A "point debt" down at the bowling alley

Extending the bowling alley analogy about how money is made and managed.

I enjoyed an essay/book by Warren Mosler, one of the advocates of MMT, the modern form of Keynesianism. Especially the point he made about the government making money pretty much the same way a bowling alley makes points .. they just make them up! (using a few rules, of course). So I thought I would try to extend this to model some more aspects of the monetary system such as banks, inflation, unemployment, and more.

Image a bowling alley, where people come to enjoy themselves and get points for doing so. At the outset, the only worth those points have is reputational- we take pleasure in winning and knowing we have won, and want to know our bowling/social status vs other people.

The point system is rather rigid. Points are created and awarded for certain accomplishments, then disappear uselessly after the game of ten frames ends. So while the alley might provide the service of tallying up and presenting the points won after every frame, the players themselves might whip them out of thin air just as easily.

This part is reminiscent of the way banking used to work. Before the federal reserve system, banks, and even individuals, used to make up their own currency, in the form of "notes" or IOUs, also called notes of hand in the case of individuals. In the 1800's, banks created their own notes, which were sort of a hybrid between bonds and currency. The Federal government first issued its own paper notes "greenbacks" only in 1861. All these were passed around, and since the banks promised to redeem them for gold, they functioned as currency, as long as the issuing bank was solvent. Thus started the tradition of banks taking super-secure names like First National Trust, and so forth, to hide the phenomenal danger they pose to customers as well as to the larger monetary system.

Bank. In this case the architecturally amazing National Farmer's Bank of Owatonna, Minnesota.

Gold was the great common denominator, so just as in the bowling alley case, once one knew how much gold one had (or how many pins one had knocked down), one knew how many dollars (or points) one had as well. It all seemed very easy, at least until the proceeds from a massive gold rush caused inflation, or foreign exchange problems caused other fluctuations, or people agitated for silver to be added to a "bimetallic" system because there wasn't enough gold to back the amount of currency needed (the so-called "cross of gold"), etc. ... Rest assured that our current floating, fiat currency system is far easier to manage!

Now let's switch gears and regard the bowling alley as something closer to a fiat currency system, where the alley generates points as it sees fit based on the health of the bowling economy. Let us also imagine that bowlers pay up front in points (not in dollars) to participate (renting shoes, balls, lanes, etc.). If they win more than they paid, they come out ahead and can save their points (minus a cut for the alley- more on that below). But if not, woe to them! The alley casts them into the dark depths and makes them oil the machinery that sets up the pins!

Let's also imagine a middle tier of bowling bankers, who sit outside the front door with desks, lamps, and green eyeshades, lending points to people who come along, after reviewing their past bowling scores and satisfying themselves that those customers will likely come out with more points than they were loaned going in. The alley lends these bankers a few points to start with- say, 10% of what the bankers plan to lend out. But the bankers get to make up the rest of the points as they go along, and if they make a string of bad loans, then a lot of customers will find themselves in the back of the alley, shining gear boxes, the bank will be out of business, the alley will be out its set of base points, fewer customers will be able to come in, and a lot of points will have gone up in smoke.

(Note that the sidewalk bankers make up points out of thin air just as the alley itself does. Only the rule is that they have to have a capital base of points of some fraction of what they are lending out. The points they create are just as good as those from the alley itself, and when the credit crash comes, those points evaporate as bowlers default and the banks go out of business when their losses exceed their capital base. Leverage like this is extremely fragile to adverse shocks, or to plain mismanagement.)

Obviously, that is where we find ourselves today. Due to lax regulation, short-termism, fraud, a race to the bottom of underwriting standards, etc.. the banking system overextended itself, and we are left holding the bag, both for the specific banks, and for the ailing economy as a whole. The deepest effect is that a huge amount of money has gone up in smoke, causing fewer customers to come in the front door to bowl (reduced demand). Now that the alley has fewer customers it will shutter some of its lanes and fire some of its employees, (unemployment), and there are more customers working menial jobs in the back, buffing the pins to a high shine (i.e. debtors are defaulting and going in to backruptcy and poverty at high rates, twiddling their thumbs, doing nothing productive).

Note that nothing real has happened, however. There are still just as many people who might like to bowl, they bowl just as well as they did before, (for some time, at least), and just as many alleys are there for them if they could get in the door. What has changed is that there is shortage of point-tokens due to the collapse of the sidewalk bankers, which led to contraction of the bowling economy.

