(1) Bank Reserves — A Definition

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Working toward a better understanding of bank reserves, here is a general definition:

As eloquently stated by Clews, Salmon and Weeken (2010), ‘reserves are overnight balances that banks hold in an account at the central bank. As such, they are a claim on the central bank. Together with banknotes, reserves are the most liquid, risk-free asset in the economy. And they are the ultimate asset for settling payments; banking transactions between customers of different banks are either directly or indirectly settled through transfers between reserves accounts at the central bank’. As discussed above reserves can be thought of a[s] current account balances held by commercial banks at the central bank in the same way that individuals hold such accounts at commercial banks.

The source.

Versäumnisse der ökonomischen Theorie und das System der Bankreserven

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Aus einem privaten Schreiben:

[...]

Es ist eine gute Idee, MMT in einer Präsentation darzustellen. Das hilft/zwingt, den großen Überblick zu finden, an dem man sich dann beim Schreiben eines Buchs orientieren kann. 

Das letzte verbleibende große Mysterium sind die Bankreserven. Es ist schon auffällig, wie schwierig es ist, eine genaue, vollständige und richtige Darstellung der Art wie Bankreserven funktionieren, zu finden. Es kursieren auch viele falsche Darstellungen, besonders aus den Federn der etablierten Ökonomen. 

Wenn du Zeit finden solltest, könntest du, entweder dieses Thema recherchieren oder Quaesivi durchsuchen nach den Posts, die ich bereits zum Thema MMT geschrieben habe, um aus ihnen vielleicht eine Struktur zu entwickeln für die Präsentation/das Buch.

Was ich an MMT gut finde, ist, dass es uns nicht zur Dogmatik verlockt/zwingt. MMT bemüht sich um Objektivität, indem die Anhänger dieser Theorie die prozessuale Wirklichkeit des Zentralbankwesens rekonstruieren. Aus den Ergebnissen dieser Forschung ergibt sich, dass die konventionelle Geldtheorie eine Wirklichkeit beschreibt, die es nicht gibt. Auf diese Weise gestaltet sich MMT zu einem alternativen Ansatz, der allein schon deshalb einen Wert hat, weil er uns dabei hilft, die herkömmliche Ökonomie zu hinterfragen: wie ich hier geschrieben habe: 

http://quaesivi.blogspot.com/2018/09/1-studying-modern-monetary-theory-mmt.html 

Die herkömmliche Ökonomie versagt (ist unvollständig und widersprüchlich), weil ihr Ideal einer sich selbst regelnden Gleichgewichtsökonomie (ohne Wirtschaftskrisen und Arbeitslosigkeit) zerschossen wird, wenn man ihr Bild der Wirtschaft ernsthaft mit dem "Störenfried" Geld konfrontiert – wie Keynes das seinerzeit gewagt hatte. Stattdessen behandeln die wirtschaftswissenschaftlichen Hauptströmungen die (moderne) Wirtschaft als eine Tauschwirtschaft, in der es kein Geld gibt, bzw. trivialisieren das Geld, indem sie es auf eine oder zwei Funktionen reduzieren (die mit der Vorstellung einer Naturalwirtschaft vereinbar zu sein scheinen). Oder sie treffen nachträglich ad hoc Annahmen, um bestimmte geldinduzierte Phänomene aus dem Stegreif irgendwie in ihr Modell einzubauen. 

Das ist bereits ein Kapitel in unserer Präsentation/Buch: die Versäumnisse der herkömmlichen Ökonomie bei der Erfassung des Geldphänomens und wie MMT diese Unterlassungsfehler vermeidet. Man kann aus dieser Perspektive das systematische Versagen der etablierten Wirtschaftslehre rekonstruieren/aufrollen, wobei es für uns schwierig sein wird, dieses Riesengebiet zu überblicken und in angemessener Kürze zu behandeln (die ausführlichere Variante wäre etwas für den den Kürteil).

[...]

