March 09, 2004, 8:47 a.m.
The Debtor Nation, Revisited
A response to Prof. Brad DeLong.

Far too often, professional economists with the highest credentials make headlines with opinions, analysis, and ridicule that may satisfy their constituents, but unfortunately fly in the face of the causal and operational realities of today's monetary economics. Perhaps the latest example is J. Bradford Delong's (Harvard educated professor of economics at Berkeley) criticism of our analysis of the dynamics of the U.S. trade deficit.

In his "Why Is the National Review So Stupid?" DeLong, as is evident in his title, has injected arrogance in his argument from the outset. In the following analysis, however, we let that slide, and instead rebut DeLong's position on the trade deficit point by point with cold, hard analysis and logic. As you read this, you may want to revisit our argument on debtor nations and DeLong's response. We are hopeful that in the end you will share our concern as to what's being taught at the highest levels of academia.

DELONG: "In the English language, the entity that lends the money is the one that does the saving — the funding — holds the asset."

MOSLER & NUGENT: This analysis is not a question of the "English language." The causation is "loans create deposits," not the other way around. This relationship is taught in every first year "Money & Banking" course, and is a matter of accounting, not theory. The Federal Reserve Bank of Chicago has published a primer on this subject, Modern Money Mechanics. The Chicago Fed makes the process of bank-money creation clear: "Loans are made by crediting the borrower's account, i.e., by creating additional deposit money. This is the beginning of the deposit expansion process."

The basic economics textbook for the Chartered Financial Analysts program, "Economics, Private and Public Choice," by Gwartney and Stroup, describes the process: "Under a fractional reserve banking system, an increase in reserves will permit banks to extend additional loans and thereby create additional transaction (checking) deposits. Since transaction deposits are money, the extension of the additional loans expands the supply of money.'

In addition, readers can find a clear definition of this relationship in Understanding Modern Money, by L. Randall Wray, associate professor of Economics at the University of Denver. Professor Wray explains: "A loan is nothing more than an agreement by a bank to make payments now on the basis of a promise of the borrower to pay later. Loans represent payments the bank made for business, households and governments in exchange for their promises to make payments to the bank as some future date. All of this occurs on the balance sheets of banks; the money that is created by a bank is nothing more than a credit to another bank's balance sheet." In fact, every text we have seen says almost the exact same thing.

DELONG: "The German car company makes a deposit — that is lending to the bank."

MOSLER & NUGENT: No, the sequence of events is the opposite. The German car company receives a U.S. dollar deposit — a credit to its bank account — when the car it sells is paid for. Obviously, the bank advanced the funds to the consumer before the German car company received the deposit. In other words, the German car company doesn't begin with the bank deposit it ends up with it.

DELONG: "The bank, a financial intermediary, lends the money to the consumer."

MOSLER & NUGENT: Yes! The bank grants the consumer a loan. One way this is done is by giving the consumer a check for the amount of the loan, which he uses to pay the German car company. When the German car company deposits the check and it clears, assuming the car company uses the same bank, the bank then has both a loan to the buyer of the car and the deposit of the German car company on its books. If the car company uses a different bank, that bank is "long" fed funds and the other bank is "short" fed funds, and these banks find each other in the money markets and do a fed funds trade. At the end of the day, the banking system has created a new loan and a new deposit.

DELONG: "The German car company has thus indirectly funded the desire of the consumer to purchase."

MOSLER & NUGENT: Apparently, Delong is claiming that Americans are dependent on foreigners for the funding of our purchases of foreign goods, a message the media in general conveys almost daily. But that is not what happened in the example of the German car company. In fact, the German car company has provided the car in exchange for the bank deposit.

The idea that the process starts with the banking system holding deposits and then lending them out is a throwback to "loanable funds" theories that prevailed under fixed exchange rates, and are at best not applicable. Under a fixed exchange rate policy, like a gold standard, banks are at risk of depositors withdrawing their deposits and exercising their right to actual convertible currency. The quantity of real convertible currency issued by the government is limited to the size of the gold stock in the case of a gold standard or the reserve currency in the case of a fixed exchange rate. The availability of reserves therefore constrains bank lending, as insufficient reserves for withdrawal demands cause the bank to fail.

With a floating exchange-rate policy bank lending is not constrained by reserve availability. The government of issue stands by to lend banks actual currency in the case of customer withdrawals, and the government is unconstrained by the need for reserves as the currency is not convertible into gold (or another currency) at the Fed.

DELONG'S CONCLUSION: "If I were anyone who wrote for National Review on any other topic, I would be yelling and screaming at the editors to institute some quality control in their 'economics' writing. For stupidity has a way of leaking across pages, and their reputations are harmed as well when the stupidity quotient exceeds the level at which the alarm bells start to ring."

MOSLER & NUGENT: Unfortunately, the general tenor of Professor Delong's diatribe seems to be characteristic of many economists these days. They have acquired constructs divorced from the operational and causal realities of today's central banking dynamics, and are passing them along to both their students and the general public.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc. Warren B .Mosler is associate fellow, Cambridge Centre for Economic and Public Policy, Department of Land Economy, University of Cambridge, Cambridge, U.K.