Friday, 9 February 2018

What is the Benefit to Banks from Money Creation?



In a response to a recent post by Brian Romanchuk, somebody made the following comment:

"If private banks are ..... allowed to create and lend out their own money, they can undercut the ..... free market rate of interest, and for the simple reason that printing money is cheaper than having to borrow it or earn it."

This seems to suggest a kind of model in which banks choose whether to finance themselves with someone else's money that they have to pay to borrow, or money they create for themselves for free.  I think the problem is that this confuses two distinct ideas: that there is a benefit from having monetary liabilities and that bank lending increases deposits.

The potential benefit that accrues to banks by virtue of their status as money issuers arises through a reduced rate of interest on monetary liabilities.  If a particular type of bank deposit, such as a positive current account balance, is readily available for making payments, then it typically carries a lower rate of interest than other deposits. 

Sometimes the rate of interest on such balances is zero, but it need not be.  The important point is that there is a benefit to the bank through a reduced funding cost.  Set against this is the cost to the bank of providing current account services in the form of the costs of premises, staff and equipment.

At this point it is worth noting that these costs and benefits are based on the level of the bank's outstanding monetary liabilities.  It is nothing to do with which bank makes the loan that creates the deposit.  It is quite possible to have banks making lots of loans, but having minimal liabilities in the form of immediately available deposits, because that bank relies on different funding techniques.  These banks would be creating new money, but not getting any of the potential benefit that arises from having monetary liabilities.

On the other hand, it would be possible to have a bank with very large current account liabilities but which never engaged in deposit creation.  This would happen if the bank was simply taking deposits through payments received in from other sources and making all of its loans in cash[1].  The potential benefit of operating current accounts would be very important to such a bank.  

The point here is that it makes no sense to say that it is cheaper for a bank to print money than borrow it.  What the bank does at the point of making a loan is irrelevant.  What matters is how it chooses to manage its liabilities going forward and in particular the extent to which it chooses to compete for current account deposits.

The extent of the benefit depends then on how competitive that market is.  Under perfect competition, banks would have to offer interest rates on current accounts that would simply leave them with normal profits.  However, it is likely that there is a degree of monopolistic competition in the provision of banking services, particularly at the retail level, and this means that there is some supernormal profit that accrues to banks as providers of monetary liabilities.

It is difficult to assess how profitable it is for banks to have monetary liabilities, largely because many of the costs are shared with other activities.  Even for the banks themselves, it is somewhat arbitrary how costs get allocated.  However, the point here is that any such profit is just regular monopolistic profit in the market for current account services and not something to do with money being created out of thin air.


[1] Making loans in cash does in fact "create money" in the sense of increasing the broad money supply, but it is not what people usually have in mind when they talk of banks "printing money".

Saturday, 27 January 2018

Automation and Real Wages



Economists generally work on the basis that improvements in technology lead to higher real wages.  Conventional production functions (when combined with other assumptions) invariably produce this result.  Looking at the Cobb-Douglas production function, as the most common example, an increase in total factor productivity raises labour's marginal product.  With the normal assumptions about competition, this leads to higher real wages.

Although I have no problem with using such things at times, I am wary of simple aggregate production functions.  It seems clear to me that technological developments can lead to reduced real wage levels, even without considering how such developments might impact on monopoly power.

Although I'm sure others have produced models that illustrate this, I'm not aware of any and, in any event, I like to experiment with things myself, so I have constructed a little model of production in which technological innovation leads to a fall in real wages.

There is a single good produced by a combination of labour and capital.  There are two possible production techniques, each of which requires a fixed quantity of labour and a fixed quantity of capital to produce a fixed quantity of the good.  These quantities are set out in the table below:


Output
Labour Input
Capital Input
Technique A
12
1
1
Technique B
24
1
4


Total labour and total capital are fixed.  There is perfect competition and no demand deficiency.  This has two implications:

1. The use of each techniques will normally be such that will ensure full employment of both labour and capital.  However, if the ratio of available labour to available capital is too extreme, then all production will use a single technique (whichever maximises use of the abundant factor) and some of that abundant factor will be unutilised.  This possibility is ignored here - it is assumed that available labour and capital always lead to some combination of possible techniques.

