Understanding Leverage

 In response to Coffee with Stephanie Kelton
UMM = Understanding Modern Money (Buy on Amazon)
NFA=Net Financial Assets
HPM =High Power Money
JWM = JW Mason
LRW = L. Randall Wray

Does anyone else find it ridiculous that so many think Stephanie was actually making a bet about 2016. This is all DeLong putting words in her mouth when all she’s saying is that QE doesn’t allow the pvt sector to deleverage and has no transmission mechanism aside from stimulating spending more out of current income through borrowing or asset price bubbles. There’s quite obviously no bet that the economy won’t be doing better by 2016. As Dan says, there’s all sorts of reasons why the economy might do better by then. And we’ve always saudi that we can increase Nfa the easy way or the hard way; by 2016 the hard way plus very low interest rates might have gotten us to the point that the economy’s moving at a good pace and businesses are ready to invest again. Along the way the collateral damage has been excessive and even immoral, but there’s no MMTer that doesnt think that’s a serious possibility.

Explaining Leverage:

Leverage actually has more than one meaning in finance–go look at a text book. I teach financial mgmt, investments, financial institutions, and it’s ubiquitous throughout in different senses.

In financial mgmt, leverage is the ratio of total assets to total equity. It’s a key part of the Du Pont expansion of return on assets and return on equity. Every textbook has it. This is one of the senses in which leverage is used in MMT to discuss using horizontal to leverage vertical. Horizontal money and vertical money are both assets for the non-govt sector, but only vertical is net equity. This is not a value statement about which is better–that always depends on context even though some think we are only about vertical (apparently they’ve never seen Randy’s first book on credit money)–just a fact.

There is also the sense of leverage as debt. The two are often used synonymously, though that’s a tad sloppy in my view (even though I’ve done that myself in the past).

There is also the sense of leverage as one’s position relative to funds invested (as when margin is used) or increasing one’s exposure to movements in prices. For instance, a bank has a natural short position in reserves–this means that it is negatively affected by an increase in their price (the federal funds rate) since banks must acquire them to settle payments or meet reserve requirements. As banks make loans and thus create deposits, they leverage this short position as they are increasing their exposure to movements in the price of reserve balances. This is how Randy intended “banks leverage reserve balances” in UMM.

When Marc Lavoie wrote his critique of MMT’s use of leverage, I responded via email and he acknowledged he was not familiar with the term “leverage” as used in financial management that I explained above.

Compatibility of Chartalist Vertical Money & Endogenous Money:
FWIW, I posted this comment in response to JW Mason at Matias’ site a few days ago. JWM was arguing a position much like that which Mark is arguing here. Might be of interest for helping to clear things up.

JWM–your misinterpretation of LRW there was common up to about 10 years ago. Since then, most everyone has come to understand that it was a far too literal one. As noted above, Lavoie and Parguez do understand this. At any rate, the key point is to recognize the paradigm LRW and Lerner build in terms of distinguishing b/n fiscal and monetary policy. In UMM, LRW sets monetary policy as accommodating the demand for reserves and setting an interest rate. Fiscal policy controls the qty of net financial assets–the national debt (obviously, this is somewhat endogenous through the automatic stabilizers). Given this division of labor, when there is a deficit the choice to issue bonds is part of setting the interest rate by draining reserves by monetary policy to accommodate the demand for reserves. For fiscal policy, it’s just about printing the money for spending, HPM or reserves in this case (since spending is by key strokes, the part of HPM changing is reserves, not currency). So, when LRW discusses changing HPM in UMM, he’s referring to a govt deficit, NOT a monetary aggregate in any sense like monetarists, new Keynesians, etc. Whether that deficit ends up as bonds instead of HPM is a separate monetary policy decision in UMM. So, we have changes to the deficit (changes to HPM) as exogenous (abstracting from automatic stabilizers) and the quantities of reserves (vs. bonds) and traditional monetary aggregates as endogenous (via the central bank and commercial banks, respectively). In the particular LRW quote you cite, he is simply saying that the non-govt sector desires to net save–i.e., a positive national debt–that’s it. Again, this has NOTHING to do with monetarism or similar views of money demand, the money multiplier model, exogenous control over monetary aggregates or HPM in the neoclassical sense, and the like. Hopefully this clears things up for you–we say things differently now (though the meaning has not changed) precisely because some of the terminology there confused people. It’s not uncommon for stuff like this to get hashed out after an important book is written and to determine that the same message and paradigm might be better understood if terminology is altered a bit.

