By Matthew Berg
The central insight of the sectoral balances model of the economy is that not all sectors of the economy can net-save at the same time. That means that if all those of us in the private sector in aggregate want to (on net) take in more money than we spend, then some other sector will have to spend more money than it receives. In a simple three sector version, the three sectors are the domestic private sector, the government sector, and the foreign sector.
Net financial assets of all sectors in the economy necessarily add up to zero. This is clearly true – in fact, it’s an accounting identity. Interested readers can find a more thorough explanation of sectoral balances and net financial assets here, but the essential point can be seen visually in the chart below.
The bottom of the chart is the mirror image of the top of the chart:
The same thing is also true if we break down the sectors a bit further, dividing the domestic private sector into Household, Non-Financial Firms, and Financial Firms sub-sectors, and breaking down the government sector into Federal and State & Local sectors.
In fact, the same thing would be true no matter how we might choose to break down the sectors:
Sometimes, something interesting and seemingly contradictory can happen in the economy. And when it does, it has important implications for the economy’s financial stability. That interesting thing is this:
Private sector net worth can increase even if private sector net financial assets were negative, as they were from 1997 to 2008 (except for a brief period in 2003/2004).
The reason this was possible is that net worth is dependent upon valuations, whereas accounting flows are not dependent upon valuations. One important financial asset class that enters into private sector net worth calculations are stocks.
If the market price for a stock is $90 and then I buy one share of the stock from you for $100, all that changes in the transaction itself is that I have $100 less than I had previously and you have $100 more than you had previously, and I have one more share of stock and you have one less share of stock. But what also happens is that the stock’s quoted market price increases from $90 to $100.
That means that everyone else who owns a share of the same stock thinks that they are now $10 wealthier per share of stock. The same thing happens any time the stock market goes up, writ large.
And what will the stock market do? In the words of J.P. Morgan, “it will fluctuate.” We might add that the same applies to the housing market.
In fact, there is a word in common usage for what happens when private sector net financial assets go negative but net worth nonetheless simultaneously goes up. It’s called a “bubble.”
For a while, the “wealth effect” of rising stock prices may encourage people to spend more of their income or even to take on another car loan or a second mortgage. After all, if your net worth is increasing, it seems like you can afford it! And this actually does have a animating effect on the economy during the market rise – as people spend more, their spending becomes someone else’s income, which also causes government tax receipts to rise. In a bona-fide bubble such as the Dot-Com bubble or the Housing bubble, this effect is stronger still.
But as the private sector’s financial position deteriorates, enough people eventually decide that they would like to sell at the new, higher market price. And when they do, we call that a “panic” or a “financial crisis.”
It’s like a game of musical chairs. When the music stops, there are not enough chairs (net financial assets) to go around.
So while the private sector did not net save during the Dot-Com and Housing bubbles, nonetheless when people received their monthly bank statements, quarterly portfolio reports, and annual property tax assessments, they saw that the numbers were going up. Times seemed to be good.
But to those who were looking at the underlying fundamentals – private sector net financial assets – it was clear that this prosperity was built upon a house of cards. There were not enough private sector net financial assets to support the increasingly fragile financial superstructure.
Indeed, this fundamental insight harkens back to the work of Hyman Minsky, originator of the Financial Instability Hypothesis. In 1999, Randall Wray wrote a prescient policy brief entitled, “Can The Expansion Be Sustained? A Minskian View.”
After reminding us that:
“In Minsky’s view, the floor to aggregate demand provided by a deficit’s maintenance of personal income is a key stabilizing feature of the postwar big government economy we have inherited.”
And after noting that:
“if it is true that the wealth effect has been driving consumption, it is not necessary to have a crash to kill the expansion. As Godley has argued, stock market capital gains provide only a one-time boost to consumption levels; continued economic growth requires rising stock prices.”
Wray’s conclusion was emphatic:
“I know of no reputable economic theory that concludes that growing private sector deficits are any more sustainable than are growing public sector deficits, and Minsky would have concluded that rising private sector deficits are far more risky!”
Likewise, Wynne Godley outlined “Seven Unsustainable Processes” earlier in the same year, in which he warned that the “negative forces” of the government’s “restrictive fiscal stance” and of unfavorable “prospects for net export demand” “cannot forever be more than offset by increasingly extravagant private spending, creating an ever-rising excess of expenditure over income.”
Godley went on to describe, oracle-like, precisely what the private sector’s deficit meant:
“The private financial deficit measures something straightforward and unambiguous; it measures the extent to which the flow of payments into the private sector arising from the production and sale of goods and services exceeds private outlays on goods and services and taxes, which have to be made in money. While capital gains obviously influence many decisions, they do not by themselves generate the means of payment necessary for transactions to be completed; a rise in the value of a person’s house may result in more expenditure by that person, but the house itself cannot be spent. The fact that there have been capital gains can therefore be only a partial explanation of why the private sector has moved into deficit. There has to be an additional step; money balances must be run down (surely a very limited net source of funds) or there must be net realizations of financial assets by the private sector as a whole or there has to be net borrowing from the financial sector. Furthermore, a capital gain only makes a one-time addition to the stock of wealth without changing the flow of income. It can therefore, by its very nature, have only a transitory effect on expenditure. It may take years for the effect of a large rise in the stock market to burn itself out, but over a strategic time period, say 5 to 10 years, it is bound to do so.”
And in the more recent past, Rob Parenteau discerned in his 2006 public policy brief, “U.S. Household Deficit Spending” that the American economy was on a “rendezvous with reality.” What did he mean by that?:
“In other words, the U.S. household sector may be engaging in what the late economist Hyman P. Minsky would recognize as a form of Ponzi finance. Since the primary financial surplus is exhausted, and household income growth is below the average interest rate paid on household debt, household borrowing against the value of existing assets is required to sustain rampant deficit spending and to service prior debt commitments (principal and interest).Without a suitable and swift “euthanasia of the rentier,” such that interest rates fall below long-run household income growth, sustaining U.S. household deficit spending is predicated on sustaining asset bubbles.”
He also outlined three conditions that could sustain “persistently increasing private sector deficits,” recognizing that though a certain amount of private sector debt could be sustainable, too much of it would spell financial instability. These conditions were the conditions for “Hedge Finance” in Minsky’s financial instability hypothesis. Decades before Parenteau spotted the bubble economy, Minsky described three types of financing that people and firms in the private sector can adopt:
- “Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows.”
