Endogenous Money

During my little vacation recently from writing about monetary policy, it seems that there has been quite a dust-up about endogenous money in econo-blogosphere. It all started with a post by Steve Keen, an Australian economist of the post-Keynesian persuasion, in which he expounded at length the greatness of Hyman Minsky, the irrelevance of equilibrium to macroeconomic problems, the endogeneity of the money supply, and the critical importance of debt in explaining macroeconomic fluctuations. In making his argument, Keen used as a foil a paper by Krugman and Eggerston “Debt, Delevereging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach,” which he ridiculed for its excessive attachment to wrong-headed neoclassicism, as exemplified in the DSGE model in which Krugman and Eggerston conducted their analysis. I can’t help but note parenthetically that I was astounded by the following sentence in Keen’s post.

There are so many ways in which neoclassical economists misinterpret non-neoclassical thinkers like Fisher and Minsky that I could write a book on the topic.

No doubt that it would be a fascinating book, but what would be even more fascinating would be an, explanation of how Irving Fisher – yes, that Irving Fisher – could possibly be considered as anything other than a neo-classical economist.

At any rate, this assault did not go unnoticed by Dr. Krugman, who responded with evident annoyance on his blog, focusing in particular on the question whether a useful macroeconomic model requires an explicit model of the banking system, as Keen asserted, or whether a simple assumption that the monetary authority can exercise sufficient control over the banking system makes an explicit model of the banking sector unnecessary, as Krugman, following the analysis of the General Theory, asserted. Sorry, but I can’t resist making another parenthetical observation. Post-Keynesians, following Joan Robinson, rarely miss an opportunity to dismiss the IS-LM model as an inauthentic and misleading transformation of the richer analysis of the General Theory. Yet, the IS-LM model’s assumption of a fixed nominal quantity of money determined by the monetary authority was taken straight from the General Theory, a point made by, among others, Jacques Rueff in his 1948 critique of the General Theory and the liquidity-preference theory of interest, and by G.L.S. Shackle in his writings on Keynes, e.g., The Years of High Theory. Thus, in arguing for an endogenous model of the money supply, it is the anti-IS-LM post-Keynesians who are departing from Keynes’s analysis in the GT.

Krugman’s dismissive response to Keen, focusing on the endogeneity issue, elicited a stinging rejoinder, followed by several further rounds of heated argument. In the meantime, Nick Rowe joined the fray, writing at least three posts on the subject (1, 2, 3) generally siding with Krugman, as did Scott Fullwiler and Randall Wray, two leading lights of what has come to be known as Modern Monetary Theory (MMT), siding with Keen. Further discussion and commentary was provided by Steve Randy Waldman and Scott Sumner, and summaries by Edward Harrison, John Carney, Unlearning Economics, and Business Insider.

In reading through the voluminous posts, I found myself pulled in both directions. Some readers may recall that I got into a bit of a controversy with Nick Rowe some months back over the endogeneity issue, when Nick asserted that any increase in the quantity of bank money is a hot potato. Thus, if banks create more money than the public want to hold, the disequilibrium cannot be eliminated by a withdrawal of the excess money, rather the money must be passed from hand to hand, generating additional money income until the resulting increase in the demand to hold money eliminates the disequilibrium between the demand for money and the amount in existence. I argued that Nick had this all wrong, because banks can destroy, as well as create, money. Citing James Tobin’s classic article “Commercial Banks as Creators of Money,” I argued that responding to the interest-rate spreads between various lending and deposit rates, profit-maximizing banks have economic incentives to create only as much money as the public is willing to hold, no more and no less. Any disequilibrium between the amount of money in existence and the amount the public wants to hold can be eliminated either by a change (positive or negative) in the quantity of money or by a change in the deposit rates necessary to induce the pubic to hold the amount of money in existence.

