Latest revision:  October 26, 2021

An overview of the sixty page essay “A New Macroeconomics to explain Wealth Inequality”:

•   The major part of this summary describes the  “Fundamental monetary constraint” which is a major  foundation upon which the main essay is based.  It is deliberately repetitive to make the logic as clear  as possible.
• Part 1: Introductory description of Fundamental Monetary Constraint
• Part 2: Repeat of Part 1 with greater detail
• Part 3: Final summary of parts 1 and 2 as step by step process 
•  

Part 1: Introductory description of Monetary Constraint

 The problem: This new approach to macroeconomics begins by describing a very old problem inherent in a simple money system, which has the property of a fixed total number of money tokens, such as dollars, that are used to exchange goods/services between producers and consumers of economic goods.  In other words, a pretty normal money system. The essay first describes the problem caused by the “fundamental monetary constraint.”  As will be explained, the big problem resulting from that constraint is that a simple money system tends to reduce GDP when individuals save money in such an economy. This is equivalent to noting that two properties of money work at cross purposes (1) money is intended to be a method of quick and easy  exchange of goods/services among people, however  (2) Money can also be held out of circulation by some as saved “wealth” over potentially long periods of time which prevents it from being able to serve that necessary function.

Countervailing solutions: The next section of the essay describes important economic institutions that have been developed that try to neutralize the problem so that people who wish to have a way to save money without ruining the important function of money needed for exchanging goods/services. Those institutions act as countervailing forces, some of which are generated by government public policy, such as taxation used to purchase and deliver public goods to citizens, transfer payments such as social security and unemployment payments, as well as monetary and fiscal policy.  Possibly the most  important institution to help people’s ability to save is development of a loanable funds market, such as bank saving and bonds that allow people to save, yet avoids the negative effect on money when exchanging goods/services. The loanable funds market creates an alternative method of saving: instead of holding cash, savers loan their money to someone else to use, and so rather than cash, they hold savings as a written agreement for the money to be later returned. This allows money to remain transactional to maintain GDP.  This is an important additional method for how people can “save.”  Saving can be either saving cash, or it can mean holding an agreement to receive future cash that has been loaned.  The new macroeconomics shows that the effect of these two methods on the economy is considered to be quite different and important to distinguish from each other. In particular, this macroeconomics claims that if a minority of very wealthy people hold high amounts of cash as wealth, rather than for their transactions, that will reduce the effectiveness as cash for transactions, thus reducing GDP for an entire economy.  This likely happened during the 1930’s depression with high concentration of wealthy,  who held unusually high amounts of cash wealth because of (1) Low interest rates and (2) mistrust of other forms of financial wealth such as stocks and bonds.

Fundamental monetary constraint vs. countervailing solutions:  This macro claims that these countervailing forces can easily be understood as natural and even predictable responses to the problem caused by the fundamental monetary constraint when it is desirable to allow the possibility of “saving” wealth. Many contemporary macroeconomists who have not considered the effect of the fundamental monetary constraint have believed in an economy which rests in natural ideal equilibrium. However this new macroeconomics explains why a common “conventional” money system that allows “saving” of money is inherently unstable. This new view observes that countervailing forces have historically developed as a response to attempt to allow saving and maintain GDP, necessitated by the problem caused by the monetary constraint.

Side effects from the countervailing solutions: This macro shows that an effective economy needs public policy to properly balance these forces.  Noteworthy consequences (“side effects”) of the countervailing medicine are gradually rising nominal private and public debt, continual gradual inflation, that are often thought to be unfortunate but avoidable consequences in an economy. However this macro analysis predicts their occurrence, and sees them to be necessary to avoid even worse economic consequences of depressed GDP resulting from the fundamental monetary constraint if these compensating institutions were not making their influence felt.

Much later comes possible secular stagnation:  After extended time with savings imbalance and insufficient response from the countervailing institutions, overuse of loanable funds that was originally helpful to solve the problem eventually grows to overwhelm an economy with high debt which eventually suffocates it, resulting in a larger problem of falling GDP, unworkably large wealth inequality, and unworkably low interest rates. This could be described as a state of secular stagnation in which we find ourselves today, as well as describing the 1930’s depression.