What can the alley do? One solution is to save the bowling bankers from their self-immolation, set them up with extra points and beg them to lend again. But those who are left are scared out of their wits. They blew it big-time, and now only lend to championship bowlers who can prove statistically that they bowl >250 at least half the time. Not only that, but with some lanes temporarily closed down, (this being a very small town), several alley employees, who were being paid in points, are out of work and don't come themselves to bowl any more. They are depressed!

Something else needs to be done or the alley will have lanes closed for a very long time. It should be obvious that the quickest solution is for the alley to create and directly distribute enough extra points so that more customers start coming in again, replacing the points that went down the drain during the banker's crisis. The alley can create as many points as it likes- they are intrinsically worthless, after all. Their only purpose is to facilitate the joy of bowling that is now deficient.

But if it creates too many, then the alley will get too many customers coming in the door and too many bowlers who get in each other's way. The alley can't make more lanes, (in this scenario), so the extra points just let more people in the door to a lower-quality experience, essentially devaluing their points, which in the real world would be inflation. If the alley persisted in issuing more and more points, for whatever reason, they would create hyperinflation and essentially destroy the value of those points completely. Lines of people with plenty of points to "spend" would form outside and never get in at all!

From the bowling alley's perspective, it needs to keep just the right level of points in the system- too few, and not enough people come in the enjoy the lanes. Too many, and the points themselves become devalued, even worthless. While it was convenient for the bowling alley to use sidewalk bankers to extend points on credit to prospective customers and not take those risks itself, that system blew up in its face, with the result that it had to mop up the bankers's losses and also extend points itself to deal with the drop in bowling customers. One wonders- why have bankers at all, if they are such remarkably dangerous entities in such a system? Will the alley keep its bankers on a much shorter leash in the future, perhaps requiring 20% or even 100% capital backing? That is a question for another day.

What of all the points that have been created? Hasn't the bowling alley run up some kind of "point debt"? Not at all. Our bowling alley didn't have to get its points "from" anywhere. It just made them up. The government makes our money in just the same way, crediting and debiting electronic accounts. But one thing our government does do differently is sell public debt. Why is that? One reason is that there is a law about it, saying that if the government spends more than revenue, it has to issue debt for the difference. This is a mostly artificial system with little point, other than to hand out money to rich people who buy such bonds (in the form of future interest). It is also a relic of the gold-standard days.

The other reason is that some of this debt is essential for monetary policy & management. It helps to "drain" excess money from the system, provide a savings vehicle for the public, and set interest rates. Since that drained money only turns into the only slightly less liquid form of bonds, the functional difference isn't great, but those bonds do serve the important role of setting interest rates at various terms. Our bowlers don't think of the future, though, so no interest rates there.

Will the "point debt" have to be "repaid"? Let's assume for the moment that the bowling alley puts out a series of point-based bonds to be bought by rich bowlers who give the alley their old points in return. The alley does have to keep making small payments to the bond holders over the life of the bonds, which means making up yet a few more points over the ones they have already made up. No problem there, of course. Inflation is the only risk, can be continuously managed by a vigilant alley, and is minor considering the scale of these payments.

When these bonds come due, the alley could pay out made-up points, creating more real points in the private sphere, which could lead to point inflation. Or, it could keep issuing new bonds to replace the ones expiring. It all depends on the conditions at the time, whether inflationary or deflationary. The alley never has a problem controlling the point economy, achieving its goals of keeping the point values stable and keeping people coming to the alley at an optimal rate. The "point debt" just expresses the net position of the alley as it manages its balance of point tokens with respect to the public at large, who may have a lot of points saved up with the alley in the form of bonds.

As these bond holders age and bowl less proficiently, they will draw down their point savings to keep bowling into their golden years. The alley doesn't have to worry about "repaying" these points from some internal point vault, but does have to manage the overall level of points across the point economy. If needed, it can just make them up, or extinguish them, as needed. Its only worry is managing the current system, which, while it can be whipsawed by banking catastrophes and demand fluctuations, is ultimately manageable by the alley's point creation and extinction ability ... if it has the courage and insight to do so.

(Extinction happens through various forms of leakage, like people dying with unbequeathed points hidden in their mattresses, a fee taken off the top of shoe rentals that is not paid back out in earned points (i.e. taxes), and people using points to buy high-tech bowling balls from China, which seems to enjoy piling up bowling alley points, for reasons that are not entirely clear. The shoe taxes are not imposed to "pay the point debt", but to drain points from the economy so that a flood of points converted from savings to spending doesn't cause inflation.)