The idea stressed by Keen, Fullwiler and Wray, that banks don’t lend out deposits and hold reserves against their deposits, but create deposits in the course of lending and hold reserves only insofar as reserves offer some pecuniary or non-pecuniary yield is an idea to which I fully subscribe. They think that the money multiplier is a nonsensical concept, and so do I. I was actually encouraged to see that Nick Rowe now appears willing to accept that this is the right way to think about how banks operate, and that because banks are committed to convert their liabilities into currency on demand, they cannot create more liabilities than the public is willing to hold unless they are prepared to suffer losses as a consequence.

But Keen, Fullwiler and Wray go a step further, which is to say that, since banks can create money out of thin air, there is no limit to their ability to create money. I don’t understand this point. Do they mean that banks are in a perpetual state of disequilibrium? I understand that they are uncomfortable with any notion of equilibrium, but all other profit-maximizing firms can be said to be subject to some limit, not necessarily a physical or quantitative limit, but an economic limit to their expansion. Tobin, in his classic article, was very clear that banks do not have an incentive to create unlimited quantities of deposits. At any moment, a bank must perceive that there is a point beyond which it would be unprofitable to expand (by making additional loans and creating additional deposits) its balance sheet further.

Fullwiler argues at length that it makes no sense to speak about reserves or currency as setting any sort of constraint on the expansion of the banking system, ridiculing the notion that any bank is prevented from expanding by an inability to obtain additional reserves or additional currency should it want to do so. But banks are not constrained by any quantitative limit; they are constrained by the economic environment in which they operate and the incentives associated with the goal of maximizing profit. And that goal depends critically on the current and expected future price level, and on current lending and deposit rates. The current and expected future price level are controlled (or, at least, one may coherently hypothesize that they are controlled) by the central bank which controls the quantity of currency and the monetary base. Fullwiler denies that the central bank can control the quantity of currency or the monetary base, because the central bank is obligated to accommodate any demand for currency and to provide sufficient reserves to ensure that the payment system does not break down. But in any highly organized, efficiently managed market, transactors are able to buy and sell as much as they want to at the prevailing market price.  So the mere fact that there are no frustrated demands for currency or reserves cannot prove that the central bank does not have the power to affect the value of currency. That would be like saying that the government could not affect the value of a domestically produced, internationally traded, commodity by applying a tariff on imports, but could do so only by imposing an import quota. Applying a tariff and imposing a quota are, in principle (with full knowledge of the relevant supply and demand curves), equivalent methods of raising the price of a commodity. However, in the absence of the requisite knowledge, if fluctuations in price would be more disruptive than fluctuations in quantity, the tariff is a better way to raise the price of the commodity than a numerical quota on imports.

So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level. The central bank may not be trying to target a particular quantity of currency or of the monetary base, but it can target a price level by varying its lending rate or by taking steps to vary the interbank overnight rate on bank reserves. This, it seems to me, is not very different from trying to control the domestic value of an imported commodity by setting a tariff on imports rather than controlling the quantity of imports directly.  Endogeneity of bank money does not necessarily mean that a central bank cannot control the price level.  If it can, I am not so sure that the post-Keynesian, MMT critique of more conventional macroeconomics is quite as powerful as they seem to think.

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55 Responses to “Endogenous Money”


  1. 1 Tas von Gleichen April 12, 2012 at 1:52 am

    I’m certainly not in favor of having banks creating money out of thin air. This should be controlled by some sort of gold standard. Balancing the currency supply with gold as its hedge.

  2. 2 Nick Rowe April 12, 2012 at 3:26 am

    Very good post David! Two minor points:

    1. I haven’t changed my views on the hot potato/disequilibrium money/contra you and James Tobin question. That little argument between you and me is still on! But for the sake of argument with the MMT guys, I would sometimes set aside my unorthodox insistence on that point, and argued a more standard New Keynesian position. There are enough things to disagree about without getting into disequilibrium hot potato money too.

    2. When some Post Keynesians talk about money being “endogenous”, I don’t think they mean what you and I might mean by that word (we mean “determined inside the model”). You and I (I think) would say that the stock of money is endogenous under e.g. inflation targeting, or fixed exchange rates, etc., and that the only case it is not endogenous is if the central bank follows the k% rule (or something similar).