Part 2:  Expanded reexplanation of Monetary Constraint

A simple description of the “fundamental monetary constraint.”  A money system is typically a set of money tokens, such as dollars that, importantly, have a constant total amount in an economy, or at least the total usually changes only very slowly. In the US that total was about $5 Trillion in 2020. The simplest way to understand the monetary constraint is that since the total money amount remains approximately the same, if one group increases their cash money holdings over time, some others must necessarily have reduced their cash holdings by an equal amount over the same time period.  Therefore saving cash money is a zero sum game. That may be very surprising, but this is just a simple, (seemingly historically unrealized)  mathematical fact being enforced by the way money works. The original intention for making money work in this way seems to have been to insure that every individual over an extended time needs to produce in value equal to what value they take, importantly, not more, not less.  That constraint has important consequence for an economy. Many might think this is an unimportant detail, but it has important consequences. (It does not mean that everyone’s income is the same.)

How the fundamental monetary constraint causes GDP to fall when people save:  If one group saves money for a prolonged period of time, money will gradually accumulate by that group.  Simultaneously the monetary constraint requires that an equal amount has been dissaved by others.  This already is an early sign for how wealth inequality can begin to establish itself in a simple money economy. The reduced amount of cash available to the “dissaving” group will eventually reduce how much they are able to spend in the economy, which reduces demand for the extra goods that the savers produced to earn their savings, which will reduce overall GDP. If the “savers” continually hold their cash money without spending it, they have essentially disabled this cash from being able to purchase goods and  services. This has the same economic effect for how the Fed  deliberately slows an economy through monetary policy by removing cash from an economy.

This view has been historically criticized as being heterodox by many economists who hold the dominant economic view. The only reason I can imagine for denying the previous logic regarding the money constraint is that it is a distasteful conclusion for those who hope that the economy is inherently well self regulated. It seems that it is easier to deny that such constraint exists, rather than advance a good argument for why it is not correct.  The strongest attraction for this “heterodox” view is that it so easily explains some otherwise puzzling observed economic facts, such as the long historical development of periodic recessions having simultaneous reduced GDP,  high unemployment and a “glut” of supply that indicates a lack of demand.  It also easily explains why public and private debt needs to rise, and why such debt seldom declines during periods when economies are otherwise working well.

Loanable funds market as an important solution: One institution that developed to fix the difficulty caused by saving money provided a way to recycle those non transactional “saved” dollars to people who can use them to again buy stuff to sustain GDP–most importantly to enable purchase of the extra value in goods/services that the “savers” produced, but which they did not consume in order to achieve their savings.  The loanable funds market allows the cash savers to convert their cash savings to bank loans or bond certificates while transferring their “saved” non transactional cash to those who will spend it and thus maintain GDP.  This method of “saving” benefits the economy, and usually also offers periodic interest payments to benefit the saver, which works well provided interest rates are not too low. I will soon explain other ways that have also historically evolved that also reduce the problem of saved cash which is not intended to be immediately spent and so reduces GDP.

Savings need not be only for investment to satisfy the purpose above: Some economists claim that savings must equal investments–in fact elementary macroeconomic textbooks often claim to “prove” that assertion with dubious mathematical logic. Obviously the analysis here has no such requirement.  Saving by loaning could be used for consumption or investment with equal benefit of sidestepping the problem of extra non transactional cash caused by the monetary constraint.  This is obvious in our economy, because, despite what some economists claim in theory, some do observably borrow other’s saved money to spend for a wedding, or go on a vacation.

 Examples of other institutions that have historically evolved that reduce the problem without causing the gradual reduction of GDP by the monetary constraint: loaning saved cash could completely solve the problem if savers of cash converted all their extra savings to the loanable funds to retain GDP. But there is no guarantee that will happen.  One possible cause is that if interest rates are extremely low, it would reduce motivation for savers to loan it to others. So other methods have also developed that resist allowing a large glut of “saved” cash in a monetary system, that could accumulate to cause decreased monetary velocity.

What would other institutions need to do to correct the negative effect of declining transactional cash caused by cash saving?  Ways have been developed to  reduce “lazy” cash money that is being held by those who have accumulated more than they want to spend.   Another equivalent way to describe money that becomes non transactional is to say that its monetary velocity has been reduced. Monetary velocity is a property of money that measures of how rapidly dollars are spent.  Three types of methods that maintain monetary velocity are: (1) recycle low velocity, “non transactional” cash back to higher velocity again. (2) Reduce the rate of cash flow into cash saving. (3) Enlarge the money system with new cash that is placed so that will be transactional.   Here are examples of those three types of institutions.

