# The science of finance/Financing the economy

« Give them the power to collect the grain during those good years and to store it in your cities. It can be stored until it is needed during the seven years when there won’t be enough grain in Egypt. This will keep the country from being destroyed because of the lack of food. » (Genesis, 41,35-36)

In the absence of monetary creation by banks, the financing of the private economy would depend exclusively on the self-financing capacities and the goodwill of agents who are fortunate enough to entrust or lend their money to entrepreneurs. Such an economy would therefore face the risk of a shortage of investment, because owners can choose to keep their money instead of lending it. Monetary creation by banks makes it possible to cancel this risk of shortage of investors. Money lent by banks is like a loan without lenders, because banks lend money they have created for the occasion, not money that existed beforehand. Monetary creation can finance the economy even if there is a shortage of investors, it is enough that the banks take over. But an economy is then confronted with the risk of excess investment. If all we have to do is create money to finance all our projects, we risk funding too many projects at the same time. To benefit from sustainable prosperity, economies must navigate between these two pitfalls, too little investment, lack of private investors or of sufficient money creation, and too much investment, because of the exaggerated optimism of private investors or an excess of money creation.

## Macroeconomic fluctuations

All economic activity is the realization of all economic projects of all agents. Every day, projects are carried out, continued, renewed or abandoned, and new projects are launched.

At one point, the ability of an economy to simultaneously carry out projects is limited, because raw materials and supplies, stored or soon available, labor and capital goods are limited. If all agents simultaneously engage in projects that exceed the capacity of the economy, they will not all be able to carry them out at the same time. Some will be forced to delay or abandon their projects, either because of the shortage or because of rising prices. When the projects implemented exceed the capacity of the economy, it is said to be overheating, or overcapacity. The labor shortage is driving up wages, the scarcity of raw materials, supplies and capital goods is driving up their prices, all of which puts upward pressure on the prices of consumer goods.

If the projects in which an economy is committed are below its capacity, it is said to be under capacity. Available means are not used or they could be better used by being assigned to better projects. Underemployment of the available labor force is the main sign of an under-capacity economy.

More precisely overheating and under-capacity can be distributed in a differentiated way within the economy. Some sectors may overheat, with scarcity or price increases while other sectors are under capacity.

Whether an economy is overheating or under-capacity depends on the agents' decisions. If the atmosphere is pessimistic, they will be reluctant to engage in projects, and conversely if they are optimistic. That's why it has been said since Keynes that "animal spirits", that is mood swings, determine macroeconomic trends. The alternation of periods of high and low activity resembles manic depression (bipolarity). Episodes of depression, remission and euphoria follow each other.

But macroeconomic fluctuations do not depend only on animal spirits. They may have causes beyond the will of the agents. If, for example, the prices of raw materials imported or exported in large quantities vary significantly, this is sufficient to considerably affect the activity of an economy. In general, any unforeseen changes in the conditions of their activity may encourage agents to give up their projects or, on the contrary, to form new ones.

Overcapacity and under-capacity are not symmetrical. When an economy is overheated, there is necessarily a tendency for prices to rise unless prices are capped. On the other hand, under-capacity does not necessarily lead to lower prices, because many prices are rigid downward, especially wages, and because expectations of price increases are sufficient to raise them, even if the economy is in recession.

A policy or effect is procyclical when it tends to destabilize the economy, to amplify overheating and inflation during an upward phase, and to aggravate the recession, unemployment and perhaps deflation in a down phase. A policy or effect is counter-cyclical if it tends to stabilize the economy, to cool down overheating and to reduce the inflation that accompanies it, or to counter recession, unemployment and deflation.

## Price stability

When the currency was convertible into gold, the price of gold, \$ 35 per ounce, was a tautological price. Prices for all other goods were valued in dollars, but a dollar was equivalent, by definition, to 1/35 of an ounce of gold. To say that the price of gold was \$ 35 an ounce was simply to say that an ounce of gold is an ounce of gold. And the price of gold was considered constant. But this constancy was an illusion. Gold had a value that could vary over time. How to measure this value?

The value of gold could vary because the same amount of gold could be used to buy varying amounts of other goods. If all the prices of the other goods increased, it would automatically decrease the value of the gold, and conversely if all the prices decreased. To measure changes in the value of gold, it was necessary to measure changes in all prices in the economy. The same is true in an economy where money is not convertible into gold. To measure changes in the value of money, we must measure the variations of all prices.

The value of money is defined by its purchasing power (Fisher 1911). It is calculated by reasoning on a defined basket of economic goods. The variations in the price of this basket then represent the variations in purchasing power. A consumer price index is thus calculated on a basket that contains all the goods and services consumed during the year. The inflation rate is then defined as the annual rate of change of this index.

