Home > Uncategorized > The monetary core of the Famous Fama Fallacy

The monetary core of the Famous Fama Fallacy

I finally read the famous blog in which Eugene Fama, at the moment hyped as a future receiver of the economics Nobel, commits the ‘ex ante/ex post’ fallacy. What is this fallacy? An example: ex post (after the facts), total expenditure (as defined in the national accounts) is necessarily equal to total production (including change in inventories, an involuntary increase in unsold inventories is classified as an investment and therewith as ‘saving’, i.e. not-consumption. Note that re-classifying the purchase of cars by households as an investment instead of consumption will rise the level of investment as well as the level of saving!). Whatever – the ex post accounting identities do not in any way imply that the nominal or ‘real’ level of expenditure and production are set ex ante. The amount of water entering the Netherlands via the Rhine is equal to the amount leaving Germany – but the level of the Rhine can change. According to Fama, however, the level is pre-ordained, though it may take another course, as the amount of money (water) is fixed. Is he right about this? No. At least not according to the people who estimate the amount of money (picture 1). The green lines in picture 1 show what’s defined as ‘money’ by the statisticians of the ECB, the arrows show how the amount of money can increase or decrease. Clearly, when banks create credit the amount of money increases, while the same thing holds when households change part of their long term savings into deposit-money (happens a lot, these days). This definition of money is not beyond criticism but the great advantage of this system is that it shows that money is not some kind of good created by the government or the central bank but something created by us (by emitting debt and with a little help from the MFI’s).

Picture one: money in the Eurozone, billions, MFI’s are Monetary financial Institutions i.e. banks which are allowed to create legal tender.  


Fama clearly doesn’t understand this and his implicit concept of money smacks of ‘the cash in advance’ idea. The what? According to Wikipedia (as always a reliable source for ‘received folly’) the cash in advance idea (people carry around money because they need it to pay) is a hypothesis used by economists to explain away the awkward fact that the ‘most basic’ mainstream models do not have a place for money:

“The cash-in-advance constraint … is an idea used in economic theory to capture monetary phenomena. In the most basic economic models (such as the Walras model or the Arrow-Debreu model) there is no role for money, as these models are not sufficiently detailed to consider how people pay for goods, other than to say everyone has a budget constraint. To be able to say anything about the money supply, inflation or monetary policy and so on, economists must therefore introduce additional assumptions into their models. One possibility, and the more popular one, is to introduce a cash-in-advance constraint i.e. a requirement that each consumer or firm must have sufficient cash available before they can buy goods. An alternative assumption would be a ‘Money-in-the-Utility-Function’ assumption, which states that people have a tendency to hold a certain amount of cash because they derive utility from holding it. Without these (or similar) assumptions economic theory would find it difficult to explain why people carry around a good (money) which takes up space in their wallet, can’t be consumed and does not earn any interest.”

What’s wrong with that? Well, according to Hellwig, who wrote a supposedly very neo-classical PH. D. thesis (which I did not read) about this but then wrote an article (which I did read) in which he also asked  ‘where do monies come from’ had to state:

While the previous section discussed the existence and uniqueness of a fiat money Cash-in-Advance equilibrium as an evolutionarily stable steady-state, it does not consider the emergence of fiat money. Existing search-theoretic models also remain silent about this questions, since they consider steady-state equilibria, where fiat objects have been around forever in the past, and are valued, because they are expected to be valued forever into the future. The purpose of this section is to illustrate how fiat money may come into circulation in a ”free banking” equilibrium, and to further discuss the conditions under which a fiat object becomes a generally accepted medium of exchange. For this purpose, I adapt the model by enabling intermediaries to issue debt certificates on which they promise to pay a unit of physical goods in the future” (emphasis added)

Right. Fama is sticking to a theory which is based upon a concept of money which excludes the genesis of money, which as he takes the model at face value leads him to state that the amount of money can’t change. Well, we all make mistakes. But an economist who makes mistakes which are pointed out in introductory macroeconomic textbooks (In my case: Korteweg and Keesing, ‘Het moderne geldwezen’, part 1 (Groningen 1978)) and does not repent does not deserve a Nobel. Not even the economics one.

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  1. December 10, 2012 at 2:31 pm | #1

    Note that all these numbers are in units of money value. If the value of the units is zero (which it is if in any of the listed forms are not objects of value but merely references to such values) then the balance still holds. The fact that legislators allow banks to assert it has value to which they have a right doesn’t mean that it has.