2. The real wage will be at a level that ensures the return on capital is the same for each technique.  If it were not, suppliers of capital would switch technique which would lead to shortages or surpluses in the labour market.  With the numbers here, the real wage works out as 8 units of output per unit of labour.

Marginal productivity is not well defined for each individual technique.  However, given the above conclusion about how the techniques are combined, there is a marginal productivity of labour at an aggregate level.  It is relatively easy to show that this is equal to the real wage.

If we take factor supplies of 12 units of labour and 24 units of capital, we get the following output matrix:


Labour Used
Capital Used
Production
Technique A
8
8
96
Technique B
4
16
96
Total
12
24
192


We now want to consider the innovation of a new technique involving a more intensive ratio of capital to labour.  For this to be beneficial overall, it must yield a higher return on capital given the prevailing real wage.  The details of this new technique are:


Output
Labour Input
Capital Input
Technique C
30
1
5


Technique C dominates technique B at all levels of the real wage, so the latter is completely abandoned.  Since the relative factor input ratios have changed, there is also a change in the amount of resources devoted to technique A.  The new levels of production are shown below:


Labour Used
Capital Used
Production
Technique A
9
9
108
Technique C
3
15
90
Total
12
24
198

The change in techniques also impacts on the real wage, which must settle at a new level to continue to equate return on capital across techniques.  In fact this involves a fall in the real wage to 7.5.   

The interesting thing here is that although labour productivity (labour's average product) has increased, its marginal product has decreased.  Real wages have therefore fallen, even though output per head has risen.  The corresponding change is that the return on capital has increased.

My belief is that, on the whole, technological progress results in higher overall real wages.  However, I do not think we can assume that all new innovations will do this.

Sunday, 24 December 2017

The Irrelevance of Private Money Creation to Loanable Funds Critiques



A frequently repeated claim deployed in critiques of loanable funds theory is that private bank money creation removes the constraint on investment being limited by "prior" savings.  In a generally good article on loanable funds here, Servaas Storm spends a lot of time discussing the ex nihilo creation of private money.

I think this is highly misleading.  Whilst not denying that understanding bank behaviour is important,  the savings constraint issue is simply a result of having a monetary exchange economy and has nothing to do with where the money comes from.    

First some clarification.  It is sometimes suggested that the constraint in question is that saving must take place before investment.  To the extent this really does refer to the order of events in time, it is clearly wrong.  Saving and investment must always take place simultaneously, by their very definition, regardless of whether we are talking about a barter or monetary economy.  

What does matter is the relationship between plans and outcomes, specifically when agents have plans that are inconsistent.[1]  In a normal market for some commodity, if planned demand is different from planned supply, the amount actually traded will be the lower of the two.  Neither buyer or seller will trade more than they want. 

Translated into a loanable funds market, this means that the amount of actual saving would be the lower of planned saving and planned investment.  Savers cannot end up saving more than they planned.  And this is indeed what we find in a barter economy, where all saving is in the form of commodities.

The difference with a monetary economy is that actual saving is not constrained by planned saving.  This is because actual saving must be equal to actual investment and actual investment is not constrained by planned saving. 

The easiest way to see this is to think about bank lending and recognise that banks can provide finance to enable new investment without first needing to check the plans of their depositors.  Although this is a useful picture, it can lead to the mistaken view that it is private bank money creation that removes the planned saving constraint.  This is not correct.  What removes that constraint is monetary exchange and that holds even with a fixed, exogenous money supply.

Consider an economy where there is a fixed money supply of $100, all held by households.  Households also hold $100 in loans to firms, so $200 in total financial assets.  Firms would like to borrow more and invest more, but households do not wish to take on more credit risk.

Now assume that households become less risk averse and wish to change their portfolio to $50 money and $150 loans.  Note the important distinction here between saving and lending.  Households are planning additional lending, but they are not planning any increase in holding of financial assets (which we can equate to saving here, as we will assume households do not undertake investment expenditure).  Although we talk about loanable funds, we don't mean what is actually loaned but what is saved.  Here, the planned saving is zero.

