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Friday, July 29, 2016

Overdrafts, Bank Lines, And Negative Money

This article touches on some of the issues with bank lending in its less well known forms: overdrafts, and credit lines. I just wanted to respond to some questions as well as some articles by Nick Rowe.

(As an aside, I believe that the British English spelling would be overdraught. In this case, the Canadian English spelling matches the American -- overdraft. One of the joys of being Canadian is that you can convince people on both sides of the Atlantic that you cannot spell, even when you are correct by domestic standards...)

What Is An Overdraft?

A person or a business overdraws their bank account if they somehow withdraw more money than they had in the account in the first place. For the depositor, it looks like they have a negative bank account balance. (My quick scan of the topic suggests that the customer would either set off this negative balance versus positive balances, or else treat it as a liability. Note that nothing in this article constitutes accounting advice, yadda, yadda, yadda.) This would normally be prohibited, but it could happen as a result of unusual events.

The exception is the case when the customer negotiates an overdraft with the bank (before the event of the negative balance).
  • In North America, the only time you tend to see this is when customers get overdraft protection; they can overdraw up to a certain limit. These negative balances typically incur a penalty interest rate, but the rate will be cheaper than the penalty for a cheque (see what I said about Canadian spelling) bouncing due to non-sufficient funds.
  • In the United Kingdom, I believe that it is (or at least it was) an accepted practice for overdrafts to be used instead of bank loans. The amount of the overdraft was set in advance, but the expectation is that the overdraft would be drawn upon, and so the interest rate was a "normal" rate of interest for that business.
The interesting part is that the deposit balance can flip sign.

Credit Lines

Credit lines appear very similar, but they are more obviously loans. They are a separate account, and if you draw upon them, you generally need to transfer the balance out of the credit line account to your regular account. (It might be possible to write cheques against the credit line, but I believe the fees would be much higher than for a regular account.)

Since they are in a separate account, the balance will generally always be positive, and so there is no problem with accounting for drawn credit lines as loans.

What is interesting about credit lines is when they are undrawn. They effectively are an option by the bank customer to draw on bank liquidity, up to a certain amount. Therefore, although they do not show up on the balance sheet, they are effectively a contingent liability. (Although an asset is created when they are drawn upon, the need to supply liquidity upon demand is not to the bank's advantage.) This means that the accounting for credit lines is simple (they are at most of an off balance sheet memo item), their regulatory impact is much less simple. The liquidity issues that they pose are not easily modelled in mainstream economics and finance, which assume an infinite capacity to finance positions.

I am not an expert on the subject, but regulators watch bank's credit lines, as they are one of the means by which a bank can blow itself up.

These liquidity options are not just of theoretical interest; they are what allows the non-bank financial system to function. Commercial paper (and securities dealing) only works if the issuers have backup credit lines at banks.

Why do issuers need lines from banks, and not from other institutions? Because banks can call on the lender-of-last-resort, the central bank. Hyman Minsky explained in Chapter 3 of Stabilizing an Unstable Economy how Manufacturers Hanover Trust -- a large New York Bank -- refrained from normally lending to bond dealers, but would step in only during an emergency. It was a credible backstop, as "It was understood that if Manufacturers Hanover ran a reserves deficiency because it financed bond dealers, Manufacturers Hanover would have access to the discount window of the Federal Reserve." (page 82).

Therefore, even if the financing is supplied by the non-bank financial system, the formal banking system is still required to backstop its liquidity needs. 

Accounting For Overdrafts (For Banks)

I have not validated this against the accounting literature, but I believe that under Generally Accepted Accounting Principles, an overdrawn bank account would be treated as a receivable or loan asset. (I did not see a line item for overdrafts in the U.S. Flow of Funds, in any event.) However, the issue here is not how accountants deal with overdrafts, but rather within economic models.

In principle, we could treat the overdrawn account as being a negative deposit. This negative deposit would cancel out a positive deposit somewhere, and the net effect would be to reduce the "money supply." It should be noted that this would work if we just recast existing accounting statements to the new convention.