  2. December 10, 2012 at 6:54 pm | #2

    Money is created as a specific debt to a specific bank to be repaid at a specific time. Savings are the same “money” indefinitely withheld from the original borrower that created it. This “money” is unavailable to be earned unless it has first been borrowed into circulation.

    Assuming the original borrower is competent, the debt that created the money will be paid off with money taken from some other loan’s principal, either new money creation, or re-lending of existing money (savings).

    As long as the savings remain lent rather than spent, there will be TWO DEBTS OF THE SAME PRINCIPAL, creating a perpetual debt that can never be eliminated nor even shrink by a penny without causing mathematically inevitable defaults.

    How about this for a radical hypothesis?
    Savings are the CAUSE of the disastrous instability that economists can’t seem to explain.


  3. December 10, 2012 at 7:20 pm | #3

    if you read Milton Friedman’s Book on The Permanent Theory if Income — you will see that Milton defines savings as th purchase of any durable good — while consumption is the amount of utility obtained [consumed] from goods and services in this accounting period. If a good is durable then most of the utiles of utility gained from this durable will be “consumed” in future perods — and therefore the dusable is defined as “savings [of future utiles of satisfaction].

    As I point out on page 44 of my macro trextbook POSTKEYNESIAN MACROECONOMIC THEORY; SECOND EDITION [2011]

    “Friedman prides himself on not defining as consumption the purchase of currently produced durables such as ostentatious sports cars, mink coats, yachts, etc. Professor Friedman boasts that his taxonomy is superior to others because “much that one classified as consumption is reclassified as savings [ see page 28, of Friedman's book THE PERMERNANT THEROY OF INCOME [princton university press, 1957]

    When transitory (windfall) income is received Friedman suggests “Is not the windfall likely to be used for the purchase of durable goods?” [p.28 of Friedmann's book] If so then Friedman has validated his hypothesis that transitory income will (almost) always be ‘saved’ and not consumed. If a household suddenly recieved a large one-time windfall, how many additional nondurables could the household purchase in the current accounting period?”

    Unfortunately no one reads my macroeconomic text and therefore understands how minstream theorists define their way into their conclusions!!

    Paul Davidson

    • merijnknibbe
      December 12, 2012 at 9:33 am | #4

      Fama in fact mixes up income, money and monetary expenditure. Friedman seems to mix up the use of goods with the purchasing of goods. Looking at how people use their stuff is recomendable (and VAT on all repair business should be lowered to 0% today in Europe) – but using stuff does not add to the circular flow of money. And jobs are paid with money… Weird that Friedman did not gauge this.

  4. Lucy Honeychurch
    December 10, 2012 at 9:17 pm | #5

    Nobel Prize for Fiction then? : )

    • December 13, 2012 at 12:18 am | #6

      How about:Justaluckyfool comments,”

      Ben Bernanke should receive the Noble Prize in Economics.

      Ben Bernanke has proven MMT.
      A Monetary Sovereignty can not run out of money for purchases of assets.
      Solid proof; QE 4-for as long as need and in what amount desired!!
      BUT justaluckyfool asks
      “A..” WHY NOT do it for the people ?
      B… Stop doing it solely to benefit the “Private For Profit Banks” (PFPB).
      Justa example: Purchase all residential real estate loans and modify them at 2% for 36 years. This would allow for stabilization of the housing and construction sectors, increase jobs and the bettering of all citizens. And at the same time raise revenue, lower taxes, and fund “for the general welfare. A simple solution; if $100 trillion is needed ,what happens ? all that it does is take away from the PFPB a revenue of $5.5 trillion a year and turns into into Income for the US Treasury.
      But , who is man enough to “free the servitude of the people” as it is the right of the people as stated in the 13th amendment.
      My God continue to bless America.
      May Ben Bernanke see this moment in history, and surely President Obama could place himself next to Lincoln in history. As Lincoln freed the slaves, Obama can free all the people from servitude.
      LIVE: Ben Bernanke Delivers Press Conference On Historic Fed Decision
      Listen closely.
      Like · · Share · about an hour ago ·

  5. sergio
    December 11, 2012 at 3:19 pm | #7

    This is so sad that for the last 200 years economics could not give clear answers to fundamental questions – what is money, wealth, value, price. That is why we have completely stupid vision that wealth is money, capital is money, gold/silver is money, value is price, money emerged as a gift, or as a debt, or to solve problems of barter. This is so primitive.
    But the task for economics remain and it is explain what is money and why they emerged. Those who can clearly explain this will explain how whole economic system works works. However, I cannot dismiss idea, that some people intentionally prevent us from answering those questions. Economics is full of nonsense rubbish ideas and models , which lead us away from fundamental questions.