- “Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principle out of income cash flows.”
- “For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations.”
The meaning of this, according to Minsky, was that:
“It can be shown that if Hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of Speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.”
So, the conditions Parenteau outlined in 2006 were:
- “First, the long-run growth of private sector income must exceed the average interest rate on the debt owed by the sector. This is a necessary condition for avoiding debt trap dynamics; otherwise, interest expense commands an ever-increasing share of income.
- Second, the private sector may be deficit spending, but its primary financial balance—excluding interest expense—must be in sufficient surplus. With a primary financial surplus, income grows more than noninterest expenditures, so there is still a positive cash flow cushion before debt servicing. Less new debt must be issued to service prior liabilities.
- Third, if assets held by the private sector continue to appreciate in price at a sufficient rate, then it is possible that the growth in collateral values and capital gains will be sufficient to service existing debts and justify further lending, even to a sector that is rampantly deficit-spending.”
But after examining the data, Parenteau concluded that those conditions (again, the conditions for Minskyan “Hedge Finance”) were not met:
“On the analysis presented above, serial asset bubbles will need to be engineered in order to keep household deficit spending on a steep trajectory.”
In more general terms, we can illustrate what happens with the aid of MMT’s money pyramid.
Government IOUs (money and bonds) are on the top. Then banks and non-banks leverage their own IOUs on the government IOUs.
Now, what does it look like if we flip that pyramid upside down?
Now we have Government IOUs on the bottom, serving as the base of the economy. Bank and Non-Bank IOUs are leveraged on top of those IOUs – somewhat precariously.
In fact, you can think of the economy as a spinning top rather than a pyramid. Like a spinning top, the more top-heavy the economy becomes, the greater its tendency to instability, and the more readily it will topple over and collapse in a financial crisis.
Now, what happens if, as was the case during the dot-com bubble and the housing bubble, private sector net financial assets go negative but net worth continues to grow?
In fact, the difference between the measures of net financial assets and net worth provides us with a good rule of thumb for how to spot a bubble economy. If private sector net worth is growing at a greater rate than private sector net financial assets are growing, then that means that the economy – symbolized by our spinning top – is growing more top-heavy.
So, what happens if we make the spinning top more top-heavy? You can go ask your nearest Kindergartener – it becomes more likely to topple over.
That’s not the sort of economy we need.
What we need is not an increasingly unstable bubble economy, but rather a stable and robust economy with a solid foundation of government IOUs, to prevent it from toppling over and to fight the tendency towards financial instability.
To be clear, private sector liabilities are not always and everywhere, in any quantity whatever, disaster for the economy. As with spinning tops, so too with the economy’s asset structure – it’s all about the balance. For stable and robust growth, we need an economy with an asset structure that looks more like this, with enough government IOUs at the foundation to prevent the whole edifice from toppling over. In Minsky’s terms, we need a “Hedge” economy at most, not a “Speculative” economy and certainly not an unstable “Ponzi” bubble economy:
We must sidestep a fragile and unstable economy in which unaccountable multinational wall-street bankers arbitrarily destroy the American People’s wealth according to their own whims and caprices in unsustainable bubbles. MMT advocates a robust and stable financial system founded upon a solid structure of safe net financial assets, so that we can achieve the sort of strong and sustainable growth that the American People – and, indeed, the people of all countries – deserve. But we are being hindered from achieving that goal by man-made obstacles, which we must sweep aside in order to move forwards.
The only way to get there is by understanding how the monetary system works.
Great article Matthew, hope to see more articles from you going forward.
Glad you liked it!
You wrote, “If private sector net worth is growing at a greater rate than private sector net financial assets are growing, then that means that the economy – symbolized by our spinning top – is growing more top-heavy.”
Did you mean ” If private sector net DEBT is growing…? Or am I confused?
Think about it this way.
Net worth is “the total assets minus total outside liabilities of an individual or a company.” So there are two ways that private sector’s net worth can increase in aggregate.
1) The private sector can run a surplus, accumulating NFA from some other sector (like the government or the foreign sector).
2) The valuations we (subjectively) decide to put on our assets or our liabilities can change. For example, the market value of your house may go up $10,000, so the next time you calculate your net worth, you count yourself as $10,000 richer.
There’s also one other possibility, which is true for you, but not for society as a whole. That is that you can increase your personal net worth by paying down a debt to someone else. But that doesn’t work on aggregate, because you are decreasing the other person’s net worth by the same amount as you are increasing your own. Likewise, when you take out a loan from a bank, that does not raise either your or the bank’s net worth, because of double-entry accounting.
So, other than way #1, that leaves only way #2.
I’m confused. If I pay off a debt there is no change in my net worth since I decrease an asset by the same as a liability. The person who gets the payment increases his cash and decreases his loan, I.e. no change in his assets. The plus to all this is a decrease in risk on both sides.
Oh yeah, you’re right. What I should have said is that you can increase your net worth personally simply by saving. But this doesn’t work for the private sector as a whole, because saving decreases income. In effect, your saving prevents someone else from saving by reducing someone else’s income. So the only way the private sector can net save is by getting more NFAs from some other sector (option 1). Or the market valuations of its assets may go up (or down), which is option 2 – but that is not saving.
Net worth includes both real and financial assets.
The net worth of the private sector in the aggregate can also increase by expending labor to produce goods. If we build and sell a car or a house, that car or house adds to net worth the difference between its value and the value of the raw materials that went into it. It’s not saving, and it requires no changes in valuation.
Right, net worth includes both real and financial assets.
However, I think the distinction between “real assets” and “financial assets” is one of degree, not of type.
But since people generally try to use financial assets to store (and perhaps grow) wealth rather than to consume, and since people generally try to use real assets to consume rather than to store wealth, there is usually a practical/functional difference.
The fact that we do not expect that people are holding real assets as stores of financial wealth is the functional difference is what decides what we usually call a “real asset” and what we usually call a “financial asset.”
But homes are usually considered real assets – and obviously people saw them as stores of wealth during the housing bubble.
But if confidence soured and everyone did decide that they wanted to sell all their real assets, there would be the same problem as if they decided to sell all their safe assets. There would not be enough NFAs to go around.