However, it does not work from a behavioural perspective, and so we cannot this in realistic economic models.
  • From the perspective of a bank, an overdraft cannot be immediately called, while a deposit can walk out the door at any time. In a system with bank reserves, or liquidity requirements, the bank needs to hold liquid assets/bank reserves against the positive balances, and gets no relief for the negative deposit balances. Therefore, if we tried to cancel out the negative balances, bank reserve calculations within the model would appear incorrect.
  • We cannot view transactions as being a transfer of a negative deposit balance. (For example, a seller giving the buyer a good plus a negative deposit balance.) We can transfer claims on a third party that are in the form of a negotiable instrument, but we cannot transfer claims against ourselves. If we wanted to transfer a debt we owe to a third party, we need to get the permission of the lender, as the third party might be a greater credit risk than we are.
It should be noted that we do not have the right to transfer all debts owed to us to others, only negotiable instruments. A corporation that is required to share proprietary financial information to its bank will not allow that bank to transfer that loan (along with its covenants that give it access to information) to a commercial rival.

Red/Green Money

Nick Rowe suggested that overdrafts (and other loans) could be a form of negative money; normal (positive) money is "green," and negative money is "red."

He discusses this idea in two articles:
  1. Negative money
  2. Money demand and supply in a red/green world.
His framework will function -- in the world of a (neo-) classical economic model.

The key to those models is that entities do not default. (If the private sector in your model consists of only one representative household, who exactly is that household going to default to?) As he notes, in his framework, future generations have to inherit the debt ("red money") of their parents. However, this mechanism does not cover corporate defaults nor what happens when those without heirs pass on.

In the absence of default risk, my second objection to treating overdrafts as negative money disappears; the only remaining objection revolves around reserve requirements (which are typically not imposed in models).

Of course, in the real world, people and corporations default all the time. Thus any model that captures that reality cannot rely on "negative money." (Admittedly, defaults are complex to model, and do not appear in most post-Keynesian macro models.)

Nick Rowe wrote (in "Negative Money"):
And then some New Keynesian macroeconomists said that money didn't exist in the new combined world. They said there was no "cash", only "credit".
One may note an interesting symmetry here. I am attempting to abolish money from economic models (replacing it with credit), while Nick Rowe is attempting to abolish credit and replace it with money.

(c) Brian Romanchuk 2016

32 comments:

  1. Brian: (As an originally British Canadian, who reads a lot of US economics, I'm very confused on the spelling!)

    IIRC, my father (a UK farmer) nearly always ran an overdraft (overdraught?) in his chequing account. That was his only bank liability (except for the mortgage to buy the land). He would pay it down to roughly zero, once a year, just to prove to the bank manager that he could. In other words, my father nearly always used red money to buy things with (except for a little bit of green currency).

    "One may note an interesting symmetry here. I am attempting to abolish money from economic models (replacing it with credit), while Nick Rowe is attempting to abolish credit and replace it with money."

    Yep. Except: I want to make a distinction between IOU's that can be used as a medium of exchange ("money"); and those that can't be used as a medium of exchange ("bonds" and "loans"). Not all liabilities are red money.

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    1. With regards to your father's experience, that was the way UK banking was explained to me in some book I read years ago. (I lived in the UK, but as a control systems grad student, I tended not to enquire about the local banking customs.)

      You would need to distinguish liabilities that are transferrable; but I do not how overdrafts can be transferred; they are still on the balance sheet of the bank.

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    2. Suppose my father sells hay to another farmer, who also has an overdraft (at the same bank). The bank takes some red notes out of my father's box at the bank, and puts them in the other farmer's box.

      (I would need to think about the case where they have different banks. But we can imagine a case where both those commercial banks also have overdrafts in their chequing accounts at the central bank, in which case the central bank transfers its own red notes from my father's bank's box to the other bank's box. It's just like the standard textbook green money case, except the notes are red, and flow in the opposite direction.