So, jetzt recherchiere ich noch ein wenig in Sachen Bankreserven. Also, ich habe zunehmend den Eindruck, dass die MMTler auch hier richtig liegen. Aber um ganz davon überzeugt zu sein, würde ich gerne die praktischen Details nachvollziehen können. Wie läuft es zum Beispiel ab, wenn deine Bank, die im Gegensatz zu dir, ein Konto bei der Zentralbank hat, auf dem ihre Bankreserven verrechnet werden, die Begleichung deiner Steuerschuld im Zahlungssystem der Zentralbank ermöglicht: Der Staat (vertreten durch die Zentralbank) akzeptiert nur sein eigenes Geld zur Begleichung von Forderungen, die er dir gegenüber/jedem gegenüber hat. Dieses eigene Geld sind Bankreserven. Also nur eine Bank kann deine Steuerschuld beim Staat begleichen, den nur Banken haben Bankreserven. Offenbar ist es also so, dass du streng genommen, deine Steuerschulden (verrechnungstechnisch) bei deiner Bank begleichst (und nicht beim Staat – dazu würdest du Bankreserven benötigen, über die du nicht verfügst). Die Bank spiegelt dann die Begleichung deiner Steuerschuld ihr gegenüber im internen Verrechnungssystem von Zentralbank und Bank weiter. 

Das ist die Lösung des Rätsels, das mich lange geplagt hat: Wieso sagt MMT: alle Steuereinnahmen des Staats beruhen auf Geld, das der Staat zuvor in den Wirtschaftskreislauf eingeschossen hat. Bankreserven können nur vom Staat emittiert werden – es ist das Geld, in dem sich der Staat bezahlen lässt. Also ist alles Geld, mit dem Schulden gegenüber dem Staat beglichen werden, staatsemittiertes Geld, sprich, Bankreserven. 

Die Einzelheiten, wie Banken an Bankreserven kommen, sie verwalten, was sie sonst mit ihnen machen können, die buchhalterische Abbildung dieser Vorgänge, was zählt als Bankreserve, was geschieht genau, wenn eine Bank Einlagen als Bankreserven einsetzt - da tappe ich weitgehend noch im Nebel. 

Liebe Grüße

Steely Dan — Reelin' in the Years

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[Verse 1]
Your everlasting summer and you can see it fading fast
So you grab a piece of something that you think is gonna last
Well, you wouldn't even know a diamond
If you held it in your hand
The things you think are precious, I can't understand

[Chorus]
Are you reelin' in the years?
Stowin' away the time?
Are you gatherin' up the tears?
Have you had enough of mine?
Are you reelin' in the years?
Stowin' away the time?
Are you gatherin' up the tears?
Have you had enough of mine?

[Verse 2]
You been tellin' me you're a genius since you were seventeen
In all the time I've known you, I still don't know what you mean
The weekend at the college didn't turn out like you planned
The things that pass for knowledge, I can't understand

[Chorus]
Are you reelin' in the years?
Stowin' away the time?
Are you gatherin' up the tears?
Have you had enough of mine?
Are you reelin' in the years?
Stowin' away the time?
Are you gatherin' up the tears?
Have you had enough of mine?

[Instrumental Break]

[Verse 3]
I spend a lot of money and I spent a lot of time
The trip we made to Hollywood is etched upon my mind
After all the things we've done and seen, you find another man
The things you think are useless, I can't understand

[Chorus]
Are you reelin' in the years?
Stowin' away the time?
Are you gatherin' up the tears?
Have you had enough of mine?
Are you reelin' in the years?
Stowin' away the time?
Are you gatherin' up the tears?
Have you had enough of mine?

Steely Dan

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A breed apart. I had a Steely-Dan-"phase" in the late 1970s. I don't like the singer's voice, and yet it is an important ingredient in ab appealing musical mix.

Income Statement, Statement of Cash Flow, Balance Sheet — How the Three Financial Statements Fit Together

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A good account of the way in which income statement, statement of cash flow and balance sheet fit together:

The below video is also useful, highlighting an important link between the income statement and the balance sheet — the statement of retained earnings.

