It seems like the debate on endogenous money has moved on to new ground with not just Krugman but Scott Sumner now saying pah – so what! Lets now hope that the debate moves on to a higher level.
refutes, in one fell swoop, the nonsense one hears about how said mechanics of bank lending change everything about the role banks play in the economy.
Whilst for Sumner
I get lots of commenters coming over here breathlessly telling me the wonderful news—it’s been discovered that banks don’t actually loan out reserves! How does one even respond to that sort of ferver? Now I have a simple answer; “it’s a simultaneous system.”
Indeed the debate over the causality of the monetary transmission mechanism has obscured a much older and deeper theoretical debate which I hope we can now return because it is has never been comprehensively resolved. Wray’s recent post saying the debate goes back to the banking/currency school debate telling as I had started a post saying similar.
the 1980s debate over “exogenous” versus “endogenous” money was in a sense a reprise of the Banking School-Currency School controversy of the early 19th century. The Banking School took the endogenous money side, while the Currency School was a precursor to Milton Friedman’s Monetarist exogenous money.
Before we start digging into the relevance of this economic history this lets consider where I think Krugman is coming from. To my mind both he and Sumner both are exhibiting the Woodfordian brand of monetarism which is now dominant, the only distinction in their assumed models is Krugman believes fiscal policy is needed at the ZLB and Sumner does not. What I think Krugman is implying is that given the MV=PT identity the ‘hot potatoness’ of money gets cold pretty quickly – using the bank portfolio justification of the Tobin paper – so unlike the Friedmanite fixed V assumption it rises but quickly falls. Money is neutral ‘in the long run’ but this happens swiftly. In Sumner’s view this period outside equilibrium is only short term, at equilibrium ‘its a simultaneous system’ again – so what. So you can still hold to the position that money is but a veil and banks are just intermediaries between lenders and borrowers. In this story Central Banks can still influence the level of prices by changing interest rates. Krugman has shifted in his explanation of this, no longer the textbook ‘money multiplier’ from Central Bank money to excess reserves, but instead the portfolio behaviour of banks changed (after Tobin) by changes to the fed funds rate, which then influences the extent to which account holders wish to hold cash or other assets.
(note: I don’t think Scott Fulwilers response that banks can rapidly cool the hot potato by putting excess reserves in Central Banks reserve accounts is helpful – isn’t Krugman’s point that the Potato gets quickly cold? In any event if there are profitable lending opportunities and they don’t have reserve of tier I capital constraints they wont and whatever the banks preferences the transmission mechanism will continue providing account holders have excess reserves and the receiving bank for the deposits finds itself with new liquidity enabling new profitable lending.)
Of course the blogosphere, such as Cullen Roche, has been coruscating that he hasn’t moved beyond money 101, referring to loans being created from reserves etc.. I think its too easy to dismiss this strand because of its sloppy terminology. That doesn’t logically mean his is theoretically wrong necessarily. Of course loans are not created from reserves – but Krugman is using an old definition of reserves, consider Bagehot. Bagehot in Lombard street made the distinction between ‘currency reserves’ and ‘banking reserves’ (The latter being the modern definition vault cash + central bank reserves, the latter being the liabilities of the bank towards depositers), whilst Krugman and most textbooks seem to be referring to the former, as do much of the writings of the great economists. This confusion leads to chaos when it becomes extended to thinking of ‘excess reserves’ without clarity in terms of excess of what. I have been guilty of this charge myself, picking up terminology from old textbooks when the endogenous theory was predominant. I apologise. I have not as some (such as the Positive Money website have accused me of) stated that loans can be created from reserves (banking reserves), that is impossible as money held as either vault cash or in central bank reserves must be accounting identity be money that is capital of the bank (assets or equity) and not liabilities – otherwise banks would be guilty of a Ponzi scheme. Loans can only be created from a transfer from the assets side of a balance sheet in cash, the registering of a liability and the creation of a new asset to reflect future repayments. ‘Currency Reserves’ (deposit liabilities) cannot be used to create loans whilst they remain on the left side of a balance sheets, however I like many endogenous money thinkers like Torrens, Davidson and Phillips (see this historical note by HumpreyHumpryHumpr) hold that the fractional reserve process is one where banks temporarily leverage the stock of their deposits as assets for lending providing they can satisfy the ex post accounting requirement for honouring liabilities. They ensure this by ensuring that the cash flow into the bank from loan repayments and new deposits is greater than the cash flow from the bank from honouring deposits (vault cash requirements). Indeed it was jewellers noticing that deposits held in their vaults could be leveraged in this way that led to the invention of modern (fractional reserve as opposed to full reserve) banking. So I don’t think Krugman’s terminology is the key issue, rather it relates to the issue of whether it matters that the large majority of money is today bank created (endogenous).
