Michael Pettis: Money Is Not Created Out of Thin Air

MoneyA recurring conversation I have with clients concerns the ability of banks to create credit, and of governments to monetise debt, and whether this ability is the solution to or the cause of financial instability and economic crisis. Monetarists and structuralists have very different answers to that question as each side may assume an idealised version of an economy.

We are normally taught that banks allocate credit by lending the money that savers have deposited in the banking system, but in fact banks create deposits in the banking system by creating credit, so it seems to many as if they can create demand out of nothing. Similarly, if governments are able to create money, and if they can borrow in their own currency, they can easily monetise debt, seemingly at no cost, by printing the money they need to repay the debt – or by crediting bank accounts, which amounts to the same thing. This means that when they borrow, rather than repay by raising taxes in the future, all they have to do is monetise the debt by printing the money needed to repay it. It seems that governments too can create demand out of nothing, simply by deficit spending.

There is a rising consensus – correct, I think – that the misuse of these two processes – which together are what we mean by endogenous money – were at the heart of the debt surge that was mischaracterised as “the Great Moderation.” For example, in a book published earlier this month, Between Debt and the Devil, in which he provides a description of the rise of debt financing in the four decades before the 2008-09 crisis, Adair Turner specifies these two as fundamental to the rising role of finance in the global economy. He writes:

“…in modern economics we have essentially two ways to produce permanent increases in nominal demand: either government fiat money creation or private credit money creation.”

I am less than half-way through this very interesting book, so I am not sure how he addresses the main characteristics of debt, nor whether he is able to explain how much debt is excessive. He invokes the work of Hyman Minsky often enough, however, to suggest that unlike traditional economists he fully recognizes the importance of debt.

And it is because of this importance that the tremendous confusion about what it means to create demand out of nothing is dangerous. When banks or governments create demand “out of thin air”, either by creating bank loans, or by deficit spending, they are always doing one or more combinations of two things. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other equally easily specified cases, they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand “out of thin air”, as many analysts seem to think, as doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.

The questions arise in the context of a discussion of some of Steve Keen’s work among several regular commenters. Keen is an Australian post-Keynesian who heads the School of Economics, History, and Politics at Kingston University in London.

I’ve known of Keen’s work for many years, and last year he spoke at a seminar on central banking. He is one of the most hard-core proponents of Hyman Minsky, and regular readers know that I think of Minsky as one of the greatest economists since Keynes. In the third chapter of my 2001 book, The Volatility Machine, I explain the ways in which developing countries designed balance sheets that systematically exacerbated volatility – and which eventually led to debt-based contractions or financial crises – in terms of a framework that emerges from the work of Minsky and Charles Kindleberger. This framework – something that many Latin American economists have no trouble understanding but which has been ignored by nearly all Chinese and foreign economists covering China – explains why three decades of economic expansion in China, underpinned by rapid growth in credit and investment, would lead almost inevitably to destabilising debt structures.

Hyman Minsky’s Balance Sheets

Minsky is important not so much for the “Minsky Moment”, a phrase he never used, but rather because of his profoundly intuitive balance sheet-oriented understanding of the economy. Minsky’s insights include his now well-known description of accelerating financial fragility, along with his explanation of why instability is inherent to the financial sector in a capitalist economy.

Most insightful of all, Minsky characterised the economy as a system of interlocking balance sheets, and because he taught us to think of every economic entity as effectively a kind of bank, with one entity’s assets being another’s liabilities, it follows that economic performance is partly a function of the direction and the extent in which the two sides of each balance sheet are mismatched.

Minsky’s framework made it especially easy to predict the difficulties that China would face once it began to rebalance its economy. China can be described as an extremely muscular illustration of Minsky’s famous dictum that “stability is destabilising.” Its financial system was designed to meet China’s early need for rapid credit expansion, and it evolved around what seemed like permanently high growth rates and uninterrupted access to financing. Two decades of “miracle” levels of investment-driven growth made it obvious that the interlocking balance sheets that make up the Chinese economy had added what was effectively a highly “speculative” structure onto the way economic entities financed their operations.