Tax Revenue Comes From Funds Previously Spent By Government

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The following assertion by Bill Mitchell has triggered a question that I (writing under the pseudonym "lector") put to the commentators and a longish and very fruitful thread of answers. I reproduce some of these contributions in the present post:

Bill Mitchell's assertion:

Taxation revenue comes from funds that the government has already spent into existence.

My question:

You write: “Taxation revenue comes from funds that the government has already spent into existence.” 

I understand, however, that the largest amount of money is created by commercial banks in the process of extending credit/loans. I assume further that it is from this money that most taxes are paid/most tax revenue stems. 

Why, then, do you not write: 

“Taxation revenue comes from funds that the government has already spent into existence as well as funds that commercial banks have lent into existence?” 

Why do MMT-texts tend to suggest that only money created by government provides the money that flows back to government as tax revenues? 

Am I overlooking something?

The various attempts to answer my question:

Writes Jerry Brown:

Lector, here is my understanding of your question. The currency issuing government probably could decide what it will accept for payments of taxes. It might decide that gold or cows or labor would fulfill a tax obligation. It might decide that a promise to pay the government’s currency in the future, or upon demand, which is what bank created money is, would be acceptable. But usually in the present time, taxes get paid through the banking payments system and obligations between parties (various commercial banks and the government) are settled by transferring reserve balances at the central bank. Since the central bank is really an arm of the government, and is the only source of these reserves, central bank reserves really are ‘government created money’.

Mel:

“[Why not] “Taxation revenue comes from funds that the government has already spent into existence as well as funds that commercial banks have lent into existence?””
Another angle, or maybe the same angle but spelled differently:
That’s not how lending works. 

When I bought my last car, the bank arranged a 5-year loan. They did NOT go to the dealer and say “It’s being payed with a 5-year loan; you’ll get the money over the next 5 years.” They paid the dealer right away, with their money. I’m paying the bank over 5 years. 

Similarly, if you borrow money to pay your taxes, the bank will cover your check to the Tax Authority right away, with money from their reserves. The loan deal between you and the bank stays between you and the bank.

lector:

Jerry Brown, larry, paulmeli, Mel and Derek Henry – I want to thank you for taking up my question. 

I can’t pursue your much appreciated contributions in this thread today or tomorrow, as I’m off on a business trip. But I shall certainly mull over your attempts at helping me. 

In the past, I’ve had a number of issues when I thought MMT has got it wrong, while it actually was right. In every case, it turned out that I had not fully grasped or inadvertently distorted the MMT position. Frequently, the problem is that I tend to smuggle in assumptions that I’m not aware of myself and that are not part of the MMT take.

Adam:

It really comes down to operation impossibility. Banks create bank money by creating bank liabilities (bank deposits). When a government initially sells a government security (bond) it only is for sale in the government’s currency (or equivalent central bank deposit). Whoever wishes to buy the government security must first therefore acquire the necessary government currency which can only come from the government via prior government spending (or from the central bank). 

As Warren (and I’m sure Bill) has said… reserve drains (tax collection & government security sales) can only happen after reserve adds (government spending or central bank lending/purchasing/direct adds).

Some Guy:

Lector: This may be the problem. You or I can pay taxes with bank money, by writing a check on our bank account. As far as you or I see, there is no difference between bank money and government money here. (Say that this tax check exhausts, closes our bank account, for simplicity) But that is not the end of the matter, which I think may be your assumption. After the federal government has accepted our tax check, the bank now owes the government. 

It is as if the government now has our account at the bank. The government wants to be paid now, wants to close this account. The only thing it will accept from the bank as payment when it closes this account is federal money, reserves that it has earlier issued. If the bank does not have the reserves to pay up immediately, it will be in debt to the government, and the discount rate – determined by the government – is the rate that the bank will be paying the federal government on its “account”. If the bank can never pay this debt, it is eventually declared insolvent by the government. 

Always, the government want’s its own money back. Rendered unto Caesar, as an ancient economist said.

Simon Cohen

In relation to Lector’s useful question and Some Guy’s excellent response can we say: 

All money is ultimately Government money because when we pay for things, reserves move around so we are, in fact, using reserves all the time. 

