Last week we took a quick diversion into Euroland, which is crashing as we speak. Obviously, we went much too quickly to really give a good analysis of her problems. I urge readers to look at the front pages of NEP for timely pieces. Since this is a Primer, we want it to be more like a textbook. If Euroland completely disintegrates before next summer, I’ll add another section to do a post mortem on the misguided experiment in separating nations from their currencies. There are only very limited circumstances in which that can work—and Europe is not one of them.
Last week we received a well-thought-out query, which is pasted below in its entirety (although I removed the author’s name to respect privacy). I think the author raises points that are sufficiently important that we should take another unplanned diversion this week. This is the great thing about running the Primer this way as I can see where I’ve failed to adequately explain something. I had thought the distinction between real and financial (nominal) was clear—but obviously it was not.
At this point you might want to skip down to the bottom of this post to read the query. I will summarize the main point later, but I expect that many of you would agree with the author—so go ahead and read it first. Then we’ll get to the response.
Ok, let me try to explain this as clearly as possible.
The state’s monetary unit is a handy measuring device that we use to measure credits, debts, and something fairly esoteric we might call “value”. I am pretty sure all of you are clear on the credits and debits part of this. I owe taxes to the government and these are measured in so many Dollars. It is my debt and the government’s asset and we can record it on electronic balance sheets. I have deposits in my bank measured in Dollars that are the bank’s IOU and my credit (again, they exist only as electronic charges on a computer tape).
“Value” is more difficult. We need a measuring unit that is appropriate to measuring heterogeneous things. We cannot use color, weight, length, density, and so on. For historical reasons I will not go into right now, we usually use the state’s money of account. Otherwise, we can only measure value in terms of the thing itself. For example it is fairly easy to measure the value of sugar in terms of sugar—sugar weight will work, and if the crystals are uniform we could actually count them out. Usually however we measure sugar by volume at least for kitchen purposes. But we cannot just say “cup”, we must say “cup of sugar” and then define what we mean by sugar.
Now, I could borrow a cup of sugar from you and write “IOU a cup of sugar”. However, we might as well agree to write the IOU in Dollars since we live in a heavily monetized society that uses the state’s money or nominal measure—the Dollar—as the unit of account. Let us say the going price of sugar at the store is about $1 for a cup of sugar, so I write the IOU as “IOU a Dollar”. I might repay you in a Dollar (state’s IOU), a cup of sugar, or something else that we agree to value at a Dollar.
When I go to tally up all of my wealth I will include all the Dollar IOUs I hold against banks, the government, other financial institutions, friends and family and so on. That is my gross financial wealth. (It could include even some of those “real cup of sugar IOUs” if there is a reasonable expectation that I could collect Dollars from those owing me sugar.) Against that I count up all of my own IOUs—to banks, government, family and friends. (And again, if I issued cup of sugar IOUs in which payment could be enforced in Dollars I should include them. If my cup of sugar credits and debts will never be converted to Dollars then I should treat these as real assets and liabilities—and I can subtract the liabilities from the assets to obtain net cup of sugar real wealth. More below on real wealth.) When I subtract these financial IOUs from my gross financial wealth I am left with my net financial wealth.
Now clearly I am not done. I’ve got a house and a car (and maybe some sugar in the kitchen cabinet). Assume I’ve got some debt against them, as I took out a loan (issued my own IOU to the bank or auto finance company, etc). That is part of my financial IOUs included in the calculation above. But I’ve been paying for years and so the outstanding IOU is much less than the value of my car and home. I count the monetary value of the car and home and add that to my financial assets to get gross assets.
Now exactly how I value the house and car is tricky and subject to accounting rules. But that is not important to understand the principle here. We take the total value of gross assets (financial plus real) and subtract the outstanding liabilities (usually financial, but there could be some real sugar IOUs) to get net wealth. That of course, will be comprised of real assets plus net financial wealth. So total net wealth will be greater than net financial wealth because I’ve got real assets (car, house).
(I could have negative net financial wealth that is—hopefully—more than offset by positive real assets. Otherwise I am “underwater”.)