Note that the austerity response to our bowling alley depression would be to close more lanes and "tighten our belts", waiting for those bankers out front to smoke some weed and lower their cortisol levels to the point that they resume lending as normal. After all, if the customers are stuck in a depressed state, cutting point coupons from the local paper, shouldn't the bowling alley likewise tighten more, firing more workers and closing more lanes?

Unfortunately, the bankers under even this scenario have no rational incentive to lend to quite the level they did before, since they are facing poorer customers with less "point" collateral and forced to present more accurate bowling history documents, who, when they go in to bowl, tend to get lower scores and fewer points because they are out of practice (i.e. commercial bank customers have lowered economic prospects due to the general recession). The credit system alone will not and can not bring the system back to the happy days of yore. Austerity is the road to continued point penury and under-utilization of our bowling prowess!

But that all depends on what our goals were in running the bowling alley. I assume that the goal was not the piling up of points, (since they are ultimately worthless), but the enjoyment of bowling. I also assume that the goal was not to teach bowlers a lesson about Personal Point Responsibility by imposing bowling austerity due to a breakdown in the sidewalk credit system, thence consigning many to the pointless depths of the vast pin-collecting machinery. Nor was it to reduce wages at the bowling alley by making its workers more insecure. The ultimate cause of the crisis, after all, was lax lending leading to insolvency of the sidewalk bankers. Their customers doubtless grabbed more points than they were good for, but the fault was very much shared by their lenders, not to mention their regulators. Nor certainly was the fragility of the larger system their fault at all.

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• Bill Mitchell quote of the week:

"In other words, Summers advised the President to allow unemployment to sky-rocket but to do just enough to prevent a depression (catastrophic failure). Fiscal policy didn’t fail in the US. It just wasn’t given a chance to work when it should have been. Had the US government introduced a $US1.2 trillion stimulus and relied on multipliers to fill the identified $US2 trillion output gap things would have been very different and the job losses would have been less."

Keynes lives!

Why Milton Friedman was wrong, and Keynes was right.

Fiscal or monetary, that is the question. Milton Friedman insisted that monetary stimulus alone could solve recessions and depressions. That is to say, the Fed fiddling with interest rates and bank reserve requirements could correct any macroeconomic bubble fallout and liquidity problems. Paul Krugman wrote a fine article laying this argument to rest, since in the current crisis, (and in Japan's of the 90's), interest rates are at zero, yet deflation and other dislocations still threaten. However he did not really delve into why a fiscal stimulus can do what free money to the banks can not. (A slate guy tried to, though).

Meanwhile, David Brooks decides that since he has no understanding of fiscal policy, the whole thing is very risky and shouldn't be attempted (in the hallowed tradition of doubt mongering on tobacco, climate change, etc.). And the Cato institute puts out the ever-helpful advice that what would fix the current economic problem is a large dose of tax cuts.

With all the years and brains devoted to economics since the great depression, one would have thought that more was learned. Indeed, more has been learned, but media megaphones are usually held by those who have other interests than the pursuit of disinterested economic theory. I am no economist, so once again, caveat emptor!

We find ourselves in an odd place. A massive credit bubble has collapsed, slicing values of assets, loan portfolios, loan collateral, and investments of many sorts to fractions of their former bid-up values. The musical chairs of greater-fool (and unregulated) investing has ended, with substantially fewer chairs than players. The prospects of many kinds of future cash/investment flows has suddenly declined, inducing a whiplash effect on the banks that deal in future-denominated assets (i.e. credit). All that free money on loan from the Fed is filling craters that used to be shiny assets but now turn out to be hockey pucks, or, though the magic of leverage, craters of debt.

So the Cato guy is right- funnelling free money to the banks (and even buying up their stock to provide capital) is not going to force them to lend- not in declining economic times when the next shoe to drop may be their own. The banks play a key role in the system, and monetary policy is essential to keep banks solvent, preventing total collapse, and for setting the stage for economic recovery. But it is not enough if lending is not yet attractive, either due to the wounds already inflicted by the collapse, or due to the lack of positive growth prospects.

Monetary policy alone is enough for many things, like slaying inflation, and mild recession balancing. But deflationary spirals appear to be beyond its reach. Banks and other major investors have fled to safety- specifically, to the safety of T-bills, and that is the key to the conundrum. Banks can clear a small profit from investing their zero-rate Fed money at T-bill rates, and any other investor interested in safety goes there as well. So the government ends up with vast amounts of low-interest money siphoned from the economy. What to do with it?