(Type 1) Recycle non transactional cash to transactional: The loanable funds market is the most important institution that has already been discussed. Cash holdings of savers are converted to a promise to receive future cash from borrowers which frees the money to be spent again. However a negative consequence is that there is a slow “trickle up” flow of interest that potentially reverses the process over a longer term. Fiscal policy spending is another important example. The government sells treasury bonds, typically to those of higher wealth who hold low velocity cash.  The money so obtained  is spent for public purposes.  A possible negative for this method is having to pay to redeem the bonds later when due which would reverse the benefit. For this reason, to be an effective long range solution public debt must ideally constantly increase in nominal dollar terms, so public debt does not have to ever flow backwards, which would reverse the original benefit. In practice, nominal public debt very rarely goes down.  Another method to avoid paying back is to build some inflation into an economy to somewhat neutralize the effect of interest that must be paid. Private debt is also useful.  A certain percentage (4%/year) of private debt typically defaults which avoids having to convert debt back to non transactional form.  This works with inflation to reduce the future need to pay back the full amount. It is particularly helpful when private debt increases.  Programs to pay back  debt, known as “austerity” almost always cause damage to an economy– reversing  the benefit which was achieved when these debts were incurred.

(Type 2)  Slow the flow of cash money into saving: Taxation of those of higher wealth or income who likely have savings is another method to transform non transactional cash to transactional public spending.  This is similar to fiscal policy, but has the advantage that the need to pay future interest or the principal back in the future is avoided. Government transfers such as unemployment insurance and social security take tax money which may be from a mixture of “saved” money and new income which is immediately transferred to recipients who will likely spend it as transactional money. Social security allows an alternate method of insuring adequate money during retirement that does not directly save money, but which avoids the need for actual saving and thus reduces the necessity to “save” for retirement.  Historically some recommended the benefit of the wealthy spending on luxury goods instead of saving. This was advocated by some centuries ago who encouraged the wealthy to spend on luxury goods so their money would truly “trickle down” to workers who would be the producers of such goods, but this practice was frowned upon by those of virtue who believed strongly in saving rather than spending.  An example of misuse of a tax policy which has frequently been recently justified  is to reduce taxes on the rich, which effectively takes money that could have been used for public spending that would otherwise increase GDP, and delivers such  transactional cash likely back to non transactional savings. The claim with neither evidence or logic, is that this money would “trickle down” to those in need to spend it.  This almost surely reduces instead of increasing monetary velocity, having negative effect on an economy.

Type 3 Increase total cash money: Monetary stimulus. The Fed can purchase treasury bonds or even other bonds for cash, introducing new cash into the economy as money.  For this to work interest rates must be above the level of the “lower bound for monetary policy effectiveness.”  Otherwise such cash is likely to be held in substitute for the bond as non transactional wealth, which apparently is what happened shortly after 2010 when interest rates were extremely low. The added money mainly went to low velocity savings, without the expected benefit of increased GDP.

Part 3:  Final summary (with math) of Monetary Constraint.

So, based on the above analysis a review of what are the implications for macroeconomic policy to maintain aggregate economic demand in balance with supply :  

