also create or cancel money on its balance sheet. Thus, when individuals and businesses save in the private sector, they can (as they are now doing) reduce their outstanding debt through the banking system without having a need for the government to run a deficit for the overall FB to equal zero. Over the years the economy has been overstimulated through the accumulation of debt in the private sector. The unwinding of this excessive debt is a necessary process to get back to a sustainable balanced economy (at a lower GDP level). Government’s borrowing binge to stimulate spending in the private sector is extremely bad policy. Government could borrow to invest in capital projects that will promote productivity improvements in the future but this is not what it is doing now with cash for clunkers, house purchases, appliance replacements, social security recipients, etc, etc. We are doomed!

    1. Edward Harrison Post author

      Banks do create money in the sense that they create credit. However, they do not create the fiat currency. They are still constrained as any private sector actor is in not being able to simply print money to pay for goods and services. That is why they are in the private sector.

      1. mmckinl

        “Banks do create money in the sense that they create credit. However, they do not create the fiat currency. They are still constrained as any private sector actor is in not being able to simply print money to pay for goods and services. That is why they are in the private sector.”


        Are you sure?

        Aren’t derivatives used for just such a purpose … How do these financial institutions get to leverage of 30,40,50,100 to one if they are not printing money?

        1. marc fleury

          yes, he is sure, sort of.

          Strictly speaking, banks do not ‘print money’ in the FED sense, an asset is met by a liability. When the FED does QE and uses reserves to buy bonds, these reserves are conjured out of thin air and never financed. See previous post on functional finance.

          However at closer range the picture is murkier. A dollar in circulation is a dollar of debt that will be retired in the future. In the meantime, one can argue that it is in fact money in circulation that is indistinguishable from high powered fiat money. Again strictly speaking, bad private debt (which abounds nowadays) IS printing money, since we have circulating bank credit that is convertible in reserves at any time that is NOT backed by any private debt and will never be retired as it was written off.

          You sort of have this monetary gunk that builds up through the bad debt mechanism. As a side note, in biology, this is how cells die, they build up residue as they divide until they can’t divide any longer. At that point you need a new currency :)

          1. pebird

            The bad debt circulating for years is exactly the private banking interests taking the public’s right to create net financial assets.

            This is why the right thing to do is to clean up the bad assets ASAP, so that losses are recognized and the difference between what was loaned and what is recovered is made up by increased reserves.

            It is not the amount of money that is out there – it is in WHOSE hands that is the problem – right now it is with the idiots (or criminals, or both) that got us into this mess. By going through restructuring, those resources can be redistributed to productive uses.

          2. mike from Arlington

            AIG just printed about 180 billion. They rubbed their magic lamp and the U.S. Govn’t genie appeared and granted them one huge wish.

  8. nick

    Interesting post, as always. My question is simple: How can aggregate demand be reduced and growth maintained? If Big Government steps in to fully offset a balance sheet depression, doesn’t the public sector dissaving necessiate no reduction in AD?

  9. nick

    Interesting post, as always. My question is simple: How can aggregate demand be reduced and growth maintained? If Big Government steps in to fully offset a balance sheet depression, doesn’t the public sector dissaving necessiate no reduction in AD?

    And how can we liquidate excess capacity without simultaneously lowering AD? Fire the GM worker, and he will spend less…….


  10. Peripheral Visionary

    Edward, your insights are appreciated, but I just don’t think the situation we are facing has clear macroeconomic solutions. Reduction of overcapacity sounds well and good; but the reality is that much of the overcapacity is overseas where it is out of reach of domestic policy. Any misguided efforts to reduce overcapacity will disproportionately reduce our own productive capacity, with little effect on overseas capacity that can fall back on government support.

    I would submit that we also have less control over our own currency than we think. It is not just the currency itself, but the vast amounts of debt denominated in it that affect its value (a key omission in much of conventional economics, which looks only at money supply, interest rates, and inflation.) Given that tremendous amounts of our debt is held overseas by monolithic entities that can accumulate it or divest it en masse, with immediate impact on interest rates, we clearly do not have control over even the domestic interest rates.