  3. 3 ruggedegalitarianism April 12, 2012 at 5:24 am

    You lost me at the end David. I am not as familiar with Keen’s views as I am with MMT views, but I don’t think anyone doubts that bank lending is constrained by general economic conditions. MMTers argue constantly that what determined whether banks are expanding their lending or not is the demand for credit by qualified borrowers at interest rates that are profitable for the banks. And they argue that any influence that the Fed has over commercial bank borrowing is exerted through its influence on those interest rates. They argue that the Fed’s ability to induce more lending once interest rates are as low as they can reasonably go is thus very much constrained by the demand side of the equation, which it does not control, and cannot be overcome by injecting higher quantities of reserves into the system – and that this limiting phenomenon is independent of whether or not there is a liquidity trap. The point is that the inability to induce additional lending is not due to the fact that liquidity-hungry intermediaries are sopping up and hoarding reserves, but that the quantity of reserves makes no difference anyway except insofar as it influences the policy rate.

    However, I’m not sure what this implies about general control over the price level.

  4. 4 Bill Woolsey April 12, 2012 at 5:26 am

    David:

    Rowe is correct that the hot potato analysis applies to bank created money. It is simply not the case that banks must adjust the interest rates they pay on checkable deposits to get people to hold them. People do not refuse to sell products or assets becaues they would not want to hold larger balances in their checking accounts. They sell, anticipating a bigger balance in their checking account, intending to buy something else.

    You, however, are correct that if the process by which an excess supply of money (more spending on something or other) clears up, results in an increase in the demand for base money, then the redemption constraint does stop the process if we assume an excess supply of bank issued money.

    It isn’t that people are “getting rid” of excess money by destroying it, or even redeeming it. It is rather that more spending on assorting things results in a higher demand for base money.

    The relationship is not excactly two way. That is, higher demand for base money (due to growing nominal expendiutre, for example,) is constraining in a way that the opposite scenario is not. Banks can accumulate base money reserves. But this is a demand for base money reserves.

    I think control of base money, and redeemability of bank money, allows for determination of nominal expenditure. In equilibrium, banks do need to fund their loans. But in disequilibrium, the hot potato effect applies to privately issued money.

    One final puzzle. Any individual bank must always plan to fund loans. But the banking system does not need to fund loans. And so, no individual bank must really be able to fund loans. (That is, no bank can assume that everyone currently holding balances in the checkable deposits it issues is statisfied with the current deposit rate and is willing to hold that money. They may have an excess supply of deposits.) And yet, if monetary disequilibrium centered in banking impacts the demand for base money, the redeemability requirement implies that the banking system must fund loans.

  5. 5 Scott Fullwiler April 12, 2012 at 5:27 am

    Good post. Please note that in my post I was very clear that our position is that the CB can have some control but that this control is through price (i.e., the interest rate target) not through directly targeting quantity. From my original post:

    “Central banks stand ready to provide reserve balances at some price always. They can adjust this price up or down if they are concerned about the expansion of credit or monetary aggregates, and this increase in price can be passed onto borrowers who may then not want to borrow. But this means that the manner in which a central bank can exert control over credit expansion is indirectly through its interest rate target, not through direct control over the quantity of reserve balances.”

    Further, I was very clear that there is a profit maximizing decision by the bank:

    “If Bank A wants a more profitable loan but is not able to acquire deposits, it can raise the rate charged to Customer 1 and thereby preserve its spread, which can result in Customer 1 taking his/her business elsewhere. But it can still make the loan. In other words, it is not deposits or reserve balances that constrain lending, but rather a bank’s own choice to lend given the perceived profitability of a loan—which can be affected by the ability to obtain deposits after the loan is made—and also given a perceived creditworthy borrower (someone has to want to borrow, after all, if a loan is going to be made) and sufficient capital (since regulators will want the bank to hold equity against the loan).”