This would sharply enhance growth rates during the expansion phase, but at the expense of sub-par performance once conditions reverse. The process is actually quite easy to describe, and the fact that it caught nearly the entire community of analysts by surprise should indicate just how unfamiliar economists are with the approach championed by Minsky.

Ignoring the balance sheet framework does not always result in bad economics. When debt levels are low, and the economy close to the kind of Adam Smith described, in which there are no institutional constraints and no entities large or important enough to affect the system as a whole, it makes sense to ignore liabilities and to analyse an economy only from the asset side in order to understand and forecast growth. Evaluating only the asset side would still be conceptually wrong, because both sides of the balance sheet always matter, but the difference between analyses that ignore the liability side and analyses that incorporate the liability side are small enough to ignore.

When conditions change in certain ways, however, the differences can become too large to ignore. The more deeply unbalanced an economy, the higher its debt levels, or the more highly systematically distorted its balance sheets, the more the two forecasts will diverge and the more urgent it is that economists incorporate the balance sheet in their analyses.

In the early 1990s, the models that most economists used to analyse and explain Chinese economic growth were good enough. By the late 1990s, however, the sheer extent of bad debt within the banking system should have provided a warning that mismatches and imbalances might have become large enough to invalidate the old models. They clearly did invalidate the old models over the next few years as credit misallocation accelerated, along with the depth and direction of now-unprecedented imbalances and highly self-reinforcing price changes in commodities, real estate, stock markets, and other variables – what George Soros might have cited as extreme cases of reflexivity.

Violating Identities

To get back to the discussion, a very brisk and active debate broke out among a number of readers over Keen’s claim that next period growth is a function of both this period’s economic conditions as well as this period’s change in debt. Part of the disagreements has to do with whether Keen’s dynamic model, which incorporates changes in debt, and implies that the accounting identities I use are somehow invalid.

I don’t know if Keen actually rejects the identity, but I doubt that he does because he is too good a mathematician not to know that identities cannot be “accepted” or “rejected” like hypotheses or models. More generally, I would never say that I am using this (or any other) identity as the basis for my research, because the point of research is to test hypotheses. You cannot “test” accounting identities, however, because they are not hypothetical. They are true either by definition or as a logical necessity, and there is no chance that they can be wrong.

The important point about accounting identities is that they do not prove anything, nor do they create any knowledge or insight. Instead, they frame reality by limiting the number of logically possible hypotheses. Statements that violate the identities are self-contradictory and can be safely rejected.

Accounting identities are useful, in other words, in the same way that logic or arithmetic is useful. The relevant identities make it easier to recognise and identify assumptions that are explicitly or implicitly part of any model, and this is a far more useful quality than it might at first seem. Aside from false precision, my biggest criticism of the way economists use complex math models is that they too often fail to identify the assumptions implicit in the models they are using.

While economists tolerate models that are not constrained by accounting identities because, for some reason, economists do not seem constrained by the need for their models of the economy to conform to reality. Remembering always to maintain accounting identities does not lead to true statements or to brilliant insights, but it does make it easy to reject a very large class of false or muddled statements. Just as logic doesn’t create science, but it prevents us from making bad science, identities do not create models, but they protect us from useless models.

Keynes, who besides being one of the most intelligent people of the 20th century was also so ferociously logical that he was almost certainly incapable of making a logical mistake or of forgetting accounting identities. Not everyone appreciated his logic. For example, his also-brilliant contemporary, Ralph Hawtrey, was “sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships,” according to FTC economist David Glasner whose gem of a blog Uneasy Money is dedicated to reviving interest in the work of Ralph Hawtrey. In a recent entry Glasner quotes Hawtrey:

“[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment and saving are necessarily equal. That proposition Mr Keynes never really establishes; he evades the necessity by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr Keynes’s vocabulary.”