      (You could say that velocity is negative in the red world, because the notes circulate in the opposite direction to green notes ;-) )

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    3. I agree that you can interpret the existing behaviour with red/green money; it could be viewed as a change of accounting convention. As a similar example, we could translate all Canadian dollar transactions into the equivalent amounts in Australian dollars, and the accounting would add up. However, Canadians do not generally set prices in Australian dollar terms, and so trying to get a model using Australian dollars to work would be hard to do.

      A behavioural difference is that banks limit overdrafts (red money) to customers. Transactions will be refused if your counterparty's red money hits a limit (which also has to be periodically renegotiated), while a bank customer knows that they can always spend Green money (until the limit of 0 is hit), and their is no dependence upon the credit capacity of other entities.

      Although both cases have limits on how much you can spend, the amount of uncertainty involved in the limits for "red money" means that it is much less useful in dealing with economic uncertainty (which is one standard argument for holding "money").

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  2. Interesting post, Brian. Some thoughts.

    It is useful to recognise that credit lines and unutilised overdraft limits can be committed or uncommitted, depending on whether the bank has the right to cancel the line at any time. Undrawn, uncommitted lines might seem like a nothing, but they are important in practice, because of the inertia involved in establishing or withdrawing a line. Money market liquidity can depend extensively on uncommitted lines, but it can quickly disappear, as for example in the inter-bank market in the crisis.

    For statutory accounting, I believe undrawn, committed facilities are not recorded on balance sheet but are listed with contingent liabilities in the notes to the accounts. For economists, it's probably sufficient to think of them as equivalent to having both a deposit and a loan. If the line (including the overdraft limit) is drawn upon, then this simply represents a depletion of the deposit. Whether or not uncommitted lines should be reflected in models depends on what is trying to be achieved, but on the whole I'd say not.

    Nick Rowe's stuff is entertaining and informative as thought experiment, but I'm not sure that it translates usefully to economic models. I think I share your feelings about money in models. In my view, what is important is the existence of monetary assets, not money specifically. Often, identifying which particular assets function as money adds nothing useful. Even if we are concerned with looking at liquidity, we have to recognise that liquidity can arise across a range of assets. The fact that monetary exchange matters does not mean that there exists a particular category of monetary asset - money - that plays a unique role.

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    1. Thanks.

      Although I like to point out that shadow banks can act like banks, that is with regards to financing and taking credit risk. Credit lines are the secret sauce that allows the shadow banking system to function, even if it just appears as a bunch of contingent liabilities on financial statements (and invisible to the Flow of Funds).

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    2. Yes, but (depending on what we mean by shadow banking), the liquidity generated there is very different. So, for example, a typical ABCP conduit is going to need a backstop liquidity facility. That kind of facility is going to come from a bank, rather than another shadow banking entity. Not because a shadow bank cannot provide it but because it's not efficient for it to do so. Banks are able to write liquidity facilities partly because they hold a chunk of high quality liquid assets, but also critically because they engage in a kind of mutual liquidity insurance by having lines with all the other big money market players (as well as the access to lender of last resort, as you mentioned). It's the business they are in. By their very nature, shadow banks have a very limited number of lines.

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    3. As an aside, I believe that you are UK-based. Where do you stand on the overdraught vs. overdraft question?

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    4. Actually, I think it's overdraft here.

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    5. I seem to remember that American spelling was making inroads, particularly for words with technical meanings. I seem to recall engineers using "analog" circuitry instead of "analogue" when I was in England, but people would still use "analogue" for its other meanings. (Certainly true for Canada; I never saw "analogue circuits," but a few holdouts would still use "analogue" elsewhere.)

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  3. Does the economist want to be paid positive money to speculate about the economic significance of negative money? If so he is an oxymoron.

    This short article discusses negative balances and contra-accounts in the chart of accounts:

    http://www.accountingtools.com/questions-and-answers/what-is-a-negative-balance.html

    The negative balance or contra-account is just a means to convey information to accountants and managers. When payment clears the payee gets positive money and when the books close the bank has a receivable and the debtor has a payable. In the long run the accounting, economic, and legal implications of overdrafts are based on positive balance accounting logic.