    I have been accused of “kvetching” over our economic policy, and I realize I’m slipping back into kvetching mode, but conventional economics just don’t work given the situation we are currently in. We are in uncharted waters, where the old-fashioned economic analysis based on a simplified model of a closed-ended economy just don’t work. As such, I think we are better guided by common sense than by artificial economic models whose assumptions simply do not hold in the present situation.

    1. fresno dan

      Peripheral Visionary says
      ” have been accused of “kvetching” over our economic policy…”
      You say that as if it were a bad thing. I enjoy your kvetching – I say more kvetching!

  11. Charles Swann

    I think the point is we have experienced a huge shock to the economy from both the oil shock in 2008 and then the financial crisis. We have moved to the blue circle.

    The dis-savings by the government moves us from the blue back to the red.

    I believe the removal of excess capacity affects the aggregate supply curve (GDP in the graph above) causing it to shift to the left, (i.e. towards the blue circle). This process can definitely take on an iterative process like death spiral, or a reverse of a wage-price spiral, as you state in your last point. However, at some point the price level will adjust to workers’ in aggregate having less aggregate income.

    I just did a similar post on my website, if you want to see how AD & AS can shift about.

  12. mmckinl

    To help us increase aggregate demand money must begin to flow into average people’s pockets …

    Change the tax code to be much more progressive … everybody agrees that both income and wealth gaps are the largest in history yet very few are advocating higher income, capital gains, dividends and estate taxes …

    Enact a carbon tax and distribute it per capita to put money in people’s pockets and help them adjust to higher energy prices.

    A shorter workweek, say 30 hours.

    Make people cheaper to employ by having the Federal Government initiate single payer, mandatory pensions withdrawals from employees, pay all payroll taxes …

    Businesses would pay the same salaries as before but be free of payroll taxes except for work comp.

    There are ways to get the ball rolling again and towards a lower pollution economy but there is just no money in it for corporations or the government …. lol …

  13. ex VRWC

    Of the 4 balance requirements identified in my Economy Mindmap, debate here has touched on a few of them, specifically government deficits and planetary resources. At issus is whether a government’s revenues must balance its expenditures. I have assumed yes, these authors say no. However, folks here have correctly point out the following:

    – Governments need authority and legitimacy. Printing money denies them this, especially when accompanied by misallocation of capital, which in turn enriches the few at the expense of the many

    – The planets resources must balance the demand for them. When governments go forth willy-nilly to spend because they can, these resource constraints make themselves known. Exhibit one – modern China.

    So there are constraints on government deficits, and there are opportunities where it might help. The government could allocate resources to the economy that can help it deleverage and weather the storm caused by excess debt, but it does not.

    The Right says we mustn’t deficit spend. The Left says we must spend in the interests of all. Neither clearly trumps the other, so politicians are threatened and seek security by going to those with the money – ie those being enriched by their policies. Which are not the many but the few. Therefore, behavior that is not in the interests of many becomes self reinforcing.

    It boils down to this – the effects of the elasticity of the government’s constraints, and the governments and the peoples reactions to it. Surely a government that delegitimizes itself and its taxing authority through abusing these constraints will not long stand. It will prove to be so in the US, Eurozone, and China before we are done. If not in the near term through deficits then long term because nature itself will enforce it upon us.

    I think that understanding this is fundamental to how we will survive the future, as individuals, businesses, and nations. Debate is fine, but a clear understanding must guide our actions.

    1. mmckinl

      “– Governments need authority and legitimacy. Printing money denies them this, especially when accompanied by misallocation of capital, which in turn enriches the few at the expense of the many.”


      If only the government printed its own money. The privately owned and operated Federal Reserve does that. And if the recent Fed’s actions don’t constitute private ownership and operation I don’t know what does.

      We need to nationalize the Fed, Canada did theirs in 1936. From here we print money without debt and loan it at wholesale interest to banks. In this way we can control aggregate money and credit and therefore severely restrict bubbles while making a profit for tax payers.

      1. ex VRWC

        Well we basically equated the Fed to the government anyway. Maybe the government could send money through consumer and business focused banks, but not to investment banks. I advocated a year ago setting up an emergency banking system, bypassing the traditional culprits.

        In an emergency, the government can take over the airlines – its called the Civil Reserve Air Fleet. Why not have the governments take over, say, BOA, and run it in the interests of the people and not the privileged?