When a bank creates a loan, it later looks for reserves which are Government money (usually backed by repos-also a Government issued financial asset). 

So maybe this distinction between loans and Government money is otiose? The main difference being, as Derek pointed out, that one is a net asset and the other a simultaneous asset and liability but all the payments are the movement of reserves, hence Government money. 

I only appreciated this more recently when my friend Nigel Hargreaves pointed out to me that we are using reserves all the time and the ‘financial asset’ in ‘my’ account is not something parallel or separate from the reserves but ‘permission’ to use reserves. 

Keyne’s seems to say this in his Treatise on Money: 

‘The State-Money held by the central bank constitutes its “reserve” against its deposits. These deposits we may term Central Bank-Money. It is convenient to assume that all the Central Bank-Money is held by the Member Banks – in so far as it may be held by the public, it may be on the same footing as State-Money or as Member Bank-Money, according to circumstances. This Central Bank-Money plus the state money held by the Member Banks makes up the Reserves of the Member Banks, which they, in turn, hold against their Deposits. These Deposits constitute the Member Bank-Money in the hands of the Public, and make up, together with the State-Money (and Central Bank-Money, if any) held by the Public, the aggregate of Current Money. (Keynes, 1930 pp. 9–10) ‘ 

Not sure I quite get Keyne’s terminology here but he seems to support the point.

So maybe the artificial separation of this putative 97% from 3% cash is all unfounded?

Nicholas

Hi Lector 

Government spending adds to the non-government sector’s net financial assets.

Taxation reduces the non-government sector’s net financial assets. 

The non-government sector comprises the domestic non-government sector and the external sector (the rest of the world). 

The non-government sector’s net financial assets (denominated in the government’s currency) comprise three things: reserve balances, government securities, and physical cash on issue (i.e. physical cash that is held by banks, households, firms, sub-national governments, foreign governments – any entity that is not the issuer of the currency that we are talking about). 

Note that we are only talking about financial wealth, not real wealth (land, buildings, factories, equipment, tools, cars, art works – anything tangible). 

Retail bank deposits are NOT part of the net financial assets of the non-government sector. 

Why? 

Because retail bank IOUs are offset dollar for dollar by other IOUs within the non-government sector. 

When a retail bank issues its IOU (a bank deposit), a household or a firm is issuing its own IOU to the bank. The IOUs net to zero. They cancel each other out. 

Therefore ultimately households and firms pay their taxes with reserves, not with retail bank deposits. 

The government always taxes by writing down reserve balances. 

The government always spends by writing up reserve balances.

Nicholas

Hi Steve_American 

Sure, monetary units are fungible. We don’t know which particular dollar originated as government spending or as credit creation by a retail bank. And we don’t need to know. 

What matters is that only government spending can increase the net financial wealth of the non-government sector and only taxation can reduce the net financial wealth of the non-government sector. 

The government ALWAYS spends by crediting reserve accounts. 

The government ALWAYS taxes by debiting reserve accounts.

Nicholas:

So basically, you are asserting that if I borrow by getting a 2nd mortgage and therefore get bank created dollars; and then pay my taxes with them, that those dollars are magically converted into reserve dollars during the process of clearing the check. 

It isn’t magic, it’s just how the monetary system works. The government only accepts payments in its own IOUs. 

The government does not directly accept your retail bank deposit as payment of your tax liability. Your bank writes down your transaction account, and your bank instructs the central bank to write down its reserve account and to write up the Treasury’s reserve account. That’s how your taxes get paid.

Nicholas Haines:

all bank created money are liabilities to convert on demand into notes and coins

…and into reserves as well. 

The retail bank’s IOU is a promise to convert your bank deposit on demand into any of the two forms of high-powered money (reserves and physical currency). 

If you want to use your demand deposit to make a payment, your bank must honour its promise to convert your demand deposit into reserves. Your bank will write down your demand deposit, instruct the central bank to write down its reserve account and write up the reserve account of the recipient’s bank, and the recipient’s bank will write up the transaction account of the recipient. 

You can invoke this process to pay your taxes to the Treasury, make payments to individuals and businesses and organizations, move your demand deposit to a transaction account that you hold with a different bank.

