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Wednesday, September 19, 2018

Book Excerpt: Financial Assets Matter, Not Money

If we abolish money from economic theory, what replaces it? The answer is: financial assets. Although this might be viewed as a superficial change, there are important implications. In particular, the central bank can manipulate the amount outstanding of some types of financial assets, but it cannot control all of them. We end up with a more realistic view of central bank power. They no longer control “money” and hence all commerce, rather they are reduced to worrying about setting interest rates.

(This is an excerpt from my book Abolish Money (From Economics)! (affiliate link), which I do not think has been previously published. In case it is not obvious, I have been tied up up with non-writing tasks in recent months. Luckily, there is a light at the end of the tunnel of distractions.)

The Role of Financial Assets in Economic Models

A properly defined macroeconomic model consists of three things:

  1. the sectors of the economy that define the model,
  2. the accounting relationships amongst those sectors, and
  3. the behavioural rules the sectors follow.

There is no doubt that the behavioural rules are important, as they define the operating characteristics of a model. However, we also need to make sure we properly track the accounting relationships between the sectors.

One somewhat silly example I used on my website illustrates the importance of accounting (link). I took a standard extremely simple stock flow consistent (SFC) model, and then modified the behaviour of the business sector. (Stock flow consistent models are a standard form of models used by post-Keynesians.)

In the standard version of the model, the business sector had a 0% profit margin; it hired enough workers so that the wage bill equalled the business sector revenue. I modified this behaviour to the following: the business sector always ensured that it had a 10% profit margin.

Although it sounds like an innocuous change, the model behaviour was greatly modified. Since I had not specified what the business sector was doing with its profits, it ended up accumulating an increasing stock of financial assets. In turn, this forced the government to run perpetual deficits, as it was the sole supplier of financial assets. (In the base case model, the government moved towards a balanced budget, as the stock of financial assets converged to a fixed amount.)

The model was unrealistic, but it illustrated a key point: we need to look at the entire macroeconomic system, and the linkages between sectors, in order to predict the effect of behavioural changes. There is a widespread belief that the government determines the level of the fiscal deficit. However, In this case, the perpetual deficits were the result of a change in business sector behaviour.

Financial Assets as the Glue in Models

Mainstream economic theorists want to focus on real variables: the number of widgets produced, the number of people working, etc. Financial assets are just supposed to be a “veil” over the underlying real transactions. This belief is an underlying reason why mainstream models are uniformly terrible in describing the real world.

More realistic models account for the fact that the world is uncertain; we do not know exactly how much we will earn or spend over the coming year. When outcomes deviate from plans, we need to use financial assets to buffer the uncertainty. For example, if we spend more than we expected during the month, we either have to run down our financial assets (or borrow, which is issuing a financial asset to the lender).

Within a model, the change in financial assets for a sector is equal to the sum of all of the transactions that sector has with the other sectors. Meanwhile, the breakdown of which financial assets are held depends on the model’s assumptions for portfolio weighting behaviour. For example, the household sector might allocate between zero-interest cash and interest-bearing bonds and bills based on the (real) interest rate.

Historically, economists said that money acted as the buffer stock for uncertainty. However, that is not true, other than for very short time horizons (which we cannot hope to model). Households, firms, and governments do not just adjust their money holdings in response to surprises; they adjust their entire balance sheet of financial assets and liabilities. Although the instruments in the various measures of the money supply are convenient for settlement, the big movements in balance sheets may be in long-term financial assets.

The following essay, “Money in SFC Models,” gives a more detailed analysis. (That essay was published in draft form here.)

Concluding Remarks

Replacing “money” with “financial assets” may appear innocuous, but it delivers us from the delusion that central banks have arbitrary power to steer the economy.

(c) Brian Romanchuk 2017-2018


  1. Brian, I have a question on your 'silly example'. It's not so much a counterpoint as a request to translate my naive view into MMT terms. In that naive view I see the business as exchanging it's goods/services for the future right to receive goods/services from those it has sold to. Some of these rights are passed on to it's employees, the rest retained as profit. If they decide to buy government assets this is just a temporary transfer of the rights to goods/services. The government may decide to not to take them all, so they would just be retained by the business.

    How should interpret this under your model?

    1. I'm somewhat tied up, so I've got to respond quickly. Not sure I follow.

      The linked article explains the logic; the issue in the example is that it's not what the government wants to do, rather it is just how markets clear. The only way for supply and demand to be balanced (in a highly simplified model!) with the business sector saving is that the government has to run a deficit. This is possible because spending is fixed, and taxes depend on private sector income; income shrinks enough to lower taxes to create a large enough deficit to balance supply/demand.

  2. This is the bit I struggle with:

    “The financial assets being hoarded by the business sector have to come from somewhere; and that somewhere is the government.”

    The business sector already has an asset, the effective IOU from people it has traded with. A call on goods/services from the in the future.

    Buying financial assets isn’t gaining an asset it is a swap of assets as the government then holds and uses those IOUs.

    I don’t get why this swap must take place, why must the government take the hoards of IOUs? What is the imperative?

    1. In the model, there are no IOUs issued by the household sector - it is using government money to pay.

      The business sector could hoard IOUs issued by the household sector, but we then have to model private debt sustainability.

  3. This comment has been removed by a blog administrator.

  4. Sorry, I should have been more clear. The IOUs aren’t issued as such. They are my characterization of what the government money represents, what it betokens.


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