This is a very typical criticism of certain kinds of logical thinking in economics, and of course it misses the point because Keynes is not arguing from definition. It is certainly true that “identity so established cannot prove anything”, if by that we mean creating or supporting a hypothesis, but Keynes does not use identities to prove any creation. He uses them for at least two reasons. First, because accounting identities cannot be violated and second, even when accounting identities have not been explicitly violated, by identifying the relevant identities we can make explicit the sometimes very fuzzy assumptions that are implicit to the model an analyst is using, and focus the discussion, appropriately, on these assumptions.

No Surpluses on Capital and Current Accounts

A case in point is The Economic Consequences of the Peace, the heart of whose argument rests on one of those accounting identities that are both obvious and easily ignored. When Keynes wrote the book, several members of the Entente – dominated by England, France, and the United States – were determined to force Germany to make reparations payments that were extraordinarily high relative to the economy’s productive capacity. They also demanded, especially France, conditions that would protect them from Germany’s export prowess (including the expropriation of coal mines, trains, rails, and capital equipment) while they rebuilt their shattered manufacturing capacity and infrastructure.

The argument Keynes made in objecting to these policies demands was based on a very simple accounting identity, namely that the balance of payments for any country must balance, i.e. it must always add to zero. The various demands made by France, Belgium, England, and the other countries that had been ravaged by war were mutually contradictory when expressed in balance of payments terms, and if this wasn’t obvious to the former belligerents, it should be once they were reminded of the identity that required outflows to be perfectly matched by inflows.

If Germany had to make substantial reparation payments, Keynes explained, Germany’s capital account would tend towards a massive deficit. The accounting identity made clear that there were only three possible ways that together could resolve the capital account imbalance. First, Germany could draw down against its gold supply, liquidate its foreign assets, and sell domestic assets to foreigners, including art, real estate, and factories. The problem here was that Germany simply did not have anywhere near enough gold or transferable assets left after it had paid for the war, and it was hard to imagine any sustainable way of liquidating real estate. This option was always a non-starter.

Second, Germany could run massive current account surpluses to match the reparations payments. The obvious problem here, of course, was that this was unacceptable to the belligerents, especially France, because it meant that German manufacturing would displace their own, both at home and among their export clients. Finally, Germany could borrow every year an amount equal to its annual capital and current account deficits. For a few years during the heyday of the 1920s bubble, Germany was able to do just that, borrowing more than half of its reparation payments from the US markets, but much of this borrowing occurred because the great hyperinflation of the early 1920s had wiped out the country’s debt burden. But as German debt grew once again after the hyperinflation, so did the reluctance to continue to fund reparations payments. It should have been obvious anyway that American banks would never accept funding the full amount of the reparations bill.

What the Entente wanted, in other words, required an unrealistic resolution of the need to balance inflows and outflows. Keynes resorted to accounting identities not to generate a model of reparations, but rather to show that the existing model implicit in the negotiations was contradictory. The identity should have made it clear that because of assumptions about what Germany could and couldn’t do, the global economy in the 1920s was being built around a set of imbalances whose smooth resolution required a set of circumstances that were either logically inconsistent or unsustainable. For that reason, they would necessarily be resolved in a very disruptive way, one that required out of arithmetical necessity a substantial number of sovereign defaults. Of course this is what happened.

From Then to Now

The same kind of exercise eight-five years later, shortly after the euro crisis, made it clear that Europe was limited by similar accounting identities to three options. First, Germany could reflate domestic demand by enough to exceed the consequent increase in its domestic production of goods and services by at least 4-5% of GDP, and probably more (i.e. it had to run a current account deficit). Second, peripheral Europe could tolerate excruciatingly high unemployment for at least a decade, and probably more.

