A Kindergarten Guide to Monetary Economics

Contributed by: Kunal Sabnis, CFA

The Mumbai chapter of the IAIP hosted Dr. Frank Ashe on May 9th for a session on Modern Monetary Theory which was not only interesting but also gave a very different perspective as compared to the conventional monetary theory. He gave interesting examples to prove that the banking system is fundamentally unstable and sounded a word of caution for the banking analysts.

Frank proved that bank lending creates deposits and not the other way round. For example when a company borrows to build a factory, the money spent is transferred from the company to the individual people who work to build the factory. This money in-turn creates bank deposits in their accounts. The more the banks lend the more bank deposits it creates. This also proves another Frank’s assessments that money never leaves the banking system. It is merely transferred from one account holder to another. In the same example when the company (borrower) would draw from the loan account to pay to the workers, it is transferred to their bank accounts. When these account holders spend the money say at a super market or a gas station, it is getting transferred to the bank account of the vendor. In this way money is just transferred between accounts but never leaves the banking system.

Our conventional thinking of macro economics – central bank printing money which is then transferred to the individual banks for lending – is only applicable in the gold standard. After the gold standard was abolished, banks could create their own money because technically it is just an electronic entry for lending and the money never leaves the banking system. Even the cash which is in circulation in the economy also enters and exits the banking system periodically.

Banking system is fundamentally unstable since the basic premise is based on the state of equilibrium in the monetary system but crisis happen when the system is not in equilibrium. When economy is doing well banks merrily expand and everyone is happy but when economy stops expanding there is a collapse. The government has installed breaks on the banks expansion through regulations, capital requirements, rating agencies, board powers but they are hardly effective until the balance sheet implodes.

Frank also believes that liquidity is created or reduced only by the government when it spends or collects taxes. Therefore when the government spends and runs a deficit it creates net financial assets in the economy and when the government runs a surplus it destroys those net financial assets. During the times of economic crisis, government should spend the money and run a deficit that is the precise way how the economy would come out of crisis. But there is the one rider to this theory, the bank’s balance sheet expansion and government’s excess spending should be channelized towards building the real economy in an efficient manner otherwise it will give rise to inflation. An extremely interactive and enlightening session ended with a networking dinner.

Click here for the video link for the event: http://youtu.be/OBZLdB5c01M?t=2m31s

– K S