  6. 6 Kevin Donoghue April 12, 2012 at 6:14 am

    “… in arguing for an endogenous model of the money supply, it is the anti-IS-LM post-Keynesians who are departing from Keynes’s analysis in the GT.”

    Well, up to a point:

    “It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so. If the quantity of money is itself a function of the wage- and price-level, there is indeed, nothing to hope in this direction. But if the quantity of money is virtually fixed, it is evident that its quantity in terms of wage-units can be indefinitely increased by a sufficient reduction in money-wages; and that its quantity in proportion to incomes generally can be largely increased, the limit to this increase depending on the proportion of wage-cost to marginal prime cost and on the response of other elements of marginal prime cost to the falling wage-unit.” (GT Ch 19 section II)

    Keynes never stuck with one set of assumptions for very long. To the extent that he mostly took the quantity of money as exogenous, it was probably a concession to orthodox theory.

  7. 7 Nick Rowe April 12, 2012 at 6:35 am

    After reading Bill’s comment twice (some parts of it four times), I think I agree with it, and it’s a very good comment (except for the fact that I needed to read bits of it 4 times!).

  8. 8 Nick Rowe April 12, 2012 at 6:45 am

    Kevin (quoting Keynes): “If the quantity of money is itself a function of the wage- and price-level, there is indeed, nothing to hope in this direction.”

    What Keynes meant there (should have meant) is that if the elasticity of the supply of money wrt P and W is greater than or equal to plus one, there is no hope. (The AD curve is vertical, or even slopes the wrong way if it’s greater than one). Under inflation or price level targeting, that same elasticity is negative, because the central bank makes it negative and very big..

    (This is just an aside, not directly related to the point of your comment.)

  9. 9 Unlearningecon April 12, 2012 at 6:49 am

    Kevin Donoghue has already noted how Keynes endorsed endogenous money in later life. It is also entirely compatible with the conclusions in TGT.

    ‘But Keen, Fullwiler and Wray go a step further, which is to say that, since banks can create money out of thin air, there is no limit to their ability to create money.’

    I don’t think anybody said this. Banks are constrained by:

    - Interest rates
    - Capital
    - Regulation
    - Their own risk perceptions

  10. 10 Nick Rowe April 12, 2012 at 7:27 am

    Unlearningecon: would you (or Steve, Scott and Randall) add ” the central bank’s monetary policy, including (for example) keeping inflation on target” to that list?

    You see, if some economists argue that (M)odern (M)onetary (T)heory must be consistent with what modern central banks actually do, well, modern central banks target inflation.

  11. 11 Mike Sproul April 12, 2012 at 7:35 am

    The most rabid hot-potato people usually admit that there is no hot potato under gold convertibility, since any excess currency will immediately reflux to the issuer in exchange for gold. The same folks usually go on to admit that money can just as easily be pegged to a CPI basket, and the money issuer can just as well buy back refluxing currency with bonds as with gold.

    The fact they refuse to face is that it takes ASSETS for a bank to be able to maintain any peg, and if ever a bank’s assets are not enough to buy back ALL of the money it has issued, customers will run on the bank.

    Money has value because of the peg, and the peg only works when there is enough backing, so monetary theory all comes down to backing, not hot potatoes.

  12. 12 Nick Rowe April 12, 2012 at 8:06 am

    Mike: you wanna see “rabid”? Just watch me! ;-)

    If I have an excess supply of money, why should I want to spend it all on gold? I don’t wear bling, and my teeth don’t need fixing right now. There are loads of other assets I would try to buy first. Sure, if I and everyone else keeps on buying canoes, cars, and land, we will bid up the prices and quantities of those assets, and eventually some people will decide to sell those assets and buy gold. Eventually.

    The biggest asset a central bank has is its Present Value of seigniorage profits, that comes from the desire to hold its liabilities as a medium of exchange. The Bank of Zimbabwe’s conventional assets were negative, because nobody expected Robert Mugabe to collect taxes to service the debt, and everyone expected him to insist on collecting revenue from printing money and spending it. But the Zim dollar still had some value till it went over the top of the seigniorage Laffer Curve.