Third, peripheral Europe could leave the euro and restructure its debt with substantial debt forgiveness – or, which is nearly the same, force Germany to leave the euro, which would require much less debt forgiveness – causing losses in the German banking system at the same time that it caused Germany’s manufacturing sector to drop precipitously – a fourth option, that Europe could run huge surpluses with the rest of the world, perhaps two times or more than its current surplus, was too implausible to consider, and although Europe is certainly running irresponsibly high surpluses, they are not high enough to allow Europe to grow. So far Europe has chosen the second option, with a high probability, in my opinion, that before the end of the decade it will be forced into the third.

This is why we must keep accounting identities firmly in mind.

Creating Demand Out of Thin Air

Banks can fund investment by creating debt out of thin air. This statement is either highly confused or it too easily leads others into confusion. There is a related form of this question that often seems to come out of the MMT (modern monetary theory) framework, although I have no idea if this is a misreading of MMT or if it is fundamental to the theory, but while banks can create debt, they do not automatically create additional demand. According to MMT, as I understand it, there is no limit to fiscal deficits because governments who control the creation of money can repay all obligations regardless of their taxing capacity simply by monetising the debt.

A lot of people seem to think that this means the state can create demand out of thin air, and so demand created by the state can be added to existing demand with no other change, including no increase in savings. If savings and investment had previously balanced, according to this argument, and the state creates new demand, either this new demand is in the form of investment, in which case investment becomes greater than savings, or the new demand is in the form of consumption, in which case savings is reduced, and so once again investment exceeds savings.

This seems like a perfectly logical argument, except that it is perfectly impossible. For reasons that I will explain in the appendix to this essay, to say that investment is greater than savings is to say that the total amount of goods and services we produce is greater than the total amount of goods and services we produce, and that cannot be true.

So where is the flaw in the argument? It turns out that thanks to these same identities it is pretty easy logically to work out the flaw, and in fact to extend this process of working it out to show – and maybe this is contrary to what MMT implies – that there most certainly are limits to fiscal deficits, and that the state’s ability to monetise its debt does not mean that it can borrow indefinitely without, eventually, destroying the economy and undermining the credibility that allows it to borrow in the first place.

To work through the two different ways demand seems to be created, for convenience I will refer to the entity for whom demand is created out of thin air as Thin Air. Thin Air, in other words, is either the entity to whom the bank made a loan, or it is the government agency responsible for the deficit spending:

In the first case, assume that we are in an economy in which there is absolutely no slack. Workers are fully employed, inventories are just high enough to allow businesses to operate normally, factories are working at capacity, and infrastructure is fully used.

If Thin Air wants to spend money to buy goods and services, it must displace some other entity that is already using the goods and services that are being created by the economy, and it can only do so by bidding up the price of wages or resources. As a result, prices will rise, and these higher prices will reduce the real value of money.

Because higher prices reduce the total amount of goods and services that can be acquired with a fixed amount of money, every economic entity that is long monetary assets – assets such as money, deposits in the bank, bonds, or most expected payments, like wages, pension receipts, etc. – loses some amount of wealth equal to the reduction in the real value of these monetary assets. Everyone who is short monetary assets – anyone who has fixed obligations, for example a borrower, or an employer who owes wages, etc. – gains some amount of wealth. The losses of the former exceed the gains of the latter, with the balance representing a net transfer of wealth to the government or to the bank that created the loan for Thin Air.

The transfer need not occur only through inflation. In a financial system that is highly repressed, Thin Air’s actions might even be disinflationary. China’s case shows how. Until 2012, whenever credit was created by the system, it was done at extraordinarily low interest rates. These low rates represented a transfer of purchasing power from net savers, who were households for the most part. In that case the consequent growth in production exceeded the consequent growth in consumption (because it repressed household income growth) and so was disinflationary, but once again Thin Air’s spending represented a transfer because it simultaneously suppressed consumption.

Demand can only be created out of thin air, in either case, by suppressing consumption or investment elsewhere. At the moment the new demand is created, there is no change in the real value of GDP, although of course nominal GDP can rise or fall, depending on whether the transfer is inflationary or disinflationary.