        Your idea of taking over the corrupt Fed also has merit, certainly.

        1. mmckinl

          If we don’t take out the insolvent banks they will drag us into economic hell ala The Japanese Model … Japan has been on its back for 20 years and is now getting worse … all to save its banks.

          What Japan had was 4% unemployment and a sizable trade surplus to help them through … we don’t … we do have demographics but without jobs those demographics are just more unemployed workers.

          What I am advocating is that government NOT borrow money but print and lend it. Higher taxes and further borrowings might be necessary if the government spends too much. In any case everybody will know the culprits if monetary policy goes wrong, and since it will be government we can vote them OUT.We don’t have that option with the Fed.

          1. Skippy

            Concur, and starting to see the Fed as a cable of “Skeksis”, who’s only priority is the financial’s aka “Garthim’s” in their effort to extract our podling life essence see link:


            and I would be fizzgigg see link:


            Skippy….sorry guys could not help but see the interconnectivity…and that in its self is both funny and worrisome.

            PS I plan on having fun storming the castle, the Gurkha’s thought me that much.

  14. Harkins

    Continuing with Harrison’s elegant logic, we find that by eliminating the private sector, all these pesky imbalances disappear and recession is impossible.

    1. Dave Raithel

      “One sector’s deficit is another sector’s surplus.”

      I think Jimbo would say you’re being sarcastic, because you don’t really mean that recession is impossible if the government sector is eliminated. So the model is wrong; or, the model doesn’t depict what happens when no such objects (assumed by the model) exist?

  15. sangellone

    Let me try this in Harrison’s terms. There was obviously a macro economic condition that allowed for 2007. Some combination of government fiscal and monetary policy that combined with private sector behavior created our peak. The trick, according to the ‘government can do it crowd’, is to find a new set of government fiscal and monetary policies that can compensate for the change in the private economy since the peak.

    Assuming such a thing were even possible, the question is was that GDP peak real? Were 2 bedroom Oakland bungalows really worth $500,000? Bartenders turned mortgage brokers adding a million dollars of value to the economy, 16 million cars per year necessary?

    If it wasn’t real, and I contend it was not, then what is this business of trying to get back to those phony numbers via some economic alchemy? What is the point of the government trying to recreate via the manipulation of financial resources a situation the private sector could not sustain?

    Our economy has to shrink back to a level that is sustainable. We cannot ‘financially engineer’ any other reality.

    1. mmckinl

      “Our economy has to shrink back to a level that is sustainable. We cannot ‘financially engineer’ any other reality.”


      Agreed … but …

      We are in very real danger of falling right past a sustainable level into a depression … a very deep depression.

      In fact that would be my forecast given that the measures needed to stabilize the economy are measures that would prick the bubble of the rich and super rich individuals that call the shots in Congress and the White House …

      Just read George Washington’s column about how The White House wants to give Wall Street Banks carte blanche … at the expense of tax payers and smaller banks …

  16. RebelEconomist

    “Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.”

    IIRC, Russia DID default on its domestic obligations (GKOs) in 1998, and NOT on its foreign debt.

    It is not hard to imagine some right wing nutters in the US forcing the US into defaulting on its dollar debt to “starve the beast” (ie the government). There were real concerns about this during the 1990s debt ceiling stand-off.

    1. pebird

      Actually, you did – there were calls to increase tax rates on higher income brackets back when the Iraq war was starting. There was also a proposal to tax financial exchange transactions a penny. Neither of these got any traction.

      In addition, the deregulation of the financial industry continued, increasing leverage and decreasing transparency.

      There can be good deficits and bad deficits. The Bush deficits of 2003-2008 were very poorly designed.

    2. Dave Raithel

      Not, it isn’t hard to imagine that at all. So it raises a question: Would the Fed Gov be able to identify who is holding what gov debt and selectively default?

      The reason I ask is: An econ prof I had back in 1981, who was taking us through the “Reagan Revolution” as it unfolded while teaching a course on “Economic Policy” (as he was developing something called the “financial instability hypothesis” and teaching us to distinguish “speculation” from “ponzi” and things like that) did say this: If it is not the purpose of unsustainable government debt, the expropriation of public lands and resources, mineral rights, etc., it is certainly one possible consequence of that debt and default on it.