    • December 12, 2012 at 11:00 pm | #8

      Economists rarely define what they are talking about and hence they do not understand what each other are saying. The subject is a muddle.

      • December 12, 2012 at 11:21 pm | #9

        How clear is what Frederick Soddy wrote in 1926,1933.
        Quote,”The Role Of Money”
        “Money now is the NOTHING you get for SOMETHING before you can get ANYTHING””
        Money is the distribution system of wealth of the sovereign society , which is all the goods and services of that sovereign society.
        Mr Krugman, Wray, Keen, Wm Black , Hudson and all others
        Please challenge this statement , so as to improve it.
        Thank You, for then we could go on to “a more perfect taxation, and even perhaps Job Guarantee).

      • December 12, 2012 at 11:50 pm | #10

        It is not a definition since there are many words such as “wealth” which may have many different meanings.

  6. Paul Davidson
    December 12, 2012 at 3:26 pm | #11

    Keynes gave a clear answer to what is money.

    Since all production and exchange activities are organized by legal monetary contracts between the buyers and sellers, — then money is that thing that the State determines discharges all contractual obligations.
    This is simply known as Chartalism — and is exactly what we all practice today. Bank money is money , though not legal tender, because it is a tap issue that the government guarantees is convertible into legal tender as long as the bank is under government rules and regulations.[ Notice the government in the US insures all deposits up to $250,000 — therefore assuring bank check drawn on your account is capable of being made a tap issue for legal tender.as long as you have a positive amount in your account — even if the bank goes under.

    • December 12, 2012 at 11:19 pm | #12

      According to you then, money is currency plus all guaranteed deposits (not all deposits). That is, the quantity of money is between M0 and M1? Bank credit can normally be used to settle transactions and is therefore widely confused with money, which has the additional property of “store of value” which credit is not (unless guaranteed).

      • December 13, 2012 at 1:39 am | #13

        Money is that thing that the State defines as the item that will discharge legal monetary contracts obligations. Not the word LEGAL. Thus it is up to the State to indicate what a LEGAL contract is and what will discharge all legal contracts. For it is the State that enforces legal contractual obligations.

        Now some may think tha this limits money to legal tender — but that is not correct because the tendering of a check [a sight draft drawn against a bank account] will discharge a contracual obligation since, the State agrees that valid checks will discharge a contract –as long as the one who gives the check has a sufficient sum in his sight draft bank deposit account.

        Don’t confuse Milton Friedman’s crazy M’s classification as meaningful. If you have a bank deposit saving account that has no checkability then it is not money and you must go to the bank to get them to give you a cashier’s check or legal gtender if you want to convert that savings deposit into money that can discharge a legal contractual commitment. Similarly with marketable equities, bonds, etc — where you must sell the financial asset to get money.

        Miilton’s classfication has to do with the degree of liquidity aslthough he does not recognize it.

        Paul Davidson

      • December 13, 2012 at 7:13 am | #14

        The problem with this argument, Paul, is that money has been around a lot longer than states and contracts.

      • merijnknibbe
        December 13, 2012 at 9:11 am | #15

        About money and the state: I might send you to the very recent Ph. D. of Pit Dehing, ‘Geld in Amsterdam’ or ‘ Money in Amsterdam’, about the history of the Amsterdam ‘ Wisselbank’ (exchange bank). Though money indeed preceded this bank (established in 1609) and even preceded Amsterdam, it does show that the government of Amsterdam (dominated by large merchants) had a lively interest in a dependable, simple system of (100|% metal backed) deposit money, which was more stable than all the bewildering variety of coins of different alloy. This was the bankguilder of 20 stuivers (which had a sightly different exchange rate than the coin of 20 stuivers) and which served as the unit of account in the entire Netherlands and even parts of Germany (for instance in all kinds of commercial contracts). At the same time this government enacted (creditor centered) changes in the bankruptcy laws to facilitate effective and efficient enforcement of contracts. The point: modern (!) money is backed by the state, in different ways. Not coincidentally, the wisselbank was located inside the county hall of Amsterdam.