And it seems to me that that’s part (thought not all) of what happened when the housing bubble burst. And since the dividing line between “real assets” and “financial assets” lies on a continuum, not on an either-or category, I would further suspect that what is functionally considered to be a “financial” asset changes and shifts around particularly during periods of crisis.
Anyway, if we have a pile of wood and we build a house out of it, that is not saving, as you say. But it does (presumably) change the valuation of the pile of wood into whatever is the valuation of a house.
Regarding Private sector net worth increasing even if private sector net financial assets were negative, as they were from 1997 to 2008 (except for a brief period in 2003/2004).
This can happen simply by taking a loan from a bank to say buy a house, or a home equity loan. Isn’t that what happened starting in the late 90’s?
“This can happen simply by taking a loan from a bank to say buy a house, or a home equity loan.”
No, it can’t. Taking a loan creates a liability as well as an asset. They net out to zero (except for interest).
Taking a loan using a real asset as collateral converts part of the real asset to a financial asset.
When the price of the house you own goes up, that increases your net worth, but does not increase your net financial assets. That is what happened in the housing bubble. In the late 90’s it was more stocks than housing, but both were going up then, too.
I agree it creates a liability, but in exchange for a big chunk of money right now I return for spreading payments over time. Loans create deposits. Then that big chunk of money is created by a bank out of thin air – assuming you believe bank loans add to money supply. If banks get enough loan demand, can’t they get more reserves from the Fed increasing money supply?
That new bank money can push up asset prices, and then people take further loans such as home equity, effectively monetizing that asset.
Excellent Matthew! I like the way you are working out the implications of sectoral balances/stock-flow consistent accounting in this piece… Also, nice detail on the more detailed sectoral balance chart…
Credit goes to Scott Fullwiler on the sub-sectors. He compiled that data, and in fact it has been in his spreadsheets for a long time. It’s just that MMTers, dating back to Wynn Godley, have customarily used just the 3 familiar sectors for the sake of simplicity and clarity of exposition (Government, Private Sector, Foreign Sector).
But there’s no reason, in principle, that we could not treat each and every individual/family/firm in the economy as a separate “sector” – if we had the data to do it. And even with millions or billions of sectors of that nature, their NFA would all still net to zero.
Very good. The graph shows two things that need further explanation, though. First, it looks as if the private sector has been doing just great since 2009, accumulating NFA. That is at odds with the record of weak and weakening GDP growth since the end of the recession. Likewise, since it is a mirror, the government deficit has been huge, by recent standards. There needs to be some explanation of why this huge government deficit and huge private sector surplus is not giving us a happy result. You can say deleveraging, but the graph without explanation suggests a causal relationship that is, to say the least, “out of paradigm”.
Second, the yellow part, financial firms, is minuscule compared to the others. How does this jibe with the criticism of this sector as “too big to exist”, a cause of the Great Recession, an undeserving beneficiary of subsequent government emergency aid (aka “bailouts”), and excessively profitable. The graph makes it look like no more than a rounding error.
golfer1john, the huge government deficits starting in 2008 are the automatic stabilizers (unemployment insurance, etc) that kicked in with the massive job loss. The private sector, which received them, didn’t use them to go on a spending spree. They used them for basics and paying down their debt (deleveraging). If we want the spending to return that will begin a real recovery, then the government is going to have to spend much more in order to give the households (which accounts for 70% of all spending in the economy) the income that drives spending. Right now, they can’t do it. They are tapped out.
Right, but it’s not enough to just say “it’s huge, but it’s not huge enough”. The other argument, “it’s huge, and it hasn’t helped. Let’s try something else” seems more cogent. (And that’s without adding the $Trillions of Fed interventions that aren’t shown on the graph, which some consider an even bigger problem than the deficit itself.) Somehow you have to blend in what went on in the real side, the net worth side, not just these flows. By the graph, the private sector has already reversed all its deficits from before the crash. But they still have not reversed the losses in asset values, which are not shown in the graph, and that is why the deficit hasn’t been big enough. If there were a way to show that in a clear, obvious representation, it would make the argument complete.
Apparently it has not been huge enough.. according to the folks over at zerohedge (who I’m not a huge fan of but seem to be pretty good with financial data) say we’re still short almost 4 trillion dollars since ’08 – http://www.zerohedge.com/news/verge-historic-inversion-shadow-banking (4th chart down).
Your second question is an interesting one, I don’t know what data was used for this sectoral balance chart.. but much of the MBS/CDS/etc. may have been off-balance sheet or unreported?
QE and such is not shown because the fed has no ability to alter the NFA of the private sector. Total net financial assets remain unchanged no matter what the fed does.
Right, but there is a widespread belief (even at the Fed itself) that they can affect the real economy, the money supply, the unemployment rate, and the inflation rate, via open market operations, both the traditional ones and QE.
I was thinking about your question. I’m not quite sure what would be the answer to your second point about the financial sector, but here’s how I’d respond to the first point:
Yeah, the private sector has been accumulating NFA since 2009. That doesn’t mean that they have been doing just fine, though. One way to think about what the private sector’s NFA’s really mean is that they are a signal of whether or not the economy is becoming more unstable (moving away from hedge finance and towards speculative and ponzi finance). If the private sector is not accumulating NFA’s at least in proportion to the increase in the overall (net and non-net) financial assets in the economy, then you have to start worrying about financial instability.
In other words:
No debts = no money
This is because in the fractional reserve banking system, all money is created as debt.
Well, I think it is more a matter of double entry bookkeeping than of fractional reserve banking.
But money is treated as “debt.” And it does sort of seem to me that that really make sense, when you think about it. In order for there to be any money at all, someone (the government) must issue it. But what is the debt payable in? Well, it’s circular – more money!
If you take $5 to the government and say, “I demand payment for this debt of $5,” what are they going to give you?
They’ll give you $5.
But that’s what you already had!
“In order for there to be any money at all, someone (the government) must issue it. ”
The US government does not create money. In the US, the private banks create money out of thin air as debt. The US Treasury collects money from taxpayers via the Internal Revenue Service and any shortfall is made good by borrowing from the private sector. This is why there is a US Treasury debt of $16 trillion.
However, there is no need for any sovereign nation to go into debt in order to create money.