1. Start by assuming a simple economic system with a fixed or only slowly changing total money supply, and which does not have a loanable funds market. Assume some savers hold $D dollars more in cash than a year ago. They therefore produced $D more goods/services over a year than they consumed. This requires “dissavers” that hold $D dollars less after one year than before. Dissavers produced $D less in goods/services over a year than they consumed.
2. Over a year there was a transfer of $D dollars from dissavers to savers. There was an opposite transfer of $D worth of goods/services from savers to dissavers.  Since savers intended not to spend $D in cash, that money was effectively taken out of circulation, reducing the effective amount of total cash money by $D, similar to what happens when the Fed removes $D cash from the transaction economy, thus reducing economic activity.
3. The $D dollars held by the savers is the amount needed by the dissavers to purchase the $D worth of extra goods produced by the savers. Since dissavers don’t possess that money, they need to reduce their cash savings by $D to purchase them.
4. If “savers” and “dissavers” exchanged roles every year, it is possible that there would be no long term problematic consequence.  However because high income people are most likely to be savers, and typically income is an attribute that tends to correlate with the same groups of people, “savers” and “dissavers” tend to continue their same habits over many years.
5. If the same savers continued saving for many years without a loanable funds market, the “dissavers” would eventually run out of saved money, and the money system would no longer provide an effective means of exchanging  goods/services.  A classic “recession” could occur having a glut of unsold goods made by the savers, reduced employment and reduced GDP.
6. With a loanable funds market such unfortunate consequence could be avoided; ideally savers could transfer $D cash money to  dissavers and in exchange savers could receive a promise to be paid back in the future.  Dissavers would gain $D in cash, and have $D additional in debt. Transactional cash for producing GDP would be restored to its original amount. This would unfortunately add $D total debt to an economy, and also add a small interest flow from debtor to saver–but which is necessary to persuade the “saver” to loan the extra cash.
7. But quite possibly the amount transferred by loanable funds would be insufficient because savers transferred less than $D, which would still leave some “saved” cash funds remaining in non transactional form.  In that case there could be other options provided by the “countervailing institution” of government fiscal policy or taxation.  The government could make up the difference from the loanable funds market by purchasing an extra amount  that was necessary to purchase of all extra goods.  Government would then equalize aggregate supply and demand, by taking cash from savers and play the role of “dissaver” to provide demand by spending it for public goods, which ideally would enable consumption of all the extra goods/services produced by the savers. There are two such ways: Fiscal policy: Sell treasury bonds to recapture “saved” money from sold bonds and use it to consume goods/services for public use, which would transform non transactional cash back to transactional form. Tax policy: Collect taxes from savers, which would be spent for public goods/services, which has the advantage of not leaving a future obligation to return public debt back to cash.  However to be effective for this purpose, tax needs to source non transactional money, such as taxing wealth or high income individuals. A misuse of this policy is to use general tax money which may be a mixture of transactional and non transactional cash to reduce taxes for the rich which likely would be saved, and therefore counterproductive.
8. Many people believe that fiscal policy, by selling bonds is merely a way to force people in the future (“our grandchildren”) to “pay for” government services spent now, by increasing national debt.  In fact since such fiscal money comes from presently sold bonds, it has already is “paid for” by money earned and held by those who purchase the bonds.  As an additional reason, since the monetary value of public debt virtually always goes up,  public debt is almost never paid back in monetary terms. The only way it goes down is when measured as percentage of GDP plus inflation, which sometimes rises faster than public debt.  Public debt serves as an important method for private savers to “save” without holding money–so total amount of public debt represents an equal amount of wealth for private bond holders. There is no way to get our grandchildren to “pay for” expenses in the present unless congress legalizes time travel, to bring our grandchildren into our work force now to do the work of improving our present infrastructure and providing medical service for present social security recipients.  Some might think that since since future interest rates could be higher, grandchildren will have to pay higher interest.  It is true that some grandchildren in the future may need to pay other grandchildren who own bonds interest on those bonds in the future. So it could possibly transfer wealth from one set of grandchildren to another, but the net effect on grandchildren will be zero.  It is economically unavoidable that all the services provided by present public spending done with bond sales has to be done by workers now, not ones born twenty years later.  That is, as long as Congress does not legalize time travel.
9.  The explanation so far shows why economies do not remain at a stable equilibrium.  As soon as people save more cash than they spend they lower monetary velocity, which if there are no compensating forces, velocity continues lower, thus lowering GDP.  Maintaining an economy in equilibrium depends on the ability of an economy to transform saved, non transactional money back to transactional.  I see no obvious mechanism that regulates the countervailing forces to get the economy back to where it began.  Intentional government policy seems to be usually necessary to balance aggregate supply and demand.
10. This is especially apparent if the amount of difference $D caused by saving gradually grows over time, for example due to greater productivity caused by increasing usage of robots for production rather than human labor.   As some who produce more goods/services and therefore develop higher income and save a larger percentage of income while others become redundant, the rate of transition from transactional and non transactional cash can grow faster, requiring greater compensation rate from the countervailing institutions. If the compensating policies do not increase, money velocity can reduce more rapidly, causing reduction in aggregate demand and greater inequality. This is an important form of instability to which the economy can be subject, and which I believe we have likely already experienced.
11. The above nine steps show how transactional cash can be re balanced to where it was one year ago.  However, if monetary velocity has become very low, as it presently is, and if low employment is apparent, government could usefully increase spending more than where it was a year ago, to increase demand and GDP.  This is a longer story which is told in the longer macroeconomic essay.

Over longer time a worse economic event can develop: Secular Stagnation: When total debt in an economy is not high, as described above, converting “cash saving” to debt allows others to spend money which others have saved. This originally helps the situation for an economy by converting lazy dollars into energetic ones that power GDP.  But of course this causes a continuous increase of both private and public debt. As this happens there are always critics who view the growth of more and more debt as  the result of irresponsible behavior by incautious lenders and imprudent borrowers. However although there could be some truth in that, the analysis of this essay shows why in successful economies in which saving takes place, debt always increases over time when an economy is doing well.