Either way, if the suppressed demand consisted of investment, investment in the rest of the economy declined, whereas if it consisted of consumption, savings in the rest of the economy rose. This reduction in investment, or increase in savings, is the exact obverse of the increase in investment or consumption set off by the new demand created out of thin air, so that at no point is the identity between savings and investment ever violated.

In the second case, assume the other extreme, in which the economy has a tremendous amount of slack – there are plenty of unemployed workers who have all the skills we might need and can get to work at no cost, factories are operating at well below capacity and they can be mobilised at a flick of a switch, and there is enough unused infrastructure to satisfy any increase in economic activity.

In this case when loan creation or deficit spending creates demand out of thin air, it also creates its own supply. When Thin Air spends money to buy certain goods or services, those goods and services are automatically created by switching on the factory equipment and putting unemployed workers to work.

There is also a multiplier at work here. Assume that Thin Air’s spending is for investment, and that it plans to acquire $100 of goods and services for investment purposes. Because it has no need to build capacity or acquire inventory, the full expenditures will go towards paying wages. Let us further assume that the newly hired workers save one-quarter of their income.

As Thin Air pays wages, the workers will spend 75% of those wages on their own consumption, and they will save 25%. Their own consumption will require the production of additional goods and services, which will require hiring more workers. In order that Thin Air acquire $100 of goods and services, it can easily be shown that the total expenditures of Thin Air and of consuming workers will be the original $100 divided by the 25% savings rate, so that in the end GDP will rise by $400, consisting of $300 additional consumption and $100 additional investment. Because the increase in GDP exceeds the increase in consumption by $100, total savings will have risen by $100.

In an economy with enough slack to absorb Thin Air’s investment fully, in other words, the investment creates enough of a boost in the total production of goods and services that it becomes self-financing – it increases savings by the same amount as it increases investment. Notice then, once again, that at no point is the identity between savings and investment ever violated.


In reality no economy will ever have zero slack, as in the first case, or full slack, as in the second, but instead will exist in some combination of the two.

An important point that is often obscured by the intensely political discussion about savings is that in the second case, in which the demand created by Thin Air creates its own supply, it turns out that the lower the savings rate, the more GDP is created by any additional spending unleashed by Thin Air. Savings automatically rises to fund investment by causing the total amount of additional goods and services produced to rise by more than the total amount of additional goods and services consumed, with the difference between the two, savings, rising by exactly enough to fund Thin Air’s investment.

What this exercise shows, among other things, is that in an economy working at full capacity, a higher savings rate is likely to increase GDP by more than a lower savings rate, whereas in an economy operating with a considerable amount of slack, a lower savings rate is likely to increase GDP more. What this also shows is that in an economy that has recently experienced a crisis, with falling output to below capacity, there is a tendency for households to raise their savings rate, and because of the multiplier, as they increase their savings rate they reinforce the downward trend in the economy.

In the first case, the monetarist’s world, if Thin Air’s demand is invested in a project that increases productivity by more than the reduction in productivity caused by the transfer of wealth, it is sustainable. Otherwise it is not. If Thin Air suppresses consumption to fund productive investment, it will always lead to higher growth. If Thin Air suppresses productive investment to fund consumption, it will always lead to lower growth.

If Thin Air suppresses private sector investment to fund investment, it becomes a little more complicated, and depends on which of the two “investments” is more productive. Because monetarists usually do not believe that government can ever choose investment projects that are more productive than the market can, they would argue that if Thin Air were a government agency engaged in deficit spending, GDP growth would be reduced, because more productive investment by the private sector was suppressed in favour of less productive investment by Thin Air.

There are however many cases of highly productive investment that the government directed in the past which the private sector was unlikely to have initiated. Today, with the private sector unwilling to fund much productive investment because of weak demand, much private sector investment consists of buying assets, which is not productive. In countries that have weak infrastructure, if Thin Air, whether a government entity or a government-encouraged entity, were to build infrastructure, it would almost certainly lead to higher growth.