  13. 13 Frank Restly April 12, 2012 at 8:27 am

    “The current and expected future price level are controlled (or, at least, one may coherently hypothesize that they are controlled) by the central bank which controls the quantity of currency and the monetary base.”

    I disagree. You are forgetting about the cost of money. There is no direct correlation between the price level and the quantity of money. There is a direct connection between the price level and the cost of money (“the” interest rate).

    “Fullwiler denies that the central bank can control the quantity of currency or the monetary base, because the central bank is obligated to accommodate any demand for currency and to provide sufficient reserves to ensure that the payment system does not break down. But in any highly organized, efficiently managed market, transactors are able to buy and sell as much as they want to at the prevailing market price. So the mere fact that there are no frustrated demands for currency or reserves cannot prove that the central bank does not have the power to affect the value of currency.”

    Fullweiler is talking about the quantity of money, created by banks in making loans while you are talking about the value of the money created by banks in making loans. The two have little correlation.

    IS-LM fails to recognize a few things:

    1. There is not one interest rate. There are different interest rates for different borrowers (government, business, personal) and there are short term and long term interest rates.

    2. A capitalist system is not solely reliant on debt (bonds) to accomodate investment and savings (nor should it be). Too bad the federal government and its army of Keynesians have yet to figure this out.

  14. 14 JP Koning April 12, 2012 at 8:48 am

    David, I was hoping you’d jump in on this debate. You always say that the price of bank money is determined by convertibility into underlying central bank money or gold. And that unlike bank money, both gold and central bank money in turn have fixed supplies and a given demand which together determine their value, tying down the price level.

    But if the central bank doesn’t control the quantity of money it issues, then what determines the price level? You say it’s because the central bank targets a price level. But the way that the price level is targeted comes about via open market operations (or the threat thereof), or in other words, convertibility of central bank into bonds.

    So in the end, what’s the difference between bank money and central bank currency? Ultimately, the price of both seems to be determined by their convertibility into some underlying asset.

  15. 15 Unlearningecon April 12, 2012 at 8:59 am

    Nick,

    Yes, although that’s linked with what I meant by interest rates. I should have added ‘interest rate expectations’.

  16. 16 David Glasner April 12, 2012 at 10:09 am

    Tas, I explained in my posts on Bernanke’s lecture that a gold standard, i.e., a legal commitment to convert currency into gold on demand at a predetermined price, does not in any way prevent banks from creating money out of thin air. To do that you need a binding reserve requirement (approaching 100%) on all bank liabilities. Historically there has never been a gold standard which did that, and you could accomplish the same objective of preventing banks from creating money out of thin air by a sufficiently comprehensive reserve requirement in terms of some other asset, e.g., government created currency.

    Nick, Thanks. I wasn’t sure if I was reading you correctly or not. But hope does spring eternal, especially in the month of April. By the way, concerning Tobin, I am planning to do a post on him and my favorite paper, so stay tuned. I agree that deciding what is and what is not endogenous is very tricky. There is also a difference between a central bank freely choosing to choose a rule which makes a particular variable (say, the quantity of money) “endogenous” and saying that the central bank has no power to control that variable. Keynes’s theorem says that a central bank can control its price level or its exchange rate, but not both. So the central bank can choose which of the two it wants to make exogenous and which it will allow to be endogenous. Somehow I get the feeling that the post-Keynesians (for some reason insiders prefer not to capitalize the “p” – it seems that to insiders the choice to capitalize or not is fraught with all kinds of deep significance that only the insiders can understand) attach a more fundamental meaning to the endogeneity of money, but I don’t know enough about their views to claim to understand exactly what they mean by the endogeneity of money. One reason for this post is to try to learn more about their thinking.

    ruggedegalitarianism, Sorry for losing you. But I was just trying to work out my own views to see how they fit in with those other guys with whom I seem to have something in common, but with whom I seem to have some significant differences. Your comment helps to clear it up a bit, so thanks. I agree that at very low interest rates, it gets harder for the Fed to influence spending by adding reserves, especially if the Fed insists on paying interest on reserves, but that doesn’t mean that it is powerless, especially if the Fed chooses to aim explicitly at a price level target and is prepared to force down the dollar exchange rate as FDR did in 1933.