And in response to this comment, I see Matias acknowledged that Chartlist vertical money is perfectly compatible with endogenous money.

Scott Fullwiler

HPM = High Powered Money, UMM = Understanding Modern Money, JWM = JW Mason, LRW = L. Randall Wray


“So you are using HPM and NFA to mean the same thing.”

Depends on how HPM was used in the sentence. The words “too” has different meanings depending on how it’s used in a sentence. If we’re just talking about the monetary base = HPM, then that’s obviously not the same as NFA. But if we’re talking about UMM in which Randy creates a paradigm with the particular division of labor b/n monetary and fiscal policy, then it could be depending on how the CB chooses to set its interest rate target. Traditionally this has not been the case, but if the CB were to set the target rate equal to IOR and there were no bonds issued or all were purchased by the CB, then NFA and HPM would be the same. NOte also that even then there is almost always a difference as a result of lending by the govt/cb to the non-govt sector, which raises HPM but not NFA.

“Don’t take offense, but why do you guys change the meanings of all these terms?”

None taken. Which term have we “changed the meaning” of? Can’t think of any. There’s nothing that I’ve written above for which any meanings have ever changed, for instance.

“It looks like a shifting of sand under your feet as time goes on and your argument evolves.”

Probably, to those that haven’t understood the argument. Usually those are people that have a difficult time disabusing themselves of the framework they started out in and so they aren’t interpreting MMT correctly. Happens all the time. The argument has NEVER “evolved.” The framing has evolved. BIG DIFFERENCE. I can’t tell you why so many do get it right off the bat and so many do not. It just happens. Again, that’s why the framing evolves–hopefully it gets easier to understand over time. People like Matias and Parguez get it now, but didn’t originally.

“I still don’t see how it matters though because the private sector’s ability to borrow is not a leverage from NFA. NFA might help stabilize private balance sheets to some degree, but that’s a different matter. There’s no leveraging (of any definition) going on here in the way that MMT builds centrality around it.”

So, when the private sector increases loans and thus bank deposits, the private sector’s total assets relative to its total net financial equity has not increased? Please explain that one, because that’s what you are arguing if you want to say “there’s no leveraging (of any definition).” Good luck.

Tom Hickey’s Version which Scott says is a better explanation:
Not exactly. HPM is reserves (banks’ rb at cb and vault cash) and currency in the hands of the public. Banks get reserves from deficit spending, which increase non-govt aggregate NFA and borrowing from the cb (which doesn’t alter NFA). Unless the discount window is used, banks put up tsys as collateral to borrow and tsys are NFA, so this is just a switch in composition of NFA. So, the bulk of HPM is NFA.

And I agree that a good explanation should not require further explaining.


Scott clarifies his answer:
Anyway, the point I was trying to make was that in UMM, Randy builds a paradigm with a division of labor with fiscal and monetary policies in which bond sales are the job of the CB, not the govt. Further, with the taxes drive money view, the spending comes first. So, again, in the UMM paradigm, deficits add directly to both NFA and HPM. If the CB sets its interest rate target by issuing bonds to drain reserves, then as it does this in response to a deficit, HPM will shrink while NFA will stay the same. If it sets its interst rate target via IOR instead, then NFA and HPM stay the same.

So, NFA and HPM might or might not be the same, depending on context. And we haven’t “changed the definition” of either one, only clarified the framing.

There! That’s a far better answer than the one I provided above, hopefully.

December 21, 2012

1 Response to Understanding Leverage

  1. kavita says:

    Thanks a lot. It is one of my assignment questiondifference between operating and financial leverage . finally, my search ends here.


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