Changing lifestyles mean that the rate of inflation over a long period (decades) is impossible to calculate accurately, nor can it be interpreted without ambiguity. Each year new goods and services appear and old ones disappear or are modified. This poses a problem for the calculation of inflation, because the basket of goods and services varies over time. The statisticians solve this difficulty by reasoning on equivalent goods, but the result of the calculation depends on their judgment on these equivalences between the old and the new. As from one year to another, the consumption basket varies little, the uncertainty on the resulting annual rate of inflation is low. But if we compare very different baskets, because consumption varies a lot in one or more decades, the uncertainty is much higher.

A very high rate of inflation, called hyperinflation, is obviously harmful to the economy. If employees have to be paid every day and spend their salary immediately, because purchasing power drops sharply from one day to the next, the economy can not function normally. But a high inflation rate, 20% annually, for example, is not so obviously harmful. The monthly rate is ${\displaystyle 1.20^{1/12}-1\approx 0.015=1.5\%}$ is low enough for employees to spend their monthly salaries normally. What are the costs of such moderately high inflation? If inflation could be exactly and certainly anticipated, the costs could be relatively low. Agents would have to regularly change their prices (the waltz of labels, menus ...) and take into account inflation in all their economic calculations. But inflation can not be exactly and certainly anticipated. This makes economic activity more risky. Lenders are hurt by an unanticipated rise in inflation, and borrowers by a decline. It is this increase in risk that is probably the highest cost that high but moderate inflation charges. By targeting a very low rate of inflation, central banks make economic activity much less risky (and eliminate the cost of the waltz of labels).

### The danger of deflation

Deflation occurs when the inflation rate is negative. It must be considered as an economic disaster, because it encourages the abandonment of our projects and because it drives debtors into more debt and pushes them into bankruptcy. When deflation sets in, everything happens as if sleeping money brought in an income, because its value increases over time, and all the agents are encouraged to delay their purchases, because they anticipate a fall in prices. Debts increase in value because future repayments are fixed while their value increases.

That wages, and other prices, are rigid downward can be seen as an economic benefit, because it reduces the risk of deflation (but it does not cancel it).

Price stability could be defined by an inflation rate of zero, but that is not desirable because the economy is constantly on the brink of a precipice. Deflation tends to feed itself. It is pushing the recession and thus weakening demand, pushing prices down, and therefore further deflation. Even a weak initial deflation can have catastrophic effects. Since the inflation rate remains variable, even if inflation is properly controlled, it is better for it to remain above zero in order to reduce the risk of deflation. An average rate of 2% for example (this is the inflation target usually adopted by central banks) gives the monetary authorities leeway to react in the event of deflationary tendencies. If the target was 0%, deflation could set in before the monetary authorities have time to react (Bernanke, Laubach, Mishkin, Posen, 1999).

## The underemployment of the domestic wealth

Wealth is the difference between assets, all owned goods, including options, and liabilities, all debts. Ambivalent commitments are counted as assets or liabilities depending on whether their estimated value is positive or negative.

Domestic wealth is the sum of the wealth of all resident agents in an economy. Since all agents' liabilities are assets of other agents, one can ignore all domestic debts when one counts the domestic wealth. One can also ignore the options sold on the markets, because they are assets for the buyer offset by liabilities for the seller. Assets in bank accounts are bank debts to their customers and can be ignored. The bank notes in circulation are in the assets of their holders and the liabilities of the central bank. This is purely accounting logic, because the central bank owes nothing to anyone when it puts its notes into circulation, since they are no longer convertible into gold. But this makes it possible to count the domestic wealth correctly. If the central bank puts new notes into circulation, it does not directly create wealth. Banknotes are just paper, not real wealth. Domestic wealth is thus made up of all the durable goods preserved in an economy and all the options of all the agents (except those sold on the markets).

The value of durable goods depends on the projects to which they are assigned. When a good remains unused, it is assigned to a default project, which pays nothing, and its value is no more than the option to use it again.

Domestic wealth can therefore be considered as the portfolio of all the projects in which agents are committed and all their options. This portfolio is shared between all agents. Its management results from the management by agents of their own portfolios of projects.

The projects of an economy can require more or less labor. There is unemployment if there are too few projects or if they do not require enough labor. The problem of unemployment is therefore a problem of managing the portfolio of all the projects of an economy.

The central bank can indirectly increase or decrease the domestic wealth, when it creates money or when it refuses to create it, because it can help the agents to realize profitable projects, or on the contrary prevent them.

## Monetary power

### The intervention of the banking system on the loanable funds market

The existence of banks and a central bank, and the resulting monetary creation, make the market for loanable funds much more than a market for private lenders and private borrowers.