In the paper by Tobin Krugman refers to Tobin made a mistake, he realised in later writings. Steve Keen adds to the debate
Tobin the Younger imagined that newly created bank money could be taken out of the system in a form other than bank deposits or cash, Tobin the Elder realizes that those are the only two options at the systemic level. Individuals might get out of bank deposits into (say) gold, but to do so they transfer money from their deposits in one bank into the deposits of the gold dealer in another bank. The only way for money not to be held in a bank is for it to be converted into some other kind of asset that is not a bank liability first. The only candidate here is cash [my emphasis]
Tobin was repeating the ‘hot potato’ view of money. The term ‘hot potato’ was a colourful metaphor invented by Patinkin, referring to the cumulative process ideas of Wicksell. In fact the idea is much older and goes back to Henry Thornton in 1802. (Wicksell likely picked up the concept from the way Ricardo and JS Mill presented Thornton’s ideas in simplified form).
Tobin was presenting a ‘new view’ of money whereby instead of the old ‘loanable funds’ view of money where those with money lend to those without – and bank intermediate, rather banks intermediate between those with different portfolio preferences for leverage. The ‘hot potato’ view of money is that cash loses value, relative to other assets, because of inflation and (in times of growth) growth of capital, so those who hold cash quickly convert it to other assets or spend it if it is excess of their preferred ‘cash balance’. Ultimately people only hold cash because of the value of goods its can be used to purchase. Different kinds of asset have different ‘own rates’ if interest and so the velocity of circulation of those assets depends on these own rates. A shift in (real) interest rates will change the value of a portfolio between cash and other assets and may induce someone to hold more cash and demand loans by extending their leverage. This view I believe to be essentially correct and an advance on the earlier Cambridge Cash Balance/Liquidity Preference view of Keynes and his followers because it saw liquidity preference as a result of portfolio decisions caused by variance in rates of return within the portfolio and not a cause.
[note you will find some on the blogosphere notably Mike Sproul claiming that money is not a hot potato because for everyone getting rid of money there must be someone who desires it and who therefore must regard the potato as cold, this is unconvincing, the issue is one of velocity not single exchange and how hold long money is held as a cash balance before being spent on other assets].
For the younger Tobin then the hot potato of money gets cold very quickly, so the ‘long run’ of money neutrality arises quickly. For the Elder Tobin only liquidity preference can lead to changes in cash balances in the system as a whole. Therefore the hot potato gets cool much more slowly and therefore bank creation can have a much more lasting effect. For both Tobin’s however portfolio preferences were key.
But the hotness issue, which is really about the speed of return to a money equilibrium, is not the only issue at hand. The second and related issue is whether money creation itself affects the absolute price structure of the economy. This is why the old banking school/currency school debate is important. There were two issues at hand:
- What is it that gives money its value? – the value of assets which back it (the ‘backing theory’ also called the real bills doctrine first set out by John Law) held by the banking school, or the quantity of the assets which back it – the quantity theory held by the currency school
- What happens if there is excess money creation by banks? –the banking school held that excess money creation was impossible as if any individual held an excess cash balance that money would ‘reflux’ back to the bank – including from repayment of debts, the currency school held that the absolute level of prices would rise because the real bills doctrine imposed no limits in how much banks could issue and because the assets used to back up the currency would inflate.
The debate was not about whether money was endogenous – that was accepted on all sides – rather it was then about whether the banking system required an anchor to prevent inflation. This is why Wray’s view that exogenous money proponents are heirs to the currency school is simplistic. Rather the currency school were arguing, like modern endogenous money thinkers, that money was not simply a veil. For the currency school this was because it has real effects because the value of assets which backed money issue were nominated in money units.