Problem for an economy as debt grows to high levels:  Debt as it accumulates represents the net amount of savings that have been accumulated by savers in the past.  Simultaneously an equal amount of debt has been accumulated by dissavers.  As savings increase this represents increasing difference in wealth between previous “savers” vs “dissavers” and so is a measure of wealth inequality between these groups. High debt burdens an economy by the need to pay increasing interest which represents a transfer from debtors to savers, which reduces GDP and becomes more highly burdensome on the economy. As debt becomes higher some may declare the necessity for “austerity” to pay down such debt.   However it is also difficult to pay off, because paying off debt has the opposite effect of converting transactional cash back to non transactional cash, essentially reversing the original economic benefit gained by its former increase. Economist Richard Koo has described this as a cause of a “balance sheet recession.”  As debt rises it becomes more difficult to find credit worthy borrowers.  As wealth grows among the creditors they have more money to lend, which causes interest rates to go down because the supply of loanable funds rises while the credit ratings for potential borrowers goes down. More people get crowded out at the bottom income/wealth strata. As debt increases the risk of defaults rises. This demonstrates how “secular stagnation” can strangle an economy.

The modern Fed comes to the rescue:  Although widespread debt default usually causes great economic trauma among creditors it serves an important function of reducing the problem caused by extreme wealth inequality. When debt looks unlikely to be repaid, those who have bonds can suddenly want to sell them, which can rapidly reduce bond prices, causing a “financial crisis.”  This causes an increased desire to hold cash in lieu of risky bonds, especially when bond interest is very low and insufficient to compensate for higher risk.  A present day situation when the total bond market  value is much higher than total M1 cash, this can increase pressure to hold cash as wealth rather than risky bonds.  That can take cash out of circulation as people attempt to sell bonds and hold cash instead tending to reduce monetary velocity, hence GDP. I believe the same happened in 1929 when the stock market crashed, in which during a short period of time total stock market capitalization decreased by about the same total value of M1.  As that happened, there was strong incentive to convert stocks to cash–after which cash was being held as wealth at much lower velocity which had strong tendency to reduce GDP.  The same happened when banks collapsed causing more reason to hold cash, further reducing velocity.  I believe that the Fed is acting somewhat as an “insurer” of treasury bonds and Mortgage Backed Securities by purchasing these–perhaps wanting to be the FDIC for bondholders and stockholders–with the objective of preventing panic from those holding such debt–which could result in panic selling with a disastrous financial crash. It’s hard for me to imagine a successful end game for that strategy.

The new macro more effectively explains:

1. Why the “fundamental monetary constraint” easily explains what causes recessions, which all have similar characteristics: lots of (unsold) goods available to sell with weak demand for purchasing such goods. Some economic participants have plenty of money while others simultaneously lack sufficient money to purchase goods and who also experience high unemployment.
2. Why the “fundamental monetary constraint” produces a high amount of “credit” (money) supply simultaneously with many customers for that credit.  This explains the easy growth of both public and private debt.
3. Why the worst recessions/depressions occur when interest rates get stuck low because of wealth inequality—as likely happened in 1930 and is happening now after 2010.
4. Why a little inflation is common and “normal” and is necessary to tamp down wealth extremes in an economy.
5. Why “successful” economies easily develop greater wealth inequality over time. How such wealth inequality when it becomes extreme can ruin economies.
6. Why private and public nominal debt always rise (rarely fall) over time.
7. How the 1929 stock market crash started the depression, which differs from most economists who believe that the crash was not causal, but coincident with it.
8. Why low interest rates cause low velocity and therefore low GDP

Aspects of the economy that are described differently from traditional macroeconomics:

1. Present macro assumes one agent—who represents all the participants at once. That obscures differences in income and wealth that exist among people in an actual economy. Some even discount the significance of debt, saying “we owe it to ourselves,” which is certainly true when there is only one agent that owes money to itself .
2. When discussing economic supply and demand, “demand” is often tacitly assumed to be “desire” or “want” or even “animal spirits.” The present analysis explains how the “fundamental constraint of money” is important to understand as having imortant influence on the success of an economy.
3. This macroeconomics notes recognizes that although holding cash, loanable funds, stocks and physical assests are all types of “saving,” each has quite different macroeconomic effects.  The effect of “savings” depends on what kind they are
4. Present macro asserts that Investment must equal Savings. The new analysis does not assume this; one person’s saving can be used for another’s consumption. This claimed equality is often used by “supply siders” to wrongly claim that investment must occur if savings are increased—by tax cuts to the rich in many cases, which nevertheless manage to get saved without “investment” in a meaningful sense that would increase greater productivity.
5. Conventional macro makes government special, by showing “taxes” as negative income, and implies “government spending” as special—taxes taking away income, often being perceived as only a negative force to an economy–that taxes should always be reduced.  Tax expenditures need to be judged on the same basis as non governmental  expenses–is the positive benefit justified by the cost?
6. Monetary velocity is a number that can be defined for an entire economy, but also for every subgroup within that economy. People with high wealth or income have velocities that are lower than others, and thus can reduce GDP for an economy.