Now that I think of it, I was momentarily falling into the well-known economics trap of thinking about how Robinson Crusoe gets the first piece of money on the island…
There are objections to seeing Crusoe as economic man. He is, after all, a man alone on an island; does that make him an economy of one person? Can an economy exist if there is no society? No one in his right mind would choose the story of a man cast alone on an uninhabited island to illustrate a theory, which only applied to the exchange of goods and services.
The dispute about the origins of money is interesting to me. As it happens, I have just visited the Casa Grande Ruins National Monument. The building, named Casa Grande (big house) by Father Kino in the 17th Century, had already been abandoned for 400 years. We’ve found evidence in the Southwestern US of civilizations dating back to 300 BC or so. The Hohokam built Casa Grande, and they lived in central Arizona and traded with other civilizations from what is now Mexico, California, and New Mexico, as well as those in other areas of Arizona. We know this because some of the artifacts found in each site are made of materials found only in the other places. Casa Grande has small windows on the top floor (it’s 4 stories) that line up with the setting sun at the equinox.
None of these civilizations used money. Their trade with each other was done by barter.
They had a social organization that was very different from European societies of the same era. There is evidence that they once had very large populations, and they cultivated large areas of land and built canals to bring water long distances to their crops. They had no draft animals, and did not raise animals for food. There were different dwellings of various sizes and varying levels of desirability, so they may have had a kind of stratified society, but it seems to have been quite communal. Perhaps the chief was more like a father to the tribe than like a European King. Chiefs did not impose taxes like European kings did. Without the idea of taxes, they had no need for the idea of money. Money was not necessary to support far-reaching and vibrant trade relationships.
Perhaps the history of societies that did not have money can shed more light on the origins of money than the study of those who did have it.
Some of the first examples of writing seem to have arisen in Sumeria as cuneiform marks on clay tablets, which were tallies of agricultural production or in other words, money. This was accountancy in its infancy and has plagued us ever since 😉
golfer1john, the Sumerians kept incredibly detailed records of credit and debits. In recorded history (because few of us read Chinese here) they were the first to initiate tax reduction as social reform to flush out the abuses of “former days” where an obnoxious bureaucracy taxed the people to the point of pain, and appropriated property belonging to the temple. The historical record of this is dated around 2400 BC. It happened in Lagash, where the people threw out the reigning dynasty and selected another ruler who would restore freedom and law to the people. The historical record was talking about something that had happened 600 years before!
Read all about it in “History Begins at Sumer.” Page 45.
Yeah, I agree that the Crusoe scenario is not realistic. What I was trying to do was to step back and imagine about a world with no money at all of any sort, and then ask how do we get money in the first place.
Of course, that’s artificial, and seems to imply that barter preceded money, so it’s also a-historical.
Anyone can issue a liability (and as Minsky said, the key is getting it accepted!). And if that liability is generally acceptable, it gets traded around and functions as a “money-thing.” In practice, the liabilities that are generally acceptable will tend to be issued by those who have some sort of power in society. I do not think money has to be one particular thing, necessarily, but rather is anything that performs money-functions, shall we say.
And so if what you are trying to say is that you don’t think that it really makes sense to think of those sorts of “liabilities” as “debt,” then I am inclined to agree. It confuses the issuance of the sorts of “liabilities” that circulate through the economy performing money-functions with the sort of liabilities that do not circulate through the economy performing money-functions and instead are only extinguishable by the other class of money-functioning liabilities.
This is completely false. Our federal government is not revenue-constrained. You do not understand how fiat currency works and you don’t understand the incredibly opaque USTreas/Fed operations, nor how they work with banks to provide a payment system for the country.
The US Govt issues the currency. Period. Pull a dollar bill out of your pocket and read it. It says Federal Reserve Note because Congress authorized its bank to create them at the Bureau of Engraving and Printing and the US Mint, and it’s signed by both the Secretary of the Treasury and the Chairman of the Fed. It has the American Seal on it, per the Legal Tender Laws of the 1870s. And it says specifically: “This note is legal tender for all debt public and private.”
That $16 trillion in ‘debt’ is the record of all money created (issued) since 1792 with the Coinage Act minus the money destroyed (taxes) since then. The majority of it is sitting in pension funds. A more accurate term would be $16 trillion in money, US dollars. The problem is that it’s not in the hands of the people doing the spending, which is the household sector (70%) because our negligent congress has fueled financial capitalism and not industrial capitalism for the last 30 years. What is called the FIRE sector.
When I pull a dollar bill out of my pocket, it reads “Federal Reserve Note.” The Federal Reserve Bank is owned by a consortium of private banks, who receive a 6% dividend on their shares. It lends money to the private banks as needed at 0.25% interest. The private banking industry creates money out of thin air as debt as a multiple of up to fouteen times their asset base, according to the Basel accords.
The US Treasury does not create money, it borrows it from the banks.
However, there is no need for any sovereign nation to go into debt in order to create money.
The Kucinich Bill HR 2990 before Congress explains it quite well.
You are only telling a portion of the story and making it seem to the uninitiated here as if the “private banking industry” controls the issuing of the currency , and that is patently false. Or that it can raise the money supply all by its lonesome.
Here is Bob Eisenbeis, a former Atlanta Fed economist in a research note, recommended by both Kelton and Mosler:
The private banking industry creates money out of thin air as debt. The money supply is constrained by banking regulations, which according to the Basel accords is 14 times their asset base. The Federal Reserve Bank can also perform this function by buying bonds from the private sector (qualitative easing) or from the US Treasury (quantitative easing) The Federal Reserve cannot legally buy Treasury bonds directly from the US Treasury, but only indirectly from private banks. Of course the Federal Reserve will always oblige the US Treasury. There is no denying that.
Of the $16 trillion US Treasury debt, approximately half is intergovernmental. Of the remaining $8 trillion, the Federal Reserve owns about $1.7 trillion. The rest is spit up between private entities both domestic and foreign.
However, I still maintain that the US Treasury should be the sole creator of all money, without incurring any debt or interest payments. This would save taxpayers an enormous amount of money and there would also be no fake crises concerning debt ceilings, which Republicans in particular use in an attempt to destroy the Roosevelt new deal to further enrich the already wealthy.
Banks would still be able to borrow and lend this money at interest, but would merely be middleman rather than creators of money.