And so on ... 

(5) Net Financial Assets — Demonstrating That and How "Magical" Demand Management Works

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Like other reviewers of Modern Monetary Theory (MMT), I have wondered why the school's promoters attach so much weight to the concept of net financial assets. It seems to me the answer is: by pointing out the mechanics of net financial assets it is possible to demonstrate THAT and HOW Keynesian demand-management works in its two capacities to boost and cool the economy depending on what the economic cycle demands.

Unlike the non-government sector, government has the ability to create net financial assets in the non-government sector. It is in a position to add to the balance sheet of the non-government sector financial assets that are not balanced by liabilities of the same amount. In fact, government may add financial assets without any corresponding liabilities ensuing for the beneficiaries of the financial assets. In other words, by spending into the non-government sector more than it takes out of it through taxation, government is able to lengths the sector balance sheet on the asset side, without lengthening the sector's liabilities side. Net worth being the difference between assets and liabilities, an overhang of assets over liabilities translates to an increase in net worth. Put differently: net worth is the difference between what you own and what you owe. A positive net worth means that on calling in all claims represented by one's assets and discharging all of one's liabilities, there remains a positive amount: net worth (Reinvermögen).

Thus, by deficit spending government is able to increase the non-government sector's net worth, making it more wealthy and hence more willing to and capable of spending (itself out of a crisis), strengthening effective demand and derivatively the economy.

Putting more spendable money, i e. money available for spending, into the system, government promotes (a) effective demand, (b) the ability of the non-government sector to save at it's desired level and (c) in a riskless manner — by investing in debt instruments offered by an entity (government issuing its own money) that is free from default or liquidity risk.

Conversely, when government takes more out of the economy than it spends into it, it shortens the asset overhang, reducing the net worth of the non-government sector. A government surplus is tantamount to a deficit of the non-government sector which is forced to reduce its net worth to comply with the government-ordained drain of financial assets.

Summary:

In formalising the process of creating and destroying net financial assets we are able to show that what seems magical — the creation of wealth out of nothing — is actually well within the means of government, in other words: the ability to make the non-government sector richer than it is, when it needs to be richer than it is but cannot make itself richer than it is. For instance, when debt levels are too high, spending and investment activities are too sluggish to pull the economy out of a trough.

And also the ability to make the non-government sector poorer than it is when it needs to be poorer while not being willing or able to make itself poorer — such as when the non-government sector is so rich as to take away too many resources from government (so the latter is not able to fulfil its mandate) and an inflationary bidding war between government and non-government ensues for the finite resources available in the economy. 

(4) Net Financial Assets — Vertical and Horizontal Money Creation

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On my way to a clearer understanding of the pivotal position of "net financial assets" in Modern Monetary Theory, I found this piece by Tom Hickey of help:

[ ... T]he key here is the MMT concept of vertical and horizontal in relation to money creation. This is sometimes called exogenous (outside) and endogenous (inside).  

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” [because it comes from the outside and the outside is above the inside, i. e. higher in terms of spending capabilities] or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of nongovernment net financial assets. 

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero. 

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets. 

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case. 

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for CB-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system. 

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Tsy’s. That is, when a Tsy is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating CB and Treasury as “government”). 

When the Tsy’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction. 

Therefore, the key to understanding MMT is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase nongovernment net financial assets, and taxation withdraws net financial assets from nongovernment. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the CB to hit its target rate. 

These principles are then applied to Y+C+I+G+NX to balance nominal aggregate demand with real output capacity in order to achieve full capacity utilization, hence, full employment, along with price stability. This is based not on theory requiring assumptions but on operational reality that can be represented using data, standard accounting identities, and stock-flow consistent macro models.

The source.

(3) Net Financial Assets — The Mechanics of Government's Adding Net Financial Assets to Non-Government

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The below is an excerpt from this post by The Heteconomist:
 

The government spending, in addition to creating income for the spending recipients (see part 9), causes an increase in the net financial assets (financial assets minus financial liabilities) of non-government.