      So nutters gutting the government would have to choose between, e.g., Kimberly-Clark or some Fins or Japanese or (some Chinese start-up?) getting into the Mark Twain Forest. Now THAT kind of public argument could prove pretty interesting: Grover Norquist explaining to the same people who really believe that Blue Hats are going to occupy and control American natural resources that it’s otay if the Fins or the Japanese actual do so …

      Or else he’s got to dis the Grove City free-traders …

      Almost makes one want to believe that Mr. Harrison is correct when he says “The United States will not literally be declared insolvent as long as it issues debt in its own currency”, even if he is not …

    3. Edward Harrison Post author

      You’re right about Russia and GKOs. I actually worked on a desk that traded synthetic GKOs (because of currency convertibility) before the market blew up. So, technically, a country can default on its own fiat currency obligations.

      The big difference in Russia was tax non-compliance, something Marshall has mentioned as a threat if we saw a debtor’s revolt.

      I would also argue the default was voluntary – and not involuntary.

  17. Gary J

    I didn’t hear the keynesian’s calling for agressive fiscal restraint when the Private sector was leveraging as per “law” of the fancy chart. Net result a massive policy bias = huge excessive capacity everywhere you look.

    So in my opinion you Keynesian’s can shove you fancy curves where the sun don’t shine.

  18. RebelEconomist

    Winterspeak, please explain what you mean by “Right now, the Fed sets interest rates, and the Treasury intervenes as it needs to to hit that target.” I am baffled.

      1. RebelEconomist

        Ah, I see. I think you are making a mountain out of a molehill. Basically, because the government banks with the central bank, its transactions add and withdraw base money from circulation, and since it is practically impossible to precisely match funding (including borrowing) with disbursement from day to day, this generates shocks to the base money supply. The monetary policy operatives at the central bank therefore liaise and cooperate with the finance ministry’s treasury staff to ensure that the government’s transactions do not disturb the interest rate that the central bank is trying to set. This is what is meant by “such transactions are arranged” – it is an issue of communication (at a working level) and timing, not of the volume of government transactions.

        1. winterspeak

          I have no idea what the “mountain” I was trying to create is.

          Simply pointing out that the Fed, which is technically not part of the Govt, nevertheless dictates what the Treasury needs to do vis a vis bond issuance, by setting the target for the FFR. Your operational comment is quite accurate.

          If there is a mountain here I would like to point out, it is that the US Gov issues Treasuries not to “fund” deficit spending, but rather to drain excess reserves and thus maintain an overnight interbank market, which they need to have a FFR above zero. If the Fed decided on a true ZIRP, the Treasury could simply stop issuing bonds, and let excess reserves pile up. The UK considered doing this, actually, I don’t know if it ever ended up happening.

          I am a strong proponent of this, if only because it will kill the myth that the US needs to “borrow” from other countries to “fund” its deficit.

          Right now, the US is having it both ways by letting reserves pile up (because the idiots think this will fund “lending”) and paying interest on them directly (so interest rates are not quite zero). Counterproductive.

          1. RebelEconomist

            “the US Gov issues Treasuries not to “fund” deficit spending, but rather to drain excess reserves”

            I never met any finance ministry official who would admit to seeing it like this; how do you explain their view?

            The government cannot do anything monetary without the cooperation of the central bank. It is not essential for the central bank to buy government debt or even to provide account services to the government.

          2. winterspeak

            Thanks Ed, both for your comment, and for getting this information on Naked Capitalism.

            None of what I say is original to me. Wray, Mosler, and others have been making and pointing out these insights for a while now.

            The Federal Reserve has reasonable documentation on how it conducts its open market operations:

            Wray and Mosler almost certainly have good documentation on this as well.

            Rebel Economist: I explain my view through the simple accounting transactions that happen when Govt debt is bought (and sold). You either debit a reserve account and credit a Treasury account, or vice versa. And FFR is set via interbank lending of reserves via reserve accounts. Finance ministers can say what they like, operationally this is what happens.

          3. RebelEconomist

            Operationally, yes, but unless the government is in control, they cannot choose to fund themselves from banks’ reserve accounts, and they can go bust in their own country’s currency. Of course, most countries have laws that allow the government to direct the central bank in extremis, but if the constitutional arrangements are robust, that is a big deal, and would be likely to prompt a shake-up.