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  4. Applying the logic of Hyman Minsky overdrafts and credit lines are contingent liabilities of banks and position-making instruments of units that can draw such credit from a bank, central bank, or other financial service provider. The concepts of credit generation from thin air and positive money balances as a residual of credit activity are in my judgment more than sufficient to recognize, study, and describe the social customs that we attempt to understand as "economic models."

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  5. My familiarity with banks is based on my perceptions as a resident of the western United States. Agriculture is king in our area. From a banking standpoint, the problem is how to finance farms which buy inputs from outside the area (fertilizer, machines and parts, sprays, and taxes for examples). Obviously real money leaves the local region. None of this red stuff; red stuff will not pay the bills.

    The problem for the banks and for those in agriculture is getting money back into the local area. A one way flow out, even for vital inputs, is unsustainable for more than a season. Red money just becomes a trap, to be sprung on the unwary. Only the existence of positive money will work to pay rent, taxes, next years fertilizer bills, and food for the farmers themselves.

    I think the best way to think of agricultural lending is to consider that the bank is buying part of the potential harvest. The bank always takes first position, meaning that when the crop is sold, the bank loan is paid first. The bank becomes a senior partner to the farmer. Of course, it is the same for car loans or residential loans. The ownership position of the borrower is somewhat of a sham, the bank is the real owner if times get hard (until the loan is repaid).

    You will not be surprised when I say that the overdraft/overdraught question is mute for me. Overdrafts are just a way to accommodate careless customers, and the customers pay a premium for the privilege to overdraw.

    Along this same line, I have a new post "When Central Banks Buy Equities". I think it very clear that a mechanical interpretation of money flows demands that positive money must be used.

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  6. From Joe’s link:

    http://www.accountingtools.com/questions-and-answers/what-is-a-negative-balance.html

    “At a more specific level, the negative balance term commonly refers to the checking account, where you have a negative balance if you have issued checks for a larger amount of cash than is available in the checking account. In this situation, create a journal entry to shift the amount of the overdrawn checks into the accounts payable or a similar current liability account; doing so reduces the balance in the checking account to zero, and properly displays the overdrawn amount as a current liability.”

    I would need JKH to verify, but I agree with Joe. The checking account balance either does not go negative or very quickly goes negative and then turns into a bond/loan at the bank (asset of the bank, liability of the “overdraft” user).

    “When payment clears the payee gets positive money and when the books close the bank has a receivable and the debtor has a payable. In the long run the accounting, economic, and legal implications of overdrafts are based on positive balance accounting logic.”

    It is about positive (green) money and positive (green) bonds/loans. An overdraft is just another type of loan. There is no negative (red) money.

    “Suppose my father sells hay to another farmer, who also has an overdraft (at the same bank). The bank takes some red notes out of my father's box at the bank, and puts them in the other farmer's box.”

    Let’s say both are allowed a $2,000 “overdraft”. They both use $1,000 of it. They both owe the bank $1,000 (bonds/loans). Next, nick’s father sells $500 of hay to the other farmer. The other farmer now owes the bank $1,500. $500 of demand deposits (positive, green money) goes into the checking account of nick’s father. It is used to pay back part of the “overdraft”. He now owes the bank $500.

    Checking accounts only contain demand deposits (positive, green money). Checking accounts do not contain negative (red) money. No other account at the bank contains negative (red) money either.

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  7. Hi Brian, I think you would find this interesting considering your on-going project:
    http://www.perrymehrling.com/2016/08/financialization-and-its-discontents/

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    1. Thanks. It looks like it is in line with my arguments.

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  8. I tried to post a comment.

    It is not here. What happened?

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    1. Hi,

      Well, assuming that you are the same "anonymous", it was caught by the spam filter. The spam filter doesn't like long anonymous posts. Thanks for highlighting that, I get very little non-spam comments caught by the spam filter, so I rarely check it.

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    2. And as I forgot to note, it is now published above...

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    3. I see it now. That is fine.

      Can we say there is no negative money (red money) in the real world now?

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    4. You have convinced me; not sure about Nick Rowe...

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    5. That is good I convinced you. Nick, I doubt it.