If now it is accepted in all sides that money is endogenous it is time to return to this historic debate. Does money creation have real effects? I believe it does and I believe that both the banking and currency school were wrong. Put simply my approach is to consider what money when created is spend on. I intend to expand on this idea in a full paper with lots of math and diagrams but heres a flavour
Lets go back to the origins of the debate. Henry Thornton held that if the bank rate of interest was well below the prevailing rate of profit in an economy then money would be created to excess and this would be inflationary. Note this is not the Wicksellian explanation of the ‘cumulative process’ which relies on lending below a ‘natural rate’ of interest. Wicksells ideas were contaminated by Bohm-Berwick and his idea of natural rates of interest in a pure barter economy, this is untenable for as Sraffa pointed out there is no single ‘own’ rate or natural rate in a barter economy. Thornton’s original conception does not suffer from this flaw. Now in modern terms creating loans is not the only option available to banks, they can create other assets, banks hold portfolios like any other economic agent. So if the rate of interest is lower than the prevailing rate of profit then they will invest in other assets or if the prevailing rate of profit is negative may simply park reserves at a central bank. From our early lending power- required leverage model this will shrink the supply of lending power and so raise the interest rate back to the prevailing rate of profit. However if the banks are obtain money at a rate below the rate of profit they are presented with an arbitrage opportunity. Central Banks set interest rates for their own lending to banks (discount rates) and for interbank borrowing to maintain reserve requirements (federal funds rate in the states) and ensure that actual interbank market rates are the same as their set rates through open market operations such as purchasing bonds from banks. If a bank finds itself more liquid through having cash from selling a bond its level of reserves will be above its central bank reserve requirements – it has ‘excess reserves’. This is an asset to the bank, and a hot potato, it can keep it as a central bank deposit, invest it in securities or treat it as capital to expand its lending power. Note it does not require exogenous money creation per-se to purchase bank assets, merely the leveraging of a bank balance sheets. However it is much easier for a central bank to push down interest rates if it does so through money credited to its own balance sheets (such as through qe). If this is then used to buy securities and it is the same category of securities the central bank bought then this is price neutral. Therefore it is only possible for central bank operations to push prices up overall (as opposed to affecting price differential between different types of security) if the money is transmitted into extra lending, at times when profits in the economy are low this transmission mechanism is broken.
A lot of things have to happen on the way before an additional unit of credit affects prices.
a) It must not be saved
b) It must not be used to buy inventory in excess supply
c) It must be used for purchase of assets where scarcity rents can be charged, or;
d) If used for investment it must not be used to expand production where inputs are free goods
e) If used for investment it must be in an industry where there is a degree of monopoly rather than perfect competition
e) If not free goods and there is a degree if monopoly the holders of inputs must be able to charge scarcity rents on those factor inputs
Notice the points at which the process tree results in an increase in prices, at c and e, both involve spending on assets or non-produced means of production. In both cases the price is affected by the rent that the holder of the assets or the non-reproduced means of production can charge. For all other components the price reflects labour inputs only up till the marginal point at which labour is no longer scarce (full employment). So if interest rates plus risk and liquidity premiums is equal to the prevailing rate of profits then the labour theory of value holds because all components of price can be broken down into labour and rent, and rent can be broken down into labour, and the marginal opportunity cost of a unit of labour is equal to the value added. Once there is variation however been bank lending rates and the rate of profit this elegant relationship breaks down and the value created by capital goods is no longer equal to the value of labour embodied in it.
Imagine if all bank credit was spent solely on new production and not purchase of existing assets. Imagine too that no one was able to charge scarcity rents in non-reproduced means of production (only practical I think through taxing such rents, including scarcity rents on money). In this case an expansion of bank credit would not lead to inflation because credit creation would be exactly matched (assuming no malinvestment) by increased productive capacity. This approach is very Minskian because it makes a distinction between credit used for asset purchases and used for real investment.
Seen in this way inflation is always and everywhere a rental phenomenon, the ability to extract rent being a function of the inequality in the distribution of the resource, Any money created which does not attract rentals will stay in or reflux back to the banking system without affecting prices, any that does attract rentals will also reflux back until the non-rental components decline asymptotically to zero so they no longer affect prices. I think the key unresolved issue from this is whether this gravitates around an equilibrium or constantly under and overshoots creating a limit cycle – or likely the latter. Hence excessive credit creation for purposes of asset purchases drives the business cycle.
Notice how we have tackled Henry Thornton’s critique of John Laws Real Bills doctrine – the backing theory of money. Here money would be fully backed because it would be backed by real investment, not by speculative asset price increases, so the ‘numeraire’ effect of expansion of money would be fully compensated for by real growth. Of course if there were malinvestment that Thortons critique applies and the real bills dpoctine falls too because the value of assets backing money are inflated
I’m more and more wondering whether a formal process model of the monetary transmission process is needed (taking inspiration from Kahn/Kaldors model of the keynsian multiplier) which can account for all flows in the circuit. I hope to more fully set this out, including the necessary maths showing the relationship between V and P, in future posts. I also in future posts want to examine the classical arguments used against the real bills doctrine and to what extent they still hold in the light of this analysis.
Note: I don’t mean to imply here that central banks are the sole cause of business cycles and cost push has no role in inflation. Even with perfect central bank oversight from growth some real products will be in short supply, classically housing which is slow to respond to demand increases. This will create scarcity rents and increased demand for credit, which the central bank will be forced to accommodate. This is not money creation, is is not creating the addition units of account, banks do that, rather it is accommodating demand for additional units of exchange to accommodate demand to clear the units of account. Central banks are forced to operate in this manner to avoid a cash or credit crunch. The false idea that control of this ‘monetary base’ was possible was the idea behind monetarism’s assertion that inflation is always and everywhere a monetary phenomenon but monetary base control proved impossible in practice. In all cases inflation only bites because an ultimate scarcity of real resources causing a cost push.