      • December 13, 2012 at 12:09 pm | #16

        The PhD sounds extraordinarily interesting, Merijn. So old money was gold, i.e. a conveniently portable, non-aging commodity for wholesale barter and not exactly created out of thin air. My point is that a token for that is not at all the same thing. And on what constitutes such tokens (as against what they are taken to mean, as in Paul’s argument) I would argue that like water has four phases (ice, liquid, steam and ions) so does money (numbers in bank accounts, title deeds/shares, insurances/derivatives and a little currency). That’s fact, not what bankers assert and lawyers tell you to believe.

  7. sergio
    December 13, 2012 at 5:31 pm | #17

    This is so sad that even now, in the 21st century, not only ordinary people, but economists believe that money existed before state (and contracts); that money were invented by people to solve inconveniences of barter, that people were giving gifts each other every day, so they decided to substitute gifts with money; that gold is the best form of money ever existed. This is so sad that people continue to believe in these tales.
    I just want you to ask yourself couple of questions:
    If money existed before state, why would people invent state? If people could create money, why would they invent state?
    The role of the state is not only to enforce contracts, but in the very broadest meaning – is to reduce transaction cost. Just enormous transaction cost, which exist in reality. Creating a money by individuals requires enormous transaction cost. If individuals could create social phenomenon as “money” then that would mean that transaction cost is zero and therefore no need to invent state. Even going further, there would be no need to invent money. I am not even talking about what a huge transaction cost for individuals would be to service circulation of money. Individuals in a real world could not invent money without inventing state first. And the state invented money to perform its function to reducing transaction cost.
    Just imagine, that you live in a small community on inhabitant island. As this community is small it does not require medium of exchange, so people don’t know what is money, but suppose it is growing. Please, try to create money for that community, but without creating a state. Try to introduce gold/silver as money. Try to make people believe that gold is more valuable for life than bread. Quite problematic, right?
    Put it simply – money is the state and the state is money. And all modern problems started when – 1. Money were taken away from the state. 2 – Money were hijacked by bankers and state is hijacked by corporations. That divorce of money and state is the historical point when all modern economic problems began. Fiscal policy and monetary policy contradict each other, but they should not if we knew the origins of money and why do money exist.

  8. December 27, 2012 at 12:54 am | #18

    As Merijn also suggested, Sergio, it is irrelevant that money existed before a government (not the same as the State) sought to stabilise it in its modern form. The evidence from stone-age cultures shows that people DID use symbolic forms as tokens of mutual trust acknowledging a right to reciprocity at some future time, thus overcoming the disadvantage of barter that one has to know what one needs at the time of exchange; the potlatch culture of mutual giving expressed the same desire for mutual trust. Gold is the best form of money ever invented for those who wish to deceive the innocent or tax conquered peoples who cannot be trusted – or was until it became possible to assay its purity. And that is my answer to your first question, “If money existed before state, why would people invent state?”. The people who invented the state were not the 99% but the 1%. And “If people could create money, why would they invent state?” The people who first used money were not the same people who invented the State. Those were on the one hand pirates and conquerors seeking loot and tribute in easily transportable form like the gold women delight in for their ornaments; and on the other hand merchants like Chesterton’s wicked grocer, who “sells us sands of Araby/ As sugar for cash down”, and in due course the bankers, protecting gold from looters, who invented the scams of lending out tokens for other people’s gold at interest, then far more tokens generating far more interest than there was of other people’s gold, and in due course lent out tokens for other people’s tokens: fool’s gold “made out of thin air” with which to buy up other people’s real estate as a prelude to dispossessing its tenants. Warring kings may have adulterated gold to pay for wars, but they did also legitimately claim taxes to pay for their other roles, which after the suppression of the social functions of the Church along with seizure of its property eventally led to the creation of a State whose duties included welfare as well as warfare and the administration of justice. You are right but not accurate, Sergio, about the start of modern problems. Even before a puppet king was installed in Britain after a war paid for in Amsterdam bank notes, the root problem had long been Kings needing the means of performing their duties and the rich objecting to being taxed. Look up King John and the Magna Carta, 1215 a.d.

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