Private banks create IOU’s out of thin air, just like you and I can. That’s all a deposit balance is. But when final payment is made on those IOUs when they are redeemed, or when a draft is issued against them ordering payment to a third party, the money that is used for the redemption or for the payment is the form of money that is directly issued by the central bank, which is a branch of the government.
This is where you and I strongly disagree. The Federal Reserve is not a branch of government.
When I pull a dollar bill out of my pocket, it reads “Federal Reserve Note.” The Federal Reserve Bank is owned by a consortium of private banks, who receive a 6% dividend on their shares. It lends money to the private banks as needed at 0.25% interest. The private banking industry creates money out of thin air as debt as a multiple of up to fouteen times their asset base, according to the Basel accords.
The Chairman of the Federal Reserve Bank is appointed by the US President and that is all. The Chairman is a bank employee and not subject to direction by anyone in the US government, but he can be questioned by Congress just like anyone else.
Frank, I think you and Dan are disagreeing about the interpretation of the facts, not about the facts themselves. The central point of disagreement I see is whether the Federal Reserve is directly controlled by the government (Treasury) or whether it is an independent entity owned by the member banks. If the former, then the government is the issuer of currency as Dan maintains. If the later, then currency is issued by the private banks as you contend. I would just suggest that the Federal Reserve has aspects of both an agency of government and an independent agency, with perhaps somewhat more of the latter, but it is not totally independent. Joe Firestone and Beowulf have shown that in cases of conflict between the FR and Treasury, the Sec. of the Treasury has precedence over the FR and its director, but ownership and nomination of the board of directors by the member banks gives them a lot of control if not complete independence. In my opinion, the FR is a bastard organization that should be reigned in and made a regular part of the Treasury, or simply be abolished and the Treasury given the power to issue currency directly. Opinions are, of course, ubiquitous.
Well, we know who owns the Federal Reserve bank, don’t we ? Ownership normally confers control, but in any case I am not concerned about the control as such. The fact of the matter is that in the US, it is the private banks who create money, not the US Treasury.
It is time that this was changed as per HR 2990 before Congress:
This would enable the US Treasury to be the sole creator and issuer of US money without going into debt.
SIR JOSIAH STAMP (President of the Bank of England in the 1920’s, the second richest man in Britain)
“Banking was conceived in iniquity, and was born in sin. The Bankers own the Earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen, they will create enough deposits, to buy it back again. However, take it away from them, and all the great fortunes will disappear, and they ought to disappear, for this would be a happier and better world to live in. But if you wish to remain the slaves of Bankers, and pay the cost of your own slavery, let them continue to create deposits.”
Well, here are a few facts that are relevant:
The currency that the Fed issues is a liability of the US government.
7 of the 12 members of the open market committee are from the Board of Governors, and are thus directly appointed by the president.
No individuals own stock in the Federal reserve system or regional banks. The stock is owned only by the member banks.
This so-called stock is not transferable.
There is a statutory 6% dividend paid on this stock to the member banks. But beyond that, any “profit” made by the Fed is returned to the Treasury.
The Federal Reserve money brought into being as debt by the private banks is not a liability of the US government. The acceptance of such money relies on the fact that it is a monopoly and is good for all debts, both public and private.
Obviously, the US Treasury is responsible for redeeming US Treasury Bills with Federal Reserve notes or their electronic equivalent, but not the currency itself. In order to do this the Treasury must raise taxes or make further borrowings.
What is your problem with returning the right of money creation to the US government away from the private banks ?
The Federal Reserve money brought into being as debt by the private banks is not a liability of the US government.
Frank, it’s a liability for liabilities of the US government. The “money” that a bank creates when it issues a loan is just a kind of promissory note – a negotiable debt instrument representing the bank’s liability to the depositor. It can create these instruments in more or less the the same way you of I can create a a promissory note. These bank liabilities are not the final means of payment for debts. You can issue a draft against your deposit balance and the bank then has to execute a payment, which means it has to order the transfer of some of its own reserve balances to a payee. Those reserve balances are not issued by banks: they are assets of the bank that are liabilities of the Fed and are directly issued by the Fed. And those Fed-issued dollars are liabilities of the US government.
The banks don’t issue fiat money in the same way the Fed issues fiat money. The banks issue debt instruments which obligate them to make payments with Fed-issued money.
Nor does the Treasury have to obtain this bank-issued money. When you pay the government money by issuing a draft or check on your own deposit balance, the clearance of the check means that your bank has to transfer some of its reserve assets to the Treasury. That means that a US government liability issued by the Fed that was an asset of a commercial bank becomes an asset of the Treasury. And that just means that one government agency – the Treasury has an asset that is at the same time a liability of the self-same government, and was issued by the Fed, another government agency.
The banks don’t have any kind of “monopoly” on the issuance of money.
I’m not opposed to the Treasury assuming more direct responsibility for issuing US currency liabilities. I just think all of this business about the banks having some kind of currency monopoly that makes the government dependent on them is bunk. If your Congressman is telling you this he is lying to you, because he is trying to pass the buck for his failure to vote out an expansion of the deficit.
Well, of course it depends upon how you define “money supply,” but it seems to me that banks do in fact increase the money supply all the time, by making loans. That’s what endogenous money is all about. The Federal Reserve can of course also affect the money supply by buying or selling bonds (unless you use a broader definition of “money” which includes those bonds).
And anyway, we’ve known since at least the attempts to implement monetarism in the 1970s/80s that “the money supply” is not a such a good measuring stick for the economy.
So the point is that the private sector can’t create more NFAs by itself.
On 2/28, J.D. Alt counters your claim that “banks do in fact increase the money supply all the time, by making loans” (http://neweconomicperspectives.org/2013/02/real-dollars-and-funny-money.html)
No, he doesn’t. JD is not using the precisely defined economics terms of “money supply” and “net financial assets”.
That was wrong. He does use NFA, and says correctly that banks can’t create it. They do create money. He speaks mostly in analogies, though, and not especially precisely.
Thanks — I see Dan provided thorough explanation in the comments there.
This is not directed specifically at you, just a general observation.
I think there’s some equivocation going on in this discussion when we talk about “creating money.”