If a private lender decides to stop lending money, he has to keep it at home in the form of cash, because if he deposits it at the bank, it is like lending it, and it increases the capacity of the bank to grant loans. By depositing one's funds in the bank, there is little reduction in the loanable funds available, because the bank must keep only a small fraction of required reserves. The supply of loanable funds can therefore only decrease if the agents keep more of their money in cash, or if the banks refuse to lend, and keep excess reserves, or if the central bank withdraws money from circulation.

### Illiquidity, insolvency and loan of last resort

If there is a bank run, that is, many depositors want to recover their money at the same time, a bank can be illiquid while being solvent. To say that it is illiquid means here that it does not have enough cash to fulfill its obligations. It must therefore declare bankruptcy. But it is solvent because its assets, and in particular all the loans it has made, are greater than its liabilities. It would be enough that one lends it the necessary cash so that it escapes the bankruptcy and that it pays later all its creditors. In order to protect the banking system against this risk of illiquidity, central banks are now accepting the role of lender of last resort (Bagehot 1873, Bernanke 2015). If a bank is solvent, and no one wants to lend to it, the central bank is committed to providing the necessary funds at a rate slightly above the market rate. Of course, the central bank must judge that the bank is solvent, and it requires guarentees.

### Countercyclical monetary policy and the control of inflation

A central bank always has the means to cool an overheated economy and thus to fight against inflation, because it is in a dominant position in the market for loanable funds. If it refuses to lend the money it can create, it raises interest rates and discourages agents from engaging in some of their projects. It is said that it removes the bowl of punch while the party has just begun - overheating offers generous opportunities for speculators.

Central banks do not want to abuse rate hikes, because high rates are bad for economic development. In times of prosperity, they seek to keep rates low, and only raise them to fight against inflation. If all goes well, the economy benefits from both low and controlled inflation and low interest rates. From this point of view, we can rejoice that the central banks have acquired the power that is theirs today.

If the economy suffers from underemployment, the power of a central bank is much more limited. It is encouraged to lower interest rates, if only to counter deflationary trends, to keep inflation at a level sufficient to move away from the risk of deflation. But there is a floor, it can not, or hardly, lower rates below zero, and even rates too close to zero can be considered dangerous, because they hurt the agents that need to place their money without risk and in a liquid way, like insurance companies for example, and because they incite to take thoughtless risks.

When an economy is under-capacity, monetary policy may not be enough to revive activity. Central banks can incentivize agents to borrow, lowering rates, but they can not force them to engage in projects. In times of pessimism, even very low rates are not enough to get involved, because one always have to pay back the principal, and if the project is at risk of being lost, one is afraid of staying in debt.

If the recession is so severe that there is a danger of deflation, and if the central bank has already lowered interest rates to the lowest, it still has the power to give the money it creates to revive the activity and fight against deflation.

### Permanent inflation and monetary policy with clubs

When inflation has settled, it is very difficult to reduce, because agents anticipate future inflation, and because their expectations are self-fulfilling. If the agents think that the prices will increase, they increase their prices, not to be damaged, and by increasing their prices, they cause the inflation that they anticipated.

Central banks still have the means to fight against rising prices. It is enough to cause a rise in interest rates. But this has a cost. If a permanent inflation has settled, it is necessary to convince the agents that they must change their expectations. To make promises to them is not enough, they need proofs that inflation can decrease. By raising rates to a sufficient level, a central bank can cause an economic recession. The increase in unemployment and the economic recession are leading agents to change their expectations, and after a few months or years of suffering, expectations having changed, the central bank can lower interest rates without restarting inflation. This monetary policy, which consists of raising interest rates to trigger a recession and thereby reducing inflation expectations and hence future inflation, is sometimes called the Volcker method, after the name of the director of the US Federal Reserve, which applied it, in the early 1980s. It could be called the monetary policy with clubs: give blows of the club until people no longer want to buy. When they are stunned enough to stop buying, the upward pressure on prices is eliminated and inflation is under control.

## Fiscal power

### Public investment

The state is not just an economic agent. To consider it solely as a for-profit enterprise would obviously lead to ignoring its most important functions. But it is still a very powerful economic agent.

Complementarity between the public authorities and the market economy is one of the keys to economic development. Citizens, as owners, workers and consumers, need a powerful state that protects their interests and empowers them to engage in profitable projects. In return, the state needs a prosperous economy to raise taxes.

As soon as they promote economic development, public spending can be considered an investment. If it leads to an increase in activity, it brings at the same time additional tax receipts. The initial expenses are costs and the additional taxes revenues. If the revenues exceed the costs, the investment is profitable.

### The crowding out effect

In periods of full employment or overheating, an increase in public expenditure can not generally lead to an increase in economic activity because it is already at its peak. If the state spends more, it will use means that would otherwise have been used in private projects. Private investment is thus squeezed out by public investment. This crowding out effect must not prevent the state from spending when its objectives have priority, because the general interest goes before private profits, but it obviously affects the profitability of public investments.