However, if the $50 of additional loans to firms is spend on investment then it ends up back in the hands of households again.  Household income has risen and they end up still holding $100 of money, even though they planned to only hold $50.  Total financial assets has risen to $250.  There has been actual saving of $50, unconstrained by planned saving of zero, without any new money being created.

The point here is that what facilitates the change in investment and therefore actual saving, is not a savings decision, but a portfolio decision.  The reason bank lending matters is because it is a form of portfolio decision and, indeed, banks play a large part in the overall portfolio decisions.  Money creation matters because it changes the portfolio options for households and may therefore influence their portfolio decisions.  It is not the magic ingredient that undoes the loanable funds model.


[1] Part of the reason this whole issue doesn't figure much in more mainstream economics is that there is a tendency to focus on analysing outcomes that are consistent with plans, and less attention is given to the question of what happens when they are not.

Thursday, 4 May 2017

Comparative Advantage With Labour Inflexibility



My last post adapted Ricardo's model of comparative advantage to include internationally mobile capital.  However, what I think is much more important is the ability of labour to be redeployed between industries when production patterns are disrupted by trade liberalisation.

So I thought I'd have a go at a version of Ricardo's model that included just that.


The Model

There are two countries: England and Portugal, and three goods: wine, cloth and cars.  Each country consumes all three goods and can produce all three.  Each country has its own currency. 

Labour is the only factor input and there are constant returns to scale.  Prices are set at a fixed mark-up to unit cost, with the same mark-up in both countries and all industries.  Within each country, a single fixed nominal wage applies to all industries.  (For simplicity, the nominal wage per unit of labour, grossed up for the mark-up, is set here at one unit of the local currency, so the price of local produce is simply equal to the requisite labour input.)

Labour cannot move between countries.  Within a country, labour can generally be redeployed between different industries, with the single exception that labour currently employed in car production cannot be redeployed to wine or cloth production.  The number of labour units required to produce one unit of goods varies between industry and country as follows:


Wine
Cloth
Cars
England
1.00
1.00
1.00
Portugal
0.80
0.90
0.95


There is free trade in wine and cloth but (at least, initially) no trade in cars.  In each case of wine, cloth and cars, Portugese made versions are perfect substitutes for English made ones and there are no transport costs so, where there is free trade,  everyone just buys the cheapest.  However, wine, cloth and cars are imperfect substitutes for each other with a constant elasticity of substitution.  All income is spent currently on consumption, with a weighting in both countries of 0.45 on each of wine and cloth and 0.10 on cars.  The exact specification of consumer spending is given in the technical note at the end of the post.

As there is no saving, trade must be balanced, which is achieved by a variable exchange rate.

(To get the numbers to show what I want, I have assumed a slightly higher labour supply in England than Portugal.)


1. No International Trade in Cars

Because of the comparative advantages in wine and cloth, England ends up importing all its wine and Portugal all its cloth.  Both countries produce their own cars.


England




Portugal




Wine
Cloth
Cars
Total

Wine
Cloth
Cars
Total










Labour
0
1,081
119
1,200

913
0
87
1,000




















Goods









Produced
0
1,081
119


1,142
0
91

Traded
563
-548
0


-563
548
0

Consumed
563
533
119


579
548
91





















Expenditure









Domestic
548
533
119
1,200

463
450
87
1,000
Exports

548
0
548

450


450
Imports
-548


-548


-450
0
-450
Income
0
1,081
119
1,200

913
0
87
1,000




















Prices
Wine
Cloth
Cars
Index

Wine
Cloth
Cars
Index
Domestic
1.000
1.000
1.000
1.000

0.800
0.900
0.950
0.856
Import
0.973
1.095
n/a


0.822
0.822
n/a

Consumer
0.973
1.000
1.000
0.988

0.800
0.822
0.950
0.823




















Exchange rate (£/€)
1.217









Expenditure and prices are shown in the local currency.

The domestic producer prices shown are the prices that would be paid for domestically produced product, even though there is no actual production in industries with import penetration.  The index for these prices is weighted by consumption preference, so it is the price index that would apply with no trade.  This is higher for both countries than the actual consumer price index, showing that the trade in wine and cloth benefits both nations.

The nominal wage (expressed in the local currency) is the same in each country, so the fact that the consumer price index is higher in England implies that real wages are lower in England than Portugal.