In the second case, the structuralist’s world, as long as there is enough slack in the economy that the new demand causes an increase in output that is equal to the sum of new demand and the marginal cost of new output, it is sustainable. Otherwise we eventually revert to the first case.

Monetarists always insist that if the government is to spend money, it should not be in the form of deficit spending. The expenditure should be fully funded by tax increases. Notice, however, that in the first case, expenditures are fully funded by tax increases, but this tax consists of the inflation tax. The monetarists argue that deficit spending, aside from reducing overall productivity, is inherently inflationary and increases economic uncertainty by undermining the stability of money. This is likely to be true the closer we are to an economy that resembles the first case.

Enter China

Finally, one of the stranger and more incoherent arguments used by China bulls to propose that China’s large and soaring debt burden doesn’t matter is that China owes the money to itself. In that case why not simply monetise or socialise the debt, as MMT seems to suggest? One of the reasons is that in a world without an infinite amount of slack, monetising the debt is no different than paying taxes, except that the tax is borne by those who are long on monetary assets, i.e. Chinese households.

If China were to monetise the debt, which is effectively what it did in the past decade to resolve the enormous amounts of bad debt it had accumulated in the 1990s, this would simply reduce the household share of GDP and with it the household consumption share. Put differently, it would force up the savings rate, which is the opposite of what China needs to do if it is to limit the growth of its debt burden. And notice that, as the savings rate rises, growth drops through the declining multiplier as the GDP impact of Thin Air’s activities increases the savings rate.

This exercise shows that fiscal deficits or credit creation are good for the economy when there is enough slack that Thin Air’s expenditures do not suppress investment or consumption elsewhere in the economy, and they are good for the economy if and when Thin Air’s spending is more productive than private sector spending. Otherwise they are bad for the economy and are not sustainable.

But we already knew that. Supply-siders have explained why it is the case in a well-functioning economy, and Keynesians have explained why it is the case when the economy is operating far below capacity.

Savings Equal Investment

While defining investment and saving as different names for the same thing might at first glance seem a useless exercise, in fact, it is a rich way of understanding the links among national economies within the global economy as a single system. Savings can be defined in a number of ways, but the most useful way is to define the supply of all the goods and services an economic entity produces in any period as consisting of two things. The first is everything currently consumed, including things that are lost, thrown away, or that rot away to nothing. What is left and stored for future use is savings.

The intuition is fairly obvious: everything that the economy produces is either currently consumed or set aside for future consumption.

Supply is equal to demand (another accounting identity), so that we can restate the accounting identity by saying that the demand for everything produced is either the demand for stuff we currently want to consume, or for stuff that we want to use in the future. We call the latter investment.

We might find it useful to further distinguish between two kinds of investment. One, which we might call an increase in inventory, consists of taking some of the goods we consume and storing them for later consumption. The other consists of goods and services that we cannot directly consume, but we produce them anyway because they might help us produce even more goods and services for us to consume in the future. If we produce a hammer or a tractor, we will probably never want to consume either. Rather these can help us produce even more goods and services in the future.

Because the supply of all the goods and services an economy produces is equal to the demand for all the goods and services that an economy produces, then as long as we are consistent in our definition of consumption, it is true by definition that investment is equal to savings. This is only the case, of course, in a closed system, like the global economy. In an open system, like a country, investment and savings are rarely equal, but the sum of the excess of savings over investment in some countries and of the excess of investment over savings in others must always equal zero – another accounting identity.

This is just a way of saying that all the current account or trade surpluses in the world must add up to the same number as all of the current account or trade deficits. Because savings and investment must always balance, the idea that the savings rate in any country is determined at home is nonsense. In countries that intervene heavily in trade and capital flows, this is almost true, but in countries that do not, like the US, the truth is almost completely the opposite. The US does not determine its own savings rate, and cannot as long as it allows unlimited access by foreigners to its asset markets. Knowing the accounting identities would have made this very clear.

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