Most of the time in this primer we are focused on the monetary part of the economy—indeed on what Keynes called “monetary production” and Marx called M-C-M’) in which production begins with money, to produce a commodity for sale for “more money” (profits). We focus on that because that is basically what capitalism is all about and we are mostly concerned with how “modern money” works in a capitalist economy. (Note, however, that “taxes drive money” applies to earlier societies that were not capitalist.)
Still even in capitalism it is obvious that not all production involves money in the beginning and not all is undertaken on the prospect of making profit. In about two hours I am going to fix dinner and wash dishes. I am not going to get paid, much less earn any profits. Now at least some of this “production” process does begin with money—I bought most of the ingredients for the cooking, and purchased both water and soap for washing. But part of the ingredients (especially my labor) will not be purchased.
Is this kind of production important? Undoubtedly—even in a highly developed capitalist economy like the American it is hard to see how any of the monetary production could take place without all of the unpaid labor involved in “reproducing” the “labor power” (these are Marx’s terms—you can replace them with “supporting the family that supplies workers”). Domestic services, child rearing, recreation and relaxation, and so on are critical and mostly do not involve monetary transactions. We can—and sometimes do—put monetary values on them anyway. Not only is there a “flow” dimension (recall the discussion from the earliest MMP blogs) in the form of daily dishwashing, but there is also a “stock” dimension—accumulation of the knowledge and skills our youngsters will need later (often called “human capital” by economists). That (growing) stock should be added to our “real assets” and hence to our total net wealth. Obviously, these things are very difficult to measure in Dollar terms.
A hundred or two hundred years ago, many people built their own homes, after carving a clearing in the wilderness, killing off the lions, tigers, and bears, and so on, and running off the indigenous population. They tilled and planted seeds (that they had previously grown). Perhaps they sold a bit of their farm’s production, and bought a few goods and paid some taxes. But for the most part, they lived their lives without much use for money. They had few financial debts and few financial assets. But clearly they had real assets, and those assets were productive (even if the output was mostly consumed). We can put a monetary value on all that if we want. From the perspective of those “settlers” (a really poor choice of words, but commonly used to ignore what was being done to indigenous humans, animals, and the environment more generally) it would be a rather silly exercise to do such an accounting, of course.
At least until they decided to sell the farm and retire on a beach in Florida.
Today if you build a workshed that enhances the value of your property, you can add that to your total net wealth (less any borrowing or running down of saving to purchase materials of course). When you sell the property you realize that value in monetary form (including the extra value due to the workshed you built).
The question is: where did that money come from? Well, the purchaser issued an IOU to a mortgage lender; the loan had to be a wee bit bigger to cover the extra property value due to the workshed you built. You realize the “real asset” workshed that you built in monetary form when you sell the property.
Let us say, however, that the purchaser paid “cash” (wrote a check on a demand deposit). Well, we can quickly get into an infinite regress because now we must find out how the purchaser got the credit to her demand deposit. Perhaps she just sold a house on the Left Coast—to a purchaser who took out a mortgage loan. So her demand deposit can be traced back to a bank loan, anyway—and recall from previous blogs that the way banks make loans is by accepting an IOU (held as the bank asset) and creating a demand deposit (the bank’s IOU, held by the depositor). So we again find that a loan created the “money” that the purchaser of your house had in her checking account.
You can go through an infinite number of scenarios and you will see that it all goes back to a loan. Think about it this way: all bank deposits came from bank keystrokes created when banks accepted IOUs of borrowers. So all purchases with demand deposits have a loan somewhere in the background. The demand deposit is a bank IOU, created when the bank accepted an IOU.
There is one exception. Let us say that the purchaser was retired and living on Social Security. She saved her benefit payments for years to buy your house (and workshed). Each month the Treasury keystroked her benefit payment into existence. The Social Security payment shows up as a bank IOU to her (demand deposit) and at the same time the bank gets a credit to its reserve account at the Fed. (As we know, the bank will probably buy Treasuries rather than hold reserves—but that just substitutes what is effectively a “saving deposit at the Fed” for a “demand deposit at the Fed” since government bonds are really equivalent to central bank reserves that pay higher interest and have longer maturity.)