2 After Trade Liberalisation in Cars

At the prevailing exchange rate, England can produce cars more cheaply than Portugal.  This means that Portugal starts to import cars and closes down its own production.  By assumption, these workers cannot be employed elsewhere, so overall income in Portugal is reduced.  This reduces demand for cloth imports but, because of the additional import of cars, demand for foreign exchange is increased overall.  This causes the exchange rate to change, worsening the terms of trade for Portugal (making Portugese cars cheaper but still not as cheap as English ones).


England




Portugal




Wine
Cloth
Cars
Total

Wine
Cloth
Cars
Total










Labour
0
982
218
1,200

913
0
0
913




















Goods









Produced
0
982
218


1,142
0
0

Traded
607
-460
-102


-607
460
102

Consumed
607
522
116


535
460
102





















Expenditure









Domestic
562
522
116
1,200

428
397
88
913
Exports

460
102
562

485


485
Imports
-562


-562


-397
-88
-485
Income
0
982
218
1,200

913
0
0
913




















Prices
Wine
Cloth
Cars
Index

Wine
Cloth
Cars
Index
Domestic
1.000
1.000
1.000
1.000

0.800
0.900
0.950
0.856
Import
0.927
1.043
1.101


0.863
0.863
0.863

Consumer
0.927
1.000
1.000
0.966

0.800
0.863
0.863
0.833




















Exchange rate (£/€)
1.159









England responds to falling cloth exports by redeploying labour to production of more cars.


Conclusions

The main result here is that, if trade liberalisation results in job losses and those workers cannot be employed elsewhere, then overall output will be impaired.  This is perhaps not entirely surprising.  But there are some more interesting points here:

Trade liberalisation results in production of cars switching to England even though Portugal can produce cars with fewer labour units and thus has an absolute advantage in car production.  The reason is that English wages are lower when expressed in a common currency.  The lower wage offsets the less efficient production (less efficient in an absolute sense, not a comparative one).

In this example trade liberalisation in car production not only results in unemployment for Portugese car workers, but actually reduces the real wages of Portugese wine workers.  This is because the increased demand for imports worsens the terms of trade.  Although they can now buy cheap imported cars, cloth has become more expensive.  Everyone in Portugal has lost out.

The same is true here even if we relax the assumption that Portugese car workers cannot be employed in other industries.  As a natural importer of cars, Portugal benefits when international trade in cars is restricted, even though that means that cars are more expensive there.  However, it is still better off than if there were no trade at all.

Reducing the nominal wage in Portugal makes no difference, as it simply leads to an offsetting exchange rate movement.  However, relative wages between industries do matter.  I have assumed that the same wage applies across industries, so that wages for Portugese car workers remain the same as for wine workers, even when they cannot be employed elsewhere.  If they were to fall (relatively), then Portugese car production could be preserved.

This change in relative wages is what standard economics says should happen.  It all comes down to opportunity cost.  The opportunity cost of Portugese car production is in fact zero, because the car workers have no alternative use.  Portugese car production is lost, because the cost to producers does not reflect the true opportunity cost.

Although trade liberalisation in the car industry is damaging in this example, that does not imply that introducing measures to restrict existing trade will be beneficial.  In fact any such measures would reduce welfare here.  If we extend the assumption on labour inflexibility, then such measures may be even more damaging as workers made unemployed from exporting industries might not be employed elsewhere.  It is the fact of change that matters here, not whether it is liberalisation or protectionism.

However, being able to adapt to change is crucial to an economy's ability to develop and grow.  Even without trade, progress involves old products and procedures dying out and being replaced.  Job losses and job creation is an inevitable part of that.  Whilst there is a strong case for factoring in the dynamic consequences of trade liberalisation, that cannot be an excuse for avoiding the need for flexibility, if an economy is to secure long-term growth.


Technical Note

Consumption of good i in each country is given by  

Ci = ai . (Pi / P ) . Y / P

where: ai is the weighting,  Ci is number of units consumed, Pi is the price of good, Y is nominal income and P is the price index, which is given by:

P = { sum for i [ ai . pi(1-σ) ] }1/(1-σ)


σ is the price elasticity of demand, set at 2 for both countries.