1) Under current law, Treasury is prohibited from directly issuing money. Instead, it issues bonds. Of course, that’s arbitrary, and the government could just issue currency directly (e.g. Greenbacks) if it passed a law to do so. The only reason that there is any cash at all in the economy is that people and firms choose to withdraw it from banks and circulate it through the economy.
2) On the other hand, all reserves can have no other source than the government (specifically the Federal Reserve – though again that’s just a reflection of our current laws).
These are two different things, and talking about them using the same words causes confusion. In fact, I don’t think I quite covered the whole gamut of equivocations… There is equivocation both in the “creating” and in the “money” part, so we potential for equivocation with the phrase as a whole, and also with both individual words separately.
“Under current law, Treasury is prohibited from directly issuing money”
Yes, that was the huge swindle passed by Congress in 1913 when the Federal Reserve Bank was created and the US money supply was privatized.
Just after President Wilson signed it into law, he had this to say “I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated Governments in the civilized world no longer a Government by free opinion, no longer a Government by conviction and the vote of the majority, but a Government by the opinion and duress of a small group of dominant men.
I agree it would be useful to return some currency-issuing authority to the Treasury.
And we can also do what Canada does under its fiat system. All 50,000 shares of the Bank of Canada (their Fed Res) are owned by the Minister of Finance. The BoC regulates their banks, which appear to be national entities. If I’m wrong, a Canadian can join in and correct me.
Frank, the Fed is a public-private entity just like the military.
“The Fed is a public-private entity just like the military.”
I would take issue with that statement.
The military is funded by US taxpayers and is supposedly under the control of its Supreme Commander, the President of the United States, who in turn appoints the Joint Chiefs of Staff. Congress are also supposed to approve or disapprove of the country becoming in foreign wars, although this distinction has been blurred under the Obama administration. These days the military outsources a lot of its needs to private contractors and to mercenaries like BlackWater, whatever its name is this week.
The Federal Reserve Bank on the other hand is privately owned by a consortium of banks, who receive a 6% yearly dividend on their deposits at the Federal Reserve. Private banks are able to borrow from the Federal Reserve at 0.25% interest. The Federal Reserve is no more government owned than Federal Express parcel service. The US President does, however, get to appoint the Chairman of the Federal Reserve.
I’m not certain that the top analogy is entirely correct, because what keeps a spinning top from toppling over is it’s angular momentum, related to its speed of rotation. The top becomes less stable as it slows down until it’s speed is too low to sustain its stability. As long as an economy is spinning fast enough (turnover or churning of assets) it can appear to be stable. Even a Ponzi economy can appear stable as long as new assets are added fast enough. It becomes unsustainable when new asset addition slows below the necessary minimum to keep it going. That minimum speed is related to the size of the top, of course, but not just its size.
The top analogy can’t be stretched too far. There’s no analog in economics for angular momentum. The economy rests on a flat base, not a point, and doesn’t need to spin at all. If you forget about the spinning, and just consider the cantilever aspect of the inverted pyramid, you can see the stability implications of excessive top-heaviness. Its stability depends only on how far out the higher levels reach, as compared to the base.
As long as the pyramid is symmetrical, it doesn’t matter how far out the higher levels reach. It could just as well be a mushroom. Edible, of course.
But if it’s too big, and not spinning, it’s unstable. Any perturbation will topple it.
Perhaps the analogy isn’t quite right. I was trying to think of something other than a pyramid with the same general shape that would actually go upside down like that in real life. The spin part didn’t really factor into my thinking.
I think you are also right that even a Ponzi economy can appear (and actually be in fact, for a temporary period) stable. The reason is that financial instability is not a state that is just turned on or off light a light switch, but rather is a systemic tendency.
The reason why ponzi finance is a problem is because it entails ever-increasing leverage. And ever-increasing leverage is not, per se, in-and-of-itself a problem, but rather is a problem because it is dependent upon confidence. As long as there are different people and firms in the economy acting alone on their own volition (not obeying centralized commands of some sort), the issue of confidence will eventually come into play as leverage increases.
And when the confidence dries up, that’s when you get your crisis.
Wow, I like the article, but the analogy is kind of blown. The first, roughly equilateral, downward pointing triangle is actually a much less stable design for a spinning top than the second wide, shallow design.
The ‘top heaviness’ explanation fares little better. The center of gravity of any triangle or cone will always be 2/3 of the way up from the bottom point, regardless of the angle.
so I think the analogy needs a re-think.
Glad you liked the article, even if the analogy didn’t quite work as intended!
Nice article, I get what you mean even though the analogy requires too much knowledge of physics for me.
What strikes me in the chart are the huge capital account surpluses since the 80’s. I assume this shows increased foreign ownership of US financial assets. Mainly US$ bank accounts and foreign held Treasuries. (As opposed to foreign ownership of US assets like stocks and shares.)
I’d like to learn more. This should show oil importers, German, Korean and Japanese goods importers holding onto US financial assets. It will also show the growth in low cost China outsourcing… The Chinese Government as the major seller of labour holds onto Treasuries whilst US companies stash cash under foreign registered entities to avoid taxes.
What happens when a major category decides to exchange their financial assets for something else. What if US outsourcerers decide to repatriate profits? What if importers decide to transfer holdings to another currency? or buy more tangible US assets like agricultural land? What if we look at US ownership of foreign assets too?
These are all arrangements created by change in free trade agreements and held in equilibrium by the existing regulatory framework. There is a lot of instability that could be brought on by regulatory changes. Are there any instability risks in the Capital account area that are particularly sensitive to desired MMT regulatory changes?
Let me try to explain each one, mainly as an exercise to test my own understanding of MMT.
What if US outsourcers decide to repatriate profits?
US-based multinational companies only pay US income tax on their US operations, unless they bring the profits from overseas back to the US. If they do that, they pay income tax, but presumably they do it because they have some use for the money specifically in the US, to invest in a new plant for instance. So they build the plant (65% of the money) and pay the tax (35% – but they’d get a tax credit for the tax already paid to the other country, which in almost all cases is less than 35%). Something over 65% of the money returned to the US goes into the economy here, the rest (taxes) is lost.
What if importers decide to transfer holdings to another currency?