            Note that it is not necessary to involve a reserve account when selling government debt. It depends on where the government and debt buyer bank, and, if they bank at different private sector banks, how the inter-bank settlement system works.

          4. winterspeak

            RebelEconomist: You are correct. In the current setup, the Treasury is the one entity at the Federal Reserve which cannot run an overdraft. This is due to a rule of Man, not a rule of Physics, so it can be changed. Certainly we have seen the Fed and the Treasury change (or ignore) many rules over the past 12 months.

            Also, as you say, I am assuming in all of this that we have a Govt which is able to make and change rules. Much like the one that exists currently. Personally I am not interested in fantasizing about what a Govt that is unable to make laws may or may not do. But don’t let me stop you.

            I would love for you to give me an example where a US Treasury account at the Fed gets credited without a reserve account SOMEWHERE getting debited.

          5. RebelEconomist

            I would be surprised if any Fed account holder is allowed to run an overdraft.

            You mean a government that can make and change rules like introducing universal health care or cutting American carbon dioxide emissions?

            I accept your challenge. A Treasury account gets credited without a reserve account somewhere being debited if the Treasury takes in banknotes and deposits them at the Fed.

          6. winterspeak

            Rebel Economist: You will be surprised, then, to learn that banks run overdrafts at the Fed all the time. It is banks with excess reserves lending to those who are short reserves overnight that creates the overnight interbank lending market, which sets the FFR. This is the exact same mechanism that enables the banking system to lend unconstrained by reserve requirements.

            The rule change to enable the Treasury to run an overdraft would be much more modest that the far more complex legislative changes you describe. More like changing a speed limit for 25 to 35, as it’s removing the exception in an accounting rule within a system that is entirely within the Govt already. The Govt tied its hands here unnecessarily, and can untie it with equal ease. Frankly, the decision to pay interest on reserves was a bigger deal.

            “I accept your challenge. A Treasury account gets credited without a reserve account somewhere being debited if the Treasury takes in banknotes and deposits them at the Fed.” Ah, excellent. Yes, cash currency exists independent of reserves. Bank notes make up such a tiny % of the money supply I had quite forgotten about them. You have found the molehill on the mountain.

          7. RebelEconomist

            The reason that banks borrow in the Fed funds market is to avoid an overnight overdraft at the Fed, although I suppose you could say that they can run an intra-day overdraft, depending on how the payment processing system works. May I humbly suggest that you read my blog post , which offers a practical explanation of how monetary policy implementation works.

            People can have different views about how easy it would be for governments to direct their central banks, but I can say that I have never got the impression that finance ministries routinely conduct fiscal policy on the assumption that they will be able to do so, so I am sceptical of such theories.

          8. winterspeak

            LOL! RebelEconomist, I promise you I have a very good idea of how monetary policy works. That’s why I said banks routinely run overdrafts at the Fed! That is how the overnight interbank lending market is created. Glad we now agree on that point. But the Treasury cannot run an overdraft at the Fed, whether it is day or night.

  19. Mickey

    Assuming a significant % of GDP has been attributable to the “credit spigot”, artificially inflated if you will, for approximately the past 40 years, then when the spigot is turned off, aggregate demand must fall concomitantly, right? This in itself will result in a reduction in overcapacity as firms adjust to what they deem is a permanent reduction in demand. Hence, the layoff of 7 million employees is merely a reflection of this reduced demand factored into their business models. Moreover, to the extent many of these job losses are permamanent, demand will be reduced even more as unemployment benefits and savings are exhausted, exacerbating this deflationary spiral downwards … less demand, less production, less employment, less tax revenue. Decreasing tax revenues limits the extent to which government can continue to “stimulate” the economy via deficit spending without “importing” inflation, increasing taxes to offset it, or eventually resorting to drastic cuts in such spending. The uncertainty generated by these factors is not conducive to investment and subsequent expansion of production or employment, leaving aggregate demand significantly lower than before.
    Right now, credit revulsion and increased savings can be seen as “voluntary” or self-imposed measures of AUSTERITY.