      Do you know anyone in accounting at a big commercial bank who would be willing to verify?

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  9. Brian and Anonymous: Doesn't the existence of "negative money" depend purely on the accounting convention? What I mean is that we can always present a "traditional loan" (ie. a bank credits customer's "deposit account" and debits his "loan account") in an overdraft form, and vice versa. The form/accounting convention changes, but substance remains the same. Overdraft just gives us the net balance of "loan account" and "deposit account". I actually dare to posit that overdraft is a "traditional loan" which has met Occam's razor (this meeting took place in 18th century Scotland, I think).

    The big question is: What is the *substance* I referred to above?

    I just left Nick Rowe the following comment:

    ------------------------------------------------
    I've been working two years on a theory which seems to clear all the confusion around the red/green world you guys seemed to be experiencing (or did everything become clear already?). I would be happy to elaborate, explain my theory/model step by step, but first you have to promise me one thing: You must be ready to entertain the possibility that no "medium of exchange" (money) exists in the way we are used to think about it. Based on some comments you've made, I reckon you find this hard to accept?

    The "medium of exchange" is the ledger, the accounts -- not any*thing* on the accounts. The buyer doesn't transfer anything to the seller, and the seller transfers only goods to the buyer -- no "red money". The only thing that happens in the "monetary realm" is that the buyer's account gets debited and the seller's account gets credited. In our minds we need to build an impassable wall between the two accounts; nothing moves between them. This bookkeeping, of course, serves a real purpose, which is not to track "money holdings" (there isn't any) but to track goods given (sold) and goods taken (bought). You could think of it as a "gift economy" with an explicit tracking of the gifts (there's a connection here to Kocherlakota's "Money as Memory" and Ostroy's paper which Kocherlakota builds on). No bilateral balance in trade required -- just multilateral (ie. I can buy from you and sell to Peter, and you won't be able to claim anything from anyone, but that won't make you unhappy as you can, in turn, buy from anyone and thus get rid of your credit balance).

    This solution works, but to see that it works you might have to turn your world upside down. That's not easy -- at least it wasn't for me. Let me know if anything here resonates? (I apologize for being so mysterious. Just trying to build some drama around this, I guess.)
    --------------------------------------

    I'm more than happy to clarify any claims I make above!

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    1. Sure, the accounting depends on the convention. The issue with treating a negative balance as negative money revolves around default risk. Normally, we assume that money is default risk free, and so the symmetry between positive and negative balances is broken.

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    2. Well, I don't want to go there. All I wanted to point out was that Anonymous can't make the negative balance disappear.

      I think Nick Rowe is confusing things with his red/negative money. Just like you, I'm trying to abolish money from economics, and also from the real world. I mean really abolish, Copperfield style -- there is no "medium of exchange" and "means of payment" as we knew it. It's an illusion (OK, perhaps I'm the opposite of Copperfield then...). A strong one, of course. Made even stronger by the stories on how commodity money evolved into fiat money. The thing is that if you choose to call one of them 'money' you should never call the other 'money'.

      Any thoughts on my comment to Nick?

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  10. I would like to clarify this text behind Joe's link (which Anonymous quoted above):

    “At a more specific level, the negative balance term commonly refers to the checking account, where you have a negative balance if you have issued checks for a larger amount of cash than is available in the checking account. In this situation, create a journal entry to shift the amount of the overdrawn checks into the accounts payable or a similar current liability account; doing so reduces the balance in the checking account to zero, and properly displays the overdrawn amount as a current liability.”

    We need to keep in mind that these are instructions to the accountant of the *bank customer* (a firm). As far as I know, we are trying to adopt the view of the bank's own accountant here. These are two different ledgers. I suppose that the bank has no problem with having a debit balance -- instead of the usual credit balance -- on a customer's checking account (under overdraft agreement). Even if I'm wrong, it's only a question of accounting convention, and thus not really relevant :) (In case you wonder: I'm an accountant.)

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    1. With regards to your comment, it looks like money is a form of credit. That is roughly what the post-Keynesian position is. I would have to see more details to see what is different.