As we have argued weeks ago, the government creates “net financial assets” for the nongovernment sector in the form of reserves or treasuries or cash. When the government makes the Social Security payment there are 4 keystroke entries:
Retiree: + demand deposit owned
Bank: + reserves owned, + demand deposit owed
Government + reserves owed
Note that by double entry bookkeeping, every item is entered twice—once as “owned” and once as “owed”. The bank’s position nets to zero: it owns reserves exactly equal to the demand deposit it owes. The government’s IOU goes up and that is exactly equal to the retiree’s increase to her demand deposit. That increase of the demand deposit is the addition to nongovernment net financial assets.
(For the really wonky, there are two other entries in the background. Creation of the Social Security program with rules for qualifying leads to an entry on the government’s liability side of its balance sheet equal to benefits owed; and to an entry on the nongovernment’s asset side of its balance sheet equal to benefits owned—both of these are in the future, of course. When government makes the benefit payment, its “benefits owed to qualifying population” are debited, and the nongovernment’s “benefits owed and to be paid by government” are debited. A stroke of the Congressional pen put government into debt for the amount of benefits owed, and created wealth for the private sector in the amount of benefits they will receive. A keystroke then turns that into “reality” by monetizing the benefits as government monetary IOUs in the form of bank reserves are created, and recipients get credits to demand deposits.)
What I am getting at is that the private sector does not need to “go into debt” to get “money” so long as the government supplies it. But this is not a commodity money—it is still an IOU, in the form of central bank reserves. So if we take the (closed) economy as a whole, net financial assets do still sum to zero—the government’s IOU equals the retiree’s demand deposit. But for the nongovernment sector, it is net financial wealth.
What about real wealth? Again, the government owns lots of real assets—bridges, roads, parks, public buildings, bombs, aircraft carriers. Those add to the total national net wealth.
Finally, we need to look at real and financial claims against foreigners, and foreign real and financial claims against domestics. Obviously both real and financial (as well as their sum) can be positive or negative. These will largely be denominated in different currencies, so exchange rates will need to be brought into the calculations.
OK, now what about the question below:
“If a person grew his own food and in his spare time dug gold out of the earth, he might over time accumulate significant wealth without substantial participation in the cash economy. The public sector balance might be irrelevant to him. Provided that he didn’t get so sick as to require medical care that he could not pay for, he might prosper in some measure on the fringes or entirely outside the cash economy, though he would have to enter it to purchase items (with his gold, converted to cash) that he wanted but could not make for himself. The gentleman who for decades lived alone in Alaska in a camp he built with his own labor (with an initial capital infusion of low-tech tools and occasional top-ups of the same) comes to mind. Had he been lucky enough to encamp near a rich alluvial gold deposit, he could have become quite wealthy before he retired to civilization.”
Well, that is really just our workshed example, except that it is bright and shiny and much less useful. Right? Rather than clearing a forest, building a house plus nice woodshed, I dig holes in the ground to find gold. I can value it at market price (just like my woodshed). Now I want to sell it because I want a credit to my banking account. How does someone buy the gold from me? Exactly the same as the home mortgage example discussed above: go to a bank, proffer an IOU, get a credit to a demand deposit, write a check, transfer the demand deposit to gold seller.
Or, say that the buyer already has a sufficient credit to his demand deposit. Well, infinite regress: it came from a loan.
The exception is the government. If I sell the gold to the government, it credits my demand deposit and credits the bank’s reserves. A gold purchase by government is exactly the same as a Social Security payment, except that the government now has to go to all the bother of locking up the gold and keeping the bandits away so that the gold does not get freed and put to superior use as dental crowns in mouths. (That makes a heckuva lot of sense, doesn’t it. We need to start a campaign: free the gold!)
In conclusion, I hope this distinction between real and financial is now clear. And let me add that we MMTers absolutely agree that a lot of the most interesting activity in any society takes place outside (or mostly outside) the monetary sphere. And it is important activity—the monetary sphere would not last long without these nonmonetary activities. My own view is that this continual “monetization” of ever more activities is highly problematic and probably threatens survival of our species as well as that of many of the other species on earth. I also resist assigning monetary values to things like caring for your own children—something economists are wont to do.