I think you mean exporters in other countries exchanging their dollars for other currencies. Mostly the companies already have exchanged them for their own domestic currency, and the dollars are held by central banks around the world, in the form of Treasury securities in their account at the Federal Reserve. They are free at any time to sell their Treasuries and hold cash, which pays no interest. The Fed will buy them, so as to maintain their interest rate targets. Probably the reason they would exchange their Treasuries is to buy some other asset, like gold or bonds denominated in another currency. Their forex activity would tend to drive the US dollar down in terms of other currencies, which would tend to lead to a lower US trade deficit, as the dollars pass into the hands of those wanting to buy US goods, but only at a slightly lower price.
or buy more tangible US assets like agricultural land?
I’m not sure, but I think there may be restrictions on things like this. I know some Japanese investors famously bought the Pebble Beach golf resort years ago, and then sold it at a loss after a real estate downturn. If it happened, that money would be returned to the US economy, just as if something were exported. Thereafter, any profits from the asset would belong to the foreign owners, and if they took the money to their home country, it would be lost to the US economy, just like an import, except we wouldn’t have the imported goods. I think this is all accounted for in the Balance of Payments, which is the trade balance adjusted by other transfers such as this, and shows in the sectoral balance graphs in this article.
What if we look at US ownership of foreign assets too?
Same thing, in the other direction.
As for things being held in equilibrium by current regulatory arrangements, I think things are constantly changing, and equilibrium is fleeting, if it ever occurs. If MMT were adopted, probably the US trade deficit would increase, as some of the additional money in the economy was spent on imports. Foreign governments would probably continue their mercantilist strategy of hoarding the extra dollars, so as to avoid appreciation of their own currencies. I don’t see why there would be any additional dangers or major changes in trends.
You are conflating the US trade deficit with the US Treasury debt, since they are quite separate issues.
I would imagine that the trade deficit means that there is more foreign ownership of US assets. Whether this is detrimental to US interests is a moot point. What worries me more, is foreign influence over the US political system, via anonymous bribes that we euphemistically call campaign contributions.
The US dollar is the currency of international trade, which means that there is a huge dollar float involved. My international trading company in England actually keeps its reserves and accounts in US dollars, which is quite acceptable to the Inland revenue.
I’m not conflating the trade deficit with Treasury debt. The trade deficit is the difference between our exports and imports in a year. Treasury debt is the outstanding balance of treasury securities. They are not directly related, except through the sectoral balances as explained many times in MMT writings. It the foreign sector has a surplus (the trade deficit), one or both of the private domestic and government sectors must have a deficit.
The trade deficit says nothing about foreign ownership of US assets, if by that you mean real assets. The trade deficit means that the foreign sector has accumulated financial assets denominated in US dollars.
BTW, if they spend those dollars on bribes to US politicians, that reduces the trade deficit (balance of payments, I think, is more technically the correct term for the foreign sector balance, but it is almost all trade, very little else.) In that case, influence is an export industry.
And, yes, because the $US is the world reserve currency, many governments hold dollars as reserves, just as they also hold gold, for use in maintaining the target forex value of their own currencies. And in many countries the US dollar is accepted for purchases just as easily as the local currency. I’m surprised that tax authorities would do business in a foreign currency, but if you say so I believe it.
“BTW, if they spend those dollars on bribes to US politicians, that reduces the trade deficit”
The problem is that they are bought for a relative pittance, to the much greater detriment of the US Taxpayer.
You guys are good at trying to explain the current super-complicated mess of an economic system but explaining the solution is simple. The Treasury prints and issues all currency. When an individual or a business needs a loan, the bank or credit union rely on the historical credit of the individual or business, much like now, to determine the likelihood of payback. The bank or credit union ‘borrows’ money from the Treasury and loans it to the individual or business and receives loan management fees (not interest) in addition to the scheduled repayment from the individual or business. This means that banks and credit unions will have to compete on charging the lowest fees which means that the most profitable banks and credit unions will be those that are small and local without a large overhead like a 50 story high-rise or a multi-million dollar CEO. As the individual or business repays the loan and fees the bank or credit union keeps the fees and remits the loan payment to the Treasury. If a default happens the assets involved in the loan are sold to repay the debt and any remaining balance is taxed to the individual or business back to the Treasury. Now I realize that your very complicated thought processes can’t fathom a solution so simple and will find many reasons why it wouldn’t work but if you let go of all of that complicated fluff it will be apparent that it’s a no brainer.
I too am a simpleton 😉
Agnotology, the celebration of and production of ignorance to distract from and obscure knowledge.
“Those few who can understand the bankingsystem will either be so interested in its profits, or so dependent on it favors, that there will be little opposition from that class, while on the other hand, the great body of people mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear it burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.”
That’s not much different than Warren Mosler’s proposal to eliminate the Fed Funds market and fund the banking system entirely through the discount window. The government loans to the banks, and the banks loan to bank customers. Whether the currency issuer and operator of the discount window is the Fed or the Treasury or some combination of the two is an operational choice about the governing architecture that probably doesn’t make all that much difference.
However, whether this gives us enhanced financial stability while still permitting adequate economic development of the country depends on a host of other regulatory decisions.
It also does nothing in itself to address the fundamental problem that the government is not spending enough, and we have 7.9% unemployment as a result. In the end, changing the financial architecture does not change the fact that the government can only spend more if Congress authorizes the spending. Focusing on the architecture of the monetary system when the real problem is the policy choices of the fiscal authorities is a bit of a red herring. The current system is not ideal, but Congress can spend all of the money it wants to right now. It refuses to do so because it is full of crazy people, ignorant people and a-holes.
Whether the government spends enough is a matter of political opinion. Many think it spends way too much, and sticks its nose in places where it doesn’t belong.
The economic fact, expressed correctly by Warren Mosler, is that taxes are too high for the size government we have.
An Alternative to Capitalism (since we cannot legislate morality)
Several decades ago, Margaret Thatcher claimed: “There is no alternative”. She was referring to capitalism. Today, this negative attitude still persists.
I would like to offer an alternative to capitalism for the American people to consider. Please click on the following link. It will take you to my essay titled: “Home of the Brave?” which was published by the Athenaeum Library of Philosophy:
“Insanity is doing the same thing over and over and expecting a different result.”
~ Albert Einstein
Einstein never had to deal with Windoze.