To see this, consider the key changes to financial assets and liabilities that occur if the government pays wages of $1,000 into Minnie Motza’s account at River Bank. (Other balance-sheet changes are left out to highlight the points presently under discussion.

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In the above figure, the actions of the Treasury and central bank are combined into a single consolidated T-Account. Any intragovernment transactions between the Treasury and central bank net to zero, and so are left out. Only transactions between government and non-government show up in the consolidated government’s T-Account.

We can determine the overall financial impact of the government spending by considering its effects on each non-government entity.

On the one hand, River Bank’s net position is unchanged. The bank has extra reserves, which is its asset, but this is exactly offset by the new deposit, which is its liability.

Minnie, on the other hand, has a new asset (her deposit) with no offsetting liability.

So, for non-government as a whole, there has been an increase in financial assets relative to financial liabilities. In other words, there has been an increase in net financial assets.

This is possible, even though financial assets and liabilities for the system as a whole must sum to zero, because the extra financial asset held by non-government is matched by an extra financial liability for government. Namely, the extra reserves, which are an asset of River Bank, are a liability of the consolidated government sector.

The change in net financial assets, as presented so far, equals the change in reserves of $1,000.

Taxes have a financial impact opposite to that of government spending. If Minnie Motza pays $300 in taxes, this amount will be debited from her account at River Bank, and $300 of reserves will be debited from River Bank’s account with the central bank. The net effect will be a reduction in non-government net financial assets. For River Bank, the impact is neutral. Its liability (Minnie’s deposit) is reduced by $300, but its asset (reserves at the central bank) is reduced by the same amount. Minnie, however, has less financial assets than before, since her account now has a smaller balance. Offsetting this is a reduction in the government’s liabilities (since there are less reserves in River Bank’s account with the central bank).

(2) Net Financial Assets — Viewed as Insurance Only the Government Is Capable of

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I'm only building my knowledge and therefore still agnostic concerning MMT's notion of net financial assets. Interfluidity has an interesting take on the subject:

The crucial thing to understand is what the net means in net financial assets. It is precisely financial savings net of domestic real investment by the private sector. It is the farthest possible thing from a comprehensive measure of household savings. It is private sector savings excluding the vast preponderance of household savings, which is backed by private sector assets (whether owned by households directly or owned by businesses who then issue financial claims to households). “Ordinary” private sector savings either doesn’t show up as financial assets at all (a home without a mortgage is just a real asset owned by a family, like a television or a baseball card), or else they “net out” when we aggregate, because one private sector entity’s asset is precisely extinguished by another private sector entity’s liability. If a household is “long” a share of stock, a firm is “short” that same position, and owes the household whatever that claim represents. The aggregate financial position of the private sector combines the financial positions of businesses and households, so the financial claims of households against firms are matched by mirror image liabilities of firms to households. They annihilate one another like matter and antimatter. 

So why do we care about this odd sliver of savings? Why do MMT economists make it so central to their analysis? Private sector net financial assets are “special” precisely because they are not backed by domestic real assets, but instead by promises that are credibly independent of domestic real asset values, especially promises of states. Saving that takes the form of real stuff, whether that stuff is directly held or hidden behind financial claims, is inherently risky. House prices fall. If you own a factory, or shares in a firm that owns a factory, the factory can burn down. Even if you hold a diversified stock portfolio, you will find it subject to wild swings in value. If you own private sector debt, you expose yourself to credit risk. If you own a diversified portfolio of domestic stocks and bonds, your own circumstances and that of your investment portfolio will be correlated in an unpleasant way. The times when you lose your job and need to draw on savings are likely to be the same times when stocks have crashed and people are defaulting on their debts. People desperately covet assets that are divorced from the risks of the domestic real economy. And that is precisely what “net financial assets” are. 