  20. marc fleury

    There is a straight forward explanation for QE: in a debt-deflationary environment the FED is running the money presses to derail the death spiral dynamics as in the Fisher instability narrative. We were clearly there in March and from the onset of QE (March) to now, one could say that the Bernanke medicine has worked MIRACLES (and bubbles). Monetary levels can stay constant while actual economic output decrease giving the illusion of stability and avoiding the nastier feedback loops associated with nominal numbers going down. Read “not keen on bailouts” by steve keen for a critique of this approach (spoiler: there is nothing a govt can do given the numbers in the private sector). But so far so far good said the man without a parachute.

    1. ex VRWC

      No, not so far so good. No the spigot has not worked miracles. What is has worked is bubbles driven by liquidity that have not found there way into any meaningful improvement for you and I (unless we happen to make our living as traders). It has not wrought jobs. It has wrought a short-term halt in home prices that need to happen anyway. It has wrought more money to traders on Wall Street. It has not wrought any more global trade.

      Maybe it has postponed the nastier impacts of a debt-deflationary cycle. But neither you nor I really know what that would have looked like. Edward describes war, pestilence, and famine. I don’t see that we are really doing much to avoid these anyway, or how asset bubbles, enriching the privileged, or rising stock markets do anything about these effects.

      Beware of those CNBC cheerleaders. They chant ‘recovery’ when none really exists.

      1. marc fleury

        I was not referring to a “recovery”. Merely that the nastier feedback loops of debt deflation had been avoided. In that narrow sense, QE is an unabashed success. No it has not created jobs, no it has not made the banks solvent, but it has, so far, avoided the Fisher capsizing. (In a debt deflation, as assets go down and debt goes up, debt/asset ratios go up. You sell assets to extinguish debt. Assets further go down under the selling pressure. So far, that catastrophic outcome has clearly been avoided or at least postponed. I think QE is simply the choice between an orderly/dis-orderly deleveraging.

        1. mmckinl

          So far so good …

          But we are not nearly done with bad debt …

          And all that liquidity has done little for velocity …

  21. mickey

    To continue with my previous post… AUSTERITY imposed by the private sector – unemployment, increased cost of credit when available, reductions in wages and benefits… and the list goes on.

    Just wait until the FISCAL CRISIS OF THE STATE compels it to reduce spending. Then the last vestiges of the NEW DEAL – Social Security and Medicare – will be put on the chopping block. After all, such programs were targeted for extinction by adherents of supply-side economics way back when the debate was confined to the economics department at the University of Chicago. What else could “starving the beast” mean but decreasing aggregate demand by means of massive cuts to government social programs – “entitlements” as they are now called. To think any differently is the ultimate exercise in sophistry.

    Make no mistake about it … decreasing aggregate demand is just another way of saying AUSTERITY.

  22. mmckinl

    So far so good …

    But we are not nearly done with bad debt …

    And all that liquidity has done little for velocity …

  23. molecule

    Why not have an income tax holiday? It amounts to an instant raise. Debts can then be repaid, deleveraging can happen, savings can increase, banks get paid, balance sheets can be repaired, etc, etc. Debtors are happy, creditors are happy, banks are happy. Someone suggested a debt jubilee, why not an income tax holiday? Prices might rise overnight but who will complain when their income doubled?

  24. i on the ball patriot

    The non responsive government’s house is ablaze with corruption and deception and you are picking out wall paper for the rooms.

    Deception is the strongest political force on the planet.

  25. Hugh

    What is missing in this analysis is all the fraud and corruption in the current financial system which distort or even nullify all of the standard relationships.

    1. Skippy


      I brought up this very same question a few posts ago. Some sweep it under loss, but for some reason is never quantified properly…eh.

      Skippy aka the Grand Nagus…#217 You can’t free a fish from water.

  26. Donlast

    These aggregate sector balances are ex post descriptions. They do not describe or specify causal relationships that bring about the ex post situation. To believe that the politicians and the bureaucracies can guide and control the multiplicity of decisions and prices involved in shaping the aggregates – Well I can show fairies at the bottom of my garden too if you are interested. The fallacy of Keynesianism, which is basically the manipulation of the economy’s big levers, were long ago exposed by Hayek and others. The decades-long governmental failings have been covered up by constant accretions in debt. Now the lie is totally exposed. Naturally the perpetrators are in denial.