The crowding out effect is sometimes stated in financial terms: the extra public spending is financed by indebtedness, and the money lent to the state is squeezed out of private projects that could otherwise have been financed. But when one thinks in this way, one ignores that loanable funds are not reduced to private funds, that the central bank and other banks create money by lending it.

### Countercyclical fiscal policy

In times of underemployment, there is no crowding out effect (except perhaps in some sectors that have remained at full employment) and the profitability of public investment is increased accordingly.

During a recession, individuals are not generally encouraged to invest. They all have an interest in everyone investing more to get out of the crisis, but none is encouraged to do so. If an agent engages in expensive investments, it will increase the activity, and its suppliers will benefit, but not him, because an agent alone can not restart the activity of all agents, and if the expected recovery does not occur, he will have to bear losses. On the other hand, the state has an interest in investing, because it will automatically benefit from any additional activity with additional tax revenue, and if it is sufficiently powerful it can cause the expected recovery.

A recession is very expensive for the state, because tax revenues are greatly reduced. But it is precisely at these moments when it earns the least, that the state must spend the most and go into debt. In times of full employment, the state has much less interest in investing, and it is better that they use their additional tax revenues to repay their debts. Paradoxically the state has to spend less when it earns more and it has to spend more when it earns less.

Imagine a country with years of famine and years of plenty. In times of plenty, owners are encouraged to make large stocks. In times of famine, the state goes into debt to buy and gradually distribute stocks. When abundance comes back, the state pays off its debts and lets the owners rebuild their stocks. It is a modern version of the story of Joseph and Pharaoh. Countercyclical fiscal policy is similar.

### Is fiscal austerity necessary to fight inflation?

In times of full employment or overheating, any increase in public spending, in the absence of additional taxes, and therefore through indebtedness, puts upward pressure on prices. To control inflation, the central bank must tighten the credit lines and thus raise interest rates. In such circumstances, fiscal laxity increases the costs of indebtedness and the difficulty of controlling inflation.

If, in addition, permanent inflation has taken hold, the increase in public spending is not likely to reduce inflation expectations, rather the opposite. Fiscal austerity announced and realized is then a way to change expectations and to support a monetary policy of reducing inflation.

On the other hand, in times of underemployment, and if inflation is already under control, the increase in public spending should not have an inflationary effect. In such circumstances, the problem is not inflation, but rather deflation, and any increase in investment is welcome, provided that it is for good projects.

## Financing the economy through monetary creation

Financial work is essentially about finding and evaluating projects. If we have found a good project, we have to finance it. When agents were obsessed with gold or other precious metals, when they believed that nothing could have value if it was not convertible into gold, financiers were constrained in their willingness to finance. It was not enough to find good projects, it was also necessary to find gold, or to have some in its trunk. Now this bridle is cut. The financiers can work normally, they only have to evaluate projects, they no longer have to worry about gold reserves. The most important thing is to find good projects. Once they are found, it only remains to create the money that finances them. The only real financial problem is the design and evaluation of projects.

To benefit from prosperity, agents must design and implement good projects. They often have an interest in associating in various ways because they can create value by composing their projects. The only thing that really matters is the choice of these projects, not the funds available, because the money that finances them can always be created. Money is never a problem unless there are too many projects going on simultaneously. This is why agents need to set up institutions to regulate financial resources, in order to avoid overheating and inflation, or recession, underemployment and deflation.

When the economy is not in full employment, or if it suffers shortages, or inflation, or deflation, it must be seen as an error in the composition of all its projects. Domestic wealth is collectively poorly managed. Agents have an interest in agreeing and organizing to better benefit from the wealth they share.

Because it is the largest investor, the state has additional means for global investment to be responsive to the needs and capabilities of the economy. The state must always be ready to invest in profitable projects, in order to revive the economy when private projects do not seize the available opportunities enough, but it is also necessary that it gives up its ardours and that it puts some of its projects on standby, when the economy is at full employment, so as not to hinder the development of the private economy.

## Are low rates responsible for financial crises?

Low rates promote economic development because they encourage investment in the real economy. But they also increase financial profits. With money borrowed at low rates one can increase financial profits through leverage. Easy money encourages speculation and makes possible to earn very high profits as long as there is no crisis. But when the crisis occurs leverage goes in the opposite direction. It increases losses instead of increasing profits.

Borrowing at low rates and lending at higher rates is the main source of income for banks. When they invest in the real economy by lending money directly to non-financial businesses they contribute to economic development. But if they invest in the financial markets by speculating on the rise in stock prices, they feed financial bubbles. This shows the need to discipline banks and financial firms (Admati & Hellwig 2013). Low rates should be used for the development of the real economy not for financial speculation.