The growing worker’s cooperatives movement is another solution where people actually have a stake in their productive proclivities and a say as well. This keeps money circulating within a community and helps them to remain viable and increasingly self-sufficient. Let’s reinstitute the Golden Rule in our hearts to Love thy neighbor as thyself. How about the biggest change of all. Just as ‘Land’ as a commodity was the Mother of all monopolies, Land as commons is the Mother of Liberty and please don’t use the tragedy of the commons as a dissenting example when it is and was a heretical premise that stands on a foundation of shifting sand. Keeping Land within the commons where each have access to it while ensuring private property (Land is not property – property is created by man and man didn’t create Land) rights are protected and respected is a very simple maneuver. There are simple solutions to every problem when you really care to look.
Right on Brother Frank 😉
If any of you would like to understand the land principle look to the principles of Henry George but instead of using the revenue for public expenditures as he suggested it is returned to the people equally in the form of a Land Dividend. This concept is usually only approachable by the most open-minded individuals but once it’s understood a light comes on that says duhh – I didn’t realize it could be so simple. That’s how it was for me anyway. Here’s a link to a good primer for those interested – http://www.progress.org/dividend/cdman.html
The idea of private property in Western societies certainly goes back to feudal times if not before, whereby in 1066 the Norman conquerers, deprived the Anglos Saxons of their land. (Before that the Anglo Saxons drove out the Celts) Even so, the peasants still had some rights over common land, but much later the land clearances Act robbed them of that benefit thus creating the greater rent seeking estates of the aristocracy.
Downton Abbey is well produced and entertaining, but it makes me quite sick to watch the servants bow and scrape to the lords and ladies, who inherited their wealth.
In an ideal world, all land would belong to the people or the state and be let on short leases to whomever could make the best use of it. It is time that we reversed privatization. I look forward to Thatcher’s funeral, when Arthur Scargill delivers the eulogy 😉
The popularity of Downton Abbey seems to be a symptom of the profoundly conservative times in which we live. It represents the desire and false nostalgia for a more “governable” and hierarchical social order where everyone knows his place and the rulers are decent, well-meaning and generally keen and responsible in their judgments.
I’m hoping that in the final episode some Bolshevik bombs the place.
I know the Keystone XL pipeline is in the news these days, and enraging people, but the history of oil development in Alberta is a fascinating story and sort of an example of the thinking that Scott is talking about. Apparently, when oil was discovered in Leduc in 1949, the Social Credit Premier of the province, Manning, agreed to allow the out of province and foreign oil companies to come in, but on three conditions. Manning felt deeply that the oil under the ground, in fact all resources, were the property of the people of the province. But he was also recognized that the province needed industry after WWII. I don’t know why we don’t have some of his conservation thinking here.
1. You have to build all roads in and out of the sites you’re operating on according to Department of Transportation specifications, and you have to maintain them for the duration of your operation.
2. You have to pay the province (the people of Alberta) a royalty of 10%. This is above and beyond tax on profits or sales. This was a statement that the oil companies were paying a royalty to the real owners of the resource.
3. You must return the land to the same or better condition in which you found it. This Manning put into law. They’re called the Land Reclamation Laws, get updated every few years, and Alberta was the only province to have them in Canada in the 20th C. In the US, only the mining industries in a few states like CO and WY (I think) are constrained by similar laws, but they have nothin’ on Alberta, which keeps making them stronger and stronger. I know we see hideous pictures of gaping tailings ponds, esp. when they are offered up by environmental groups, but they never show you the end result, which is quite remarkable and beautiful…and invariably way better than they found it. To wit: The oil companies have to remove all flora and top soil and save it for the decades it will take to return the land to its original condition. They have to hire botanists and biologists to protect the storage throughout that time. They have to get their plans approved by the province before they can begin. They have to stay on after the mining or extraction process is complete (sometimes 30 years) for up to 10 years more to make sure the reclamation process is going as they certified it would. If they don’t do this, they don’t get the provincial reclamation certification and the company will be fined multi-millions, can never work in the province again, and someone’s going to jail. This applies to all resources in the province from coal to uranium, and even to the gas company drilling a hole in your backyard. It also includes strip mining. You have to recreate the mountain with trees. Alberta is one of the most pristinely clean places I’ve ever been in.
We have absolutely nothing similar in the USA because we don’t recognize that the land was here before all of us, and its resources belong to the people. The only thing protecting Americans is the 1934 law that says the people own the airwaves; apart from that, nothing. If you’re rich enough here you can buy up all the good property and you automatically own what’s underneath it. You don’t have to pay a royalty to the state, meaning the state, not the federal government. So there’s no sense of common stewardship.
Henry George believed to the “iron law” of wages and capital. And he was not so far off after all. Land tax is really a no brainer economically, but very difficult politically. When a man becomes mortgage holder, he wants to tax everything else but the monopoly privilege.
If you really want to see a world in which jobs chase after people which basically means that incomes increase and the middle class grows to the point of total saturation then visit the link above and learn the lessons of Geonomy.
The last time that happened was when the Black Death ravaged Europe, caused a labor shortage and spelled the end of feudalism.
Great article Matthew You write very well and I look forward to reading more in the future.
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There is a clear change around 1995. Households stopped getting wealthier. Picture is similar to Britain (already in the 80’s.) file:///c:/Users/risberg/Documents/Taloustiede/3spoken%20%20UK%20Sectoral%20Balances%20and%20Private%20Debt%20Levels%20-%20Q3%202012.html
Yes, the wealthy top 1% have benefited from most of the gains in productivity, usually by financial manipulation. The real unemployment rate in the US is around 18% of the workforce. 143 million people have jobs out of a total population of 314 million.
This deprives the consumer economies, especially as the cost of living increases, while wages remain stagnant. Add to that offshoring of jobs to cheap labor countries, plus increased efficiencies due to automated industrial production and computerization of administrative functions results in job losses. This means government tax revenues then fall with consequent government employee lay offs and even less money spent into the economy.
It is this concentration of wealth which caused the Great Depression of the nineteen thirties. The current situation is quite similar.
Previous link points to my hard disk lol.
Matthew Berg gives a fresh look at some of the regular issues of MMT. Obviously stirred up a lot of interest, from a wide spectrum of views. His name is unfamiliar to me and I couldn’t learn about on the Web (Too many Matthew Bergs!). Could anyone, including himself, tell me about Matthew Berg? Thanks.
He’s an economic grad student at UMKC.
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