But, after all, this is a Primer on modern money and so that is where we turn most of our focus, while ignoring most of the really interesting stuff that is studied by anthropologists, political scientists, and art historians.
Here is the query:
To Whom it may concern,
I’ve been following the MMT/mainstream debate with great interest for about a month. I’m a physicist by training and not qualified to have strong opinions on economic theory, but I cannot discern flaws in your arguments.
But I do find the MMT perspective to be disorienting, and the shape of my disorientation might be useful to consider, since it may afflict others who might otherwise be more sympathetic to your approach
My basic mental stumble is that I tend to conflate or confuse financial assets with real assets. That confusion would make your perspective incomprehensible and, from the perspective of Right-leaning people, even evil.
If a person grew his own food and in his spare time dug gold out of the earth, he might over time accumulate significant wealth without substantial participation in the cash economy. The public sector balance might be irrelevant to him. Provided that he didn’t get so sick as to require medical care that he could not pay for, he might prosper in some measure on the fringes or entirely outside the cash economy, though he would have to enter it to purchase items (with his gold, converted to cash) that he wanted but could not make for himself. The gentleman who for decades lived alone in Alaska in a camp he built with his own labor (with an initial capital infusion of low-tech tools and occasional top-ups of the same) comes to mind. Had be been lucky enough to encamp near a rich alluvial gold deposit, he could have become quite wealthy before he retired to civilization.
I think that the above thought is not (or not simply) a fallacy of composition. It may be fallacious to suppose that if a few can sustain themselves or even prosper outside the cash economy, all of the unemployed could, but there is also in view here the distinction between real assets and financial assets. It is possible in principle for the private sector to produce net real assets without a public sector surplus. But that requires (or it appears to me to require) labor outside of the cash economy.
For me, at least, and perhaps for others, something like this ‘independent producer” idea (not to mention a labor-content theory of value) is lurking in the background when I read MMT sectoral balance arguments that require that private increase in wealth (where by “wealth” here I mean “financial assets” per MMT, — this is the basic confusion that I tend to stumble into, since your arguments do not touch on “wealth” per se but on “financial assets”) can only occur if the public sector is in deficit (neglecting the external sector, or considering the entire planet). In the back of my head is a Marxian view that “labor creates wealth” (“real asset wealth”) so that independent laborers ought to be able to produce their own wealth regardless of the public sector balance. I don’t know Marx’s thought at more than a very superficial level, but I have the impression that he did not consider public sector deficits in his thinking about what has to be done to consume the surplus produced by the controllers of Capital.
It occurs to me that it might be useful for the MMT community to explicitly (and perhaps you have done this already and I am too unfamiliar with your work to have noticed it) discuss the place of real assets in your framework. Certainly you care about real assets. People cannot live in or wear or eat financial assets. The consumption that is funded by income that is produced in response to demand is consumption of real objects. Real asset accumulation by as wide as possible a proportion of the population is a proper concern of a government that cares about the well-being of the governed. Perhaps this is tangential to your concerns, on the premise that real asset accumulation (or consumption) requires employment in the cash economy. In principle, it does not, but I would agree that the production of real assets, whether for consumption or accumulation, is much more efficient within the cash economy. It is not a wholesome thing to have a large proportion of the population producing for its own consumption using highly inefficient methods.
Nevertheless, it seems to me that in the present economic trouble, we may see a significant increase in “independent production.” I have read that a great deal more gardening is happening since 2007. People with time on their hands are growing some of their own food. Arguably there will be even more of this and other kinds of independent production given that the nation’s politics prevent intelligent State intervention in the labor markets. Perhaps the failure of the cash economy will lead to a massive underground barter economy of inefficiently produced real goods. This growing phenomenon instantiates the “independent producer” concept and its reality may confuse the thinking of people other than myself.
Perhaps I am alone in the reasons for my feelings of disorientation when I contemplate MMT arguments. But perhaps others are disoriented for similar reasons.
I thank you for your work and your public advocacy.
17 responses to “MMP Blog #17: Accounting for Real Versus Financial (or Nominal)”