Net financial assets are special, because they serve insurance functions that assets produced by the domestic private sector simply cannot provide. When households are risk-averse, they covet these assets especially. For firms, these assets offer protection against insolvency risk that real assets, whose values both fluctuate idiosyncratically and covary with the real economy, cannot provide. MMT economists often suggest that if the public sector fails to accommodate the private sector’s appetite for net financial assets, recession and financial instability will result. That makes sense. It’s conventional, if a bit vapid, to describe recessions as times when “animal spirits” are low, when people are risk averse. But what matters is not the courage in people’s hearts (or lack thereof). What matters is how people behave. If people’s behavior is counterproductively risk averse, you can encourage greater risk-taking by offering insurance. That’s precisely what injections of “net financial assets” into an economy provide. If firms are teetering on the brink of bankruptcy, you can flood the economy with safe assets they can use to shore up their balance sheets to reduce their risk of default. That’s precisely how the United States saved its banks in 2008 (for better or for worse). The headline bailouts and TARPs and accounting forbearance were all expedients to keep those firms alive until a flood of assetsimmune to correlated private sector collapse could find their way onto bank balance sheets (with the help of opaque subsidies). Those special assets are “net financial assets”. 

“Net financial assets” are a heterogeneous category. They include both claims against the domestic state and claims on foreign public and private sectors. A claim on a foreign firm in foreign currency does not provide the same insurance as claim against the domestic government in domestic currency. Nevertheless, claims on the foreign sector do provide insurance against domestic shocks that do not impair the foreign counterparty. And note that contrary to naive financial theory, which predicts developed economies will net-accumulate claims on emerging economies to invest in their growth, in practice emerging economies tend to net-accumulate claims on developed economies. The insurance function of safer foreign assets outweighs the investment function of accepting foreign capital (or at least it has since the Asian Financial Crisis). For firms and households in an emerging economy, foreign claims and claims on government are both useful insurance. In developed as well as emerging economies, negative positions with respect to foreign creditors increase the domestic private sector’s exposure to risk as surely as indebtedness to the state would, assuming debt contracts are uniformly enforced. 

All this terminology — private sector surplus, net financial assets, etc. — is associated with heterodox, lefty MMT, but it maps very nicely to discussion of “safe asset shortages” in the mainstream financial press or Gary Gorton’s schtick on the importance of “informationally insensitive” assets. The main difference has to do with whether we can or ought to rely upon the domestic private sector to produce these kinds of assets. The MMT analysis, by construction, excludes private sector “triple-A” assets, where people like Gorton emphasize a role of private sector in producing assets that might provide this sort of insurance. The MMTers have it right. The domestic private sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the state. (Gorton tacitly recognizes this when he suggests the state should supervise and guarantee assets produced by shadow banks like it insures bank deposits. No thank you.) 

The insurance function of “net financial assets” is not unambiguously a good thing. Net financial assets are special precisely because they provide insurance against systematic risk. When net financial assets are claims on foreign debtors, they are not so problematic, they just represent a form of diversification that can insure against domestically (but not globally) systematic shocks. Claims against the domestic state, however, offer safety to their holders in a manner that can be quite dangerous to the rest of us. “Insurance” against a truly systematic shock is necessarily a zero-sum game. If we are all collectively poorer, the only way the state can make some claimants whole is by shifting their share of the aggregate loss to people who don’t hold the government’s promises. We’ve experienced this very painfully over the past decade, as both the European and American policymakers refused to accept any risk of inflation (thereby prioritizing the value of past promises). Policymakers chose to make absolutely sure that holders of state assets would be made whole in real-terms, and imposed severe costs on debtors and the marginally employed to do so. (I think policymakers overshot the inherent zero-sum-ness of providing insurance during a systematic shock and have played a sharply negative-sum game.) It would be better, I think, if states downgraded the insurance they provide by weakening the promise they make to asset holders from price stability to an NGDP path target. And I worry much more than I think most MMT economists do about the unjust distribution of risk-bearing that might accompany a large stock of net financial assets very unequally distributed. (Unusually, I’m with Greg Mankiw on this one.) I think the economy includes people who are already overinsured by their stock of net financial assets, and those people tend disproportionately to accumulate new issues. So we should think more about how we can accommodate private sector entities’ need for some degree of insurance by redistributing existing net financial assets rather than creating new ones. 

This sentence is a pithy conclusion.