The obvious answer is to recycle it back into the economy, through a stimulus package like the ones being contemplated currently. The point of monetary policy, after all, is to maintain economic activity, especially jobs, so that the tender flame of money flowing around the economy does not sputter and go out. If the banks won't step up to the plate and the government is seeing a glut of cautious investment dollars coming its way, then it simply has to employ those dollars to give the flame a bit more fuel. Of course, if the government spends the money (as it would in a stimulus) instead of lending it (as the Fed does), then it is setting up future generations to pay back all those T-bill holders in the form of taxes.

That is where the theory of a stimulus gets interesting. The ability of future generations to repay all this money is going to depend on whether they end up better off (i.e. more productive) than we are today. If they are, then repayment will be a piece of cake. If not, they may be faced with currency devaluation or inflation as round-about ways of reneging it. The money thus should ideally take the form of investments that serve the common good in economically beneficial ways, especially in the long term. Usually, this kind of allocation is best left to private parties (forgetting for the moment the monumental short-sightedness demonstrated by our management culture in both the dot-com and finance bubbles), but now, of course, willy nilly, this decision is up to the government.

Let's consider a few different uses of the stimulus:

1. Tax breaks, as per the Cato guy. This has the virtue of leaving the decision of how to invest the money with private citizens. Unfortunately, among the rich, the money is quite likely to end up in T-bills or their equivalent once again ... not a productive use of the money at all, either short term or long term. At the lower end of the income spectrum, the extra money is likely to be spent rapidly, which is indeed good in the short term, since it would fuel the flame of economic activity in a generic way. But it would not constitute any kind of productive investment, especially if used towards the basic needs of food and gas that are likely targets. This kind of spending will maintain the economy, but productive investment must change the economy.

Incidentally, we do not know quite how stimulated the economy should be. If it was overheated and inflated two years ago, and if it is depressed and sagging today, where is the happy mean? That is a delicate question, indicating that the stimulus should be kept to a fraction (like 1/4) of the total wealth lost in this downturn. Economists probably have decent ideas about it, however. One sure-fire measure is the unemployment rate. Below is another measure, part of a Taylor rule presentation, courtesy of a treasure trove of economic data at the St. Louis Federal Reserve.

2. Foreclosure amelioration. Plummeting conditions in the real estate market underlie much of the current pain. Banks do not know how much their loans are worth, builders do not know when they will ever be able to get back to business, and wealth continues to evaporate. It would do a great deal of short-term good to prop up the mortgage industry with renegotiations and refinancing, as is being done now with voluntary programs with the banks and breathtakingly low interest rates. But this is dangerous as well, since we do not know what the natural level of the real estate market should be. If the government takes over loans that later slip further under water, what have we gained? Not much. And the unfairness of helping the most profligate mortgage holders while responsible holders get left paying the taxes to clean up the mess is also quite unattractive.

One idea is to develop incentives that encourage banks to resolve foreclosures by transforming them into market-rate rentals rather than evicting and selling at extremely steep losses. The flood of foreclosures is the worst kind of panic selling that hurts everyone- banks, householders, and the economy. The government could use HUD, or another agency along the lines of Fannie Mae to buy up titles to such properties and manage them, for eventual sale when the market improves.

3. Specific projects. Stimulus money would ideally to go into economically beneficial investments, like targeted education, power grid upgrades, green technology, research, broadband upgrades, and health system upgrades. The record of government direct investment is decidedly mixed. It brought us the internet and the highway system, but also the boondoggles of synfuels, hydrogen cars, the space shuttle, and nuclear power. Government tends not to do well in big projects, but can effectively broker small projects, as is done by the peer review system that has been such a stellar method of resource allocation at the NIH.

I'd like to see at least part of the stimulus go to small grants awarded rapidly on a peer reviewed basis on the broadest range of topics, from the arts to green technology to social policy development. Let a thousand flowers bloom, and perhaps a new internet will take root.

These investments will help shape the economy that will remain after the economic crisis is over. Short-term thinking is not useful, and over-allocation to any one sector (like research, for instance) would create unsustainable growth leading to retrenchment later on. Thus we will be shaping consciously what the future will look like, anticipating what the market will do once the current crisis, and the government participation it has called forth, leave the stage.

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Incidentally, we might ask whether we even want economic growth!

• Later link- Krugman narrates the same story, summer 2009.