  27. Tamara Holmes

    To maximize the amount of money your debt is reduced by and to lessen the risk of a scam, don’t just choose any debt settlement company; choose on that belongs to a relief network. The individuals in charge of these networks do not let anyone in; all companies must undergo testing that determines their performance, record of accomplishment, and quality of serviced provided.

  28. Siggy

    A very interesting piece and thread.

    An equally interesting question to consider would be: Do you believe that the government can control aggregate demand and aggregate supply? Can the government actually control the economy? The compliment to that is: Should the government attempt to control the economy.

    There follows another interesting question: Should there be a bank that is chartered by the government, but which is not a part of the government but is an authorized oligopoly specifically authorized to issue credit money?

    While there is much of value in this thread, it does tend to wander away from that which I see as being the nexus of the problem, our fiat currency and fractional reserve system have failed. Given that, movements in aggregate demand and supply will not achieve equilibrium in that the unit of account is itself is in absolute dis-equilibrium!

    1. Edward Harrison Post author

      Good question, Siggy. No, Personally, I don’t think the government should try to ‘control’ aggregate demand during depression or at any other time. It should look to ‘sustain’ some of the lost aggregate demand from a burst bubble and financial crisis in order to allow the private sector to increase savings and reduce debt.

      Sorry to others who have made good questions I haven’t responded to yet.

  29. Hal R

    The interest Rates in this Country are useless without the Usury Laws. It’s the bridle for commerce.

  30. JKH

    Excellent post.

    “In the depression post which kicked off this debate, I said “I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively.” Consider me a card-carrying member of the cult of zero imbalances. My preference is to see a neutral state where the sectors are balanced as the average long-term outcome. We may deviate from a zero imbalance state over the short-term, but we should be working toward it over the longer-term.”

    One argument against this is that the non government sector seeks to hold currency, and currency is effectively a form of deficit financing for the consolidated government/central bank entity. The non government demand for net financial saving is an extension of this demand for money – a low risk liquidity demand that is met by a combination of government issued currency and bonds.

    Ironically, the full Chartalist position recommends the elimination of government bonds, replaced by bank reserves and deposit liabilities. The latter are fully insured by the government, so that the banking system takes over the role of being supplier to much of the non government demand for net saving liquidity.

  31. Francis from Belgium

    If a follow your rationale stocks have soared because policymakers have answered ‘no’ to the question : Do we want the private sector to net save at this point in time? And therefore they are voting to continue the asset-based economic model pushing down interest rates and keeping quantitative and qualitative easing. What would be in your opinion the consequences of a correction of 15-20% of stock prices for the Banks and more generally for economic activity?

    1. Edward Harrison Post author

      A correction might be manageable – especially if its just stocks. It is house prices underpinning collateral and mortgages which are the largest debt by an order of magnitude which most Americans have.

      The question is: why stocks are correcting?

      1. Francis from Belgium

        well, today was a good one for stocks…

        Do you think house prices will drop during 2010 at the end of TALF and or other policy measures such raising interest rates or ending quantitative easing?
        What about Alt-A or option ARM if this happens?

  32. flow5

    aggregate demand? M*Vt = aggregate demand (our means-of-payment money times its rate of turnover). So what? It’s the gap between the rate-of-change in monetary flows (MVt) relative to the rate-of-change in real-gdp, which requires governance. Also, the United States does not have a fiat currency system.

    a fiat system is where the volume of currency issued is dictated by the deficit-financing requirements of the issuing government

    the U.S. has a managed currency system, i.e., all currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation; those rare instances when the U.S. Treasury borrows from the Federal Reserve Banks

  33. Tonydd

    Thankyou a great thought provoking discussion.

    There was earlier mention of ‘a solution to this problem’ and that there is no solution.

    The solutions are there but they are unpalatable.

    The solutions are there but they are dangerous,

    However the phoney painless solutions beng offered are likely to be even more dangerous in the longer term. In particular I see the possible destruction of the value of savings of people in China Japan and the US. This sacrifice made to soften the landing for a financial system and borrowers.

    If we talk about the slovency of the greenback we refer to the confidence savers have in it and that will include domestic savers (en mass) which a is the real foundation of recovery.

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