Friday, February 14, 2014

A simple model of monetary stimulus

When the Federal Reserve decides that it wants to increase the amount of currency in circulation, in order to stimulate the economy, its method of accomplishing this is to buy securities from its “primary dealer” banks (normally US Treasury bonds, and recently MBS or mortgage-backed securities). This has the effect of increasing the cash reserves of those banks, who are expected to then lend it out into the economy. In short, whenever new currency is created, it is first used to purchase assets from a private bank, which will then, it is hoped, lend it out into the economy for productive purposes.

This method of economic stimulus, however, has the paradoxical and quite harmful effect of concentrating wealth in the financial sector while depriving the real economy (i.e. the people and businesses that actually make things) of income. The simple reason for this is that all loans made by a bank must be repaid with interest. To the extent that a loan is not entirely repaid, there will generally be a forfeiture of property to the bank to cover their financial losses. In spite of the occasional bad loan, the net effect of adding currency to the economy through interest-bearing loans is to transfer financial assets from real-economy actors to financial-sector actors. A simple model will make plain why this is the case.

Imagine that we have an economy composed of three sectors: the productive sector (real economy), the financial sector (banks), and the government sector. We can imagine the productive sector as itself composed of households and businesses, with currency circulating continually between the two: households buy goods and services from businesses who, in turn, pay wages back to households.

Now, let us suppose that the productive sector of the economy has a monthly GDP of $1000. This means that every month, businesses pay households $1000 in wages which households then spend at businesses, providing the businesses with the revenue to pay out in wages at the beginning of the next monthly cycle. For simplicity, we assume that households spend all of their income every month and that businesses use all revenue for wages. Essentially, in our model businesses and households are simply passing $1000 back and forth between themselves.

Now let's suppose that the population of our economy grows and additional households are created. In the absence of any action from the government (which is the only sector that can add additional currency to the productive sector), the income per household in the productive sector must necessarily decline. If we previously had 10 households receiving $100 a piece per month, and now we have 11 households, each household will now only receive $90.90 per month. If the government desires to maintain wage levels at $100 per month, it will need to add an additional $100 to the amount of currency currently circulating in the productive sector.

In order to do this, the government gives $100 to the financial sector to lend into the economy. Assuming the bank lends the entire amount into the economy, in the month that the government increases the amount of currency, the GDP of the economy will increase by $100 to $1100 (as households borrow and spend the $100 into circulation), providing enough currency for each household to once again receive $100 per month. However, his return to normalcy is short-lived.

Assuming that all loans get repaid, with interest at the beginning of the next monthly cycle, during the next month the GDP of our little economy will have to decrease by $110 (assuming 10% monthly interest, for ease of calculation), in order to repay the $100 principal plus $10 in interest. This means that at the start of the following cycle, the amount of currency will be once again too low to allow incomes to remain at $100 per month. Only now, the situation will be worse than before the government's “monetary stimulus,” since the economy's real GDP will have gone from $1000 to $1100 to $990, giving an average household salary of $90—90 cents less than before the currency increase.  The apparent surge in economic activity and household prosperity is followed quickly by decline for households and businesses alike.

Now, the only way for the household sector to maintain it's level of income and consumption is to once again borrow from the financial sector. Only now, instead of borrowing $100, households must borrow $110 in total from the financial sector to maintain their income levels (which, remember, are determined by levels of spending; businesses can't pay wages to households until households first buy from them). This, of course, only further worsens the problem as $121 must now be repaid to the financial sector at the beginning of the following cycle, leaving only enough money left in the real economy to provide households with a $79.90 monthly average salary.

It should be easy enough to understand why it is that an economic stimulus program that depends on private banks lending new currency into the real economy at interest is a self-defeating and perverse policy choice (unless, of course, one happens to work in the financial sector). The only way to add wealth to the household sector through lending would be to offer the loans at a negative interest rate: that is, loan $100 and only require $90 back. In the above example the government would give the financial sector $1000 to loan into the economy at a negative 10% interest rate, leaving an extra $100 in the economy after the loans had been repaid.

If the goal of monetary stimulus is to increase the average household wage, negative interest loans make far more sense than positive interest loans. Positive interest loans, in fact, make no sense at all.

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