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    2. Yes, I would definitely place my theory in a broadly understood "credit theory" group. Where I differ from the post-Keynesian position:

      - Money is not an "IOU" (of a 3rd party). There is no "I" to point at; it's not an enforceable claim (as we know, the central bank doesn't owe a noteholder anything). It is "We owe you", 'we' being the society.

      - This makes "money" a public record which tells that the holder of it is entitled to take (buy) a good from someone without giving (selling) anything in return. This is all based on a social custom. If you sell something and your account is credited, this record means you didn't get *anything* in return for your goods; ie. you didn't get paid.

      - From this viewpoint, banks need to be seen as bookkeepers who are themselves not owed anything -- neither do they owe anything. They are the "scribes" of our society. (I believe Schumpeter would have, at times, agreed with this.)

      You might think that there is not really anything new in this? For me the new thing here is that by looking at world through this lense, we get rid of money (economics is saved from further embarrassment related to money). A credit balance in a bank's ledger just doesn't have the properties we attached to it when we described it as transferable "money".

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    3. When governments redenominate their currency, old currency notes create an enforceable claim on new notes. Currently, governments must accept their currency to pay taxes. Banks are forced to exchange deposits for currency. The various "basic" monetary instruments have the right to be exchanged for another, and they are associated with different issuers (banks, gov't).

      I am not the person to ask what is "new." A lot of different economic theories to me seem to be functionally similar. What you are describing sounds similar to the "money is credit" theories, but I could not say much more than that at this point. You are aware of the various MMT Chartalist writings?

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    4. Yes, I'm aware of Chartalist writings. Very much so. There is a lot of functional similarity between chartalist theories and my theory. At times I feel Alfred Mitchell-Innes described my model in his two articles. But in the end, not just seems my model to be clearer and simpler than chartalists'/MMT's, but I seem to manage to establish a stronger connection between the "real economy" and "monetary economy". So much so, that I sometimes wonder if I'm, after all, neoclassical :) That cannot be, but all this would speak for some kind of synthesis.

      I've been also pointed to Quantum Economics for a couple of times. This connection probably has to do with money not really existing as a medium of exchange. Frederick Soddy has also put many things in the same way as I do. But so has Schumpeter, too.

      What you say about old/new currency and various monetary instruments is for me something that happens inside the accounting system. I explain it as changes in that system. The payment of taxes with "government currency", the basic Chartalist story, I put in different terms. The idea is pretty much the same, but the link to the "real economy" becomes clearer when we consider the "tax payment" to be only an operation where the accounts are updated; taxes are paid by giving up goods without getting a permission to take goods for the same amount and be able call yourself even with the rest of the society.

      I'm not sure if you get much out of this kind of description? I'm working on a model, in the form of a story about a closed economy of ~30 individuals (I haven't so far found mathematics helpful in any way; only accounting), which should help me communicate the theory in a very concrete way. It's quite advanced already. Should you find this interesting, just let me know? I'm aiming to publish the story before the year end.

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    5. At the moment, I am not sure I could look through it; I have a lot on my plate.

      The MMT description of the accounting is correct; if all you are doing is changing the interpretation, I am unsure what the advantage is. You need to focus on what you can predict with your version, and why other descriptions cannot do the same thing.

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    6. No worries, Brian!

      Prediction and economics don't go well together? :) To me, at this stage, it's more about the elegance and simplicity of the theory. MMT might get the accounting correct, but the interpretation is everything: what are we really recording? For instance, a credit entry in the ledger of a central bank is not a government/CB "IOU". And no accounting entry can constitute a payment. When we make accounting entries, we are recording something. If we are recording a payment, then we have to show where and how that payment took place; the entry itself cannot be that payment.

      The advantage comes from being able to describe the economic phenomena in a parsimonius way, without leaving anything of relevance out. MMT, like other prevailing theories, adds an imaginative layer on top of the accounting, by seeing IOUs on accounts and payments being made purely by accounting entries. I don't. Hence, my model is much simpler once you get a good hold of it.

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