    Bill, I am not sure what it means to say that banks “must adjust the interest rate they pay on checkable deposits to get people to hold them.” I assert that there are economic (competitive) forces that induce them to adjust their interest rates. Any supplier has an incentive to adjust price if he is losing market share. Must he do so? Not necessarily, but there is such an incentive. People will not refrain from selling products just because their bank balance is larger than they want it to be. But if they are earning competitive interest on their bank balance, they will be happy to keep the money in their bank account without trying to spend the unwanted balance. As for the rest of your comment, I am sorry but I don’t quite have Nick’s patience, though I am sure that if I did, it would be amply rewarded.

    Scott, Thanks. I did note that you acknowledge that the CB does have some control, but as I tried to point out, I am not satisfied with what seems to me a superficial distinction between controlling a quantity and controlling a price. I am also happy with your recognition that banking decisions are determined within a framework of profit-maximization. But CBs can clearly control a number of variables that are relevant to the profit-maximizing decisions of banks. The question to which I am searching for an answer is whether there is a significant difference between us in how we view the ability of a central bank to conduct monetary policy.

    Kevin, Once again, you demonstrate your encyclopedic command of the text of the General Theory. However, just because he entertained the possibility that the nominal quantity of money would adjust proportionately to a change in the price level does not mean that he considered that to be the factually correct or the preferable assumption. As Rueff and Shackle point out, his liquidity preference theory of interest really does depend on an exogenously fixed quantity of money, otherwise it wouldn’t make sense to say that the demand for money determines the interest rate.

    Unlearningecon, As I pointed out, the liquidity preference theory of interest is not compatible with an elastic money supply associated with the payment of competitive interest on deposits. It is clear that I still don’t fully understand what Keen, Fullwiler and Wray are saying. From the tenor of the discussion so far, the differences between us don’t seem all that great, yet I still have the impression that they are rather significant, and I am trying to figure out where the essential differences lie.

    Nick, Good question.

    Mike, From a historical perspective, I don’t think it is true that rabid hot-potato people admit that there is no hot potato under gold convertibility. The Currency School would be my exhibit number 1,and Milton Friedman would be number 2, though in Friedman’s case there was a fair amount of equivocation and obfuscation. I think, however, that you are right that the point is probably better understood now than it was previously.

    Nick, You are forgetting that under convertibility into gold as soon as an excess supply of money starts to increase commodity prices ever so slightly there is a whole range of arbitrage transactions that become profitable, so your own personal demand to hold gold is really quite beside the point. Aside from that, I am sorry to say that you aren’t even close to getting on my top 10 most rabid list.

    Frank, I understand that we disagree about that. Unfortunately, I still have not figured out why we disagree.

    I think that you may be right about the difference between Fullweiler and me. I suspect that in his economic model, the price level is determined by something other than – to use a shorthand expression — the demand for and the supply of government (or central bank) issued currency. In my model that the demand for and the supply of government currency is what determines the price level. That is an oversimplification of course because all economic variables are simultaneously determined in a system of equations, but it is useful analytically to isolate a particular equation in which the variable is determined given all the other equations.

    JP, The short answer is what I was saying in my post. The central bank controls the supply of a particular asset, currency. It can choose to supply the currency freely at a particular price and allow the quantity to adjust or it can make a fixed amount available and let the price be determined. There is no difference in principle between controlling the market one way or the other, just as there is no difference in principle between controlling imports of a product by way of a quota or an import tariff.

  17. 17 Mike Sproul April 12, 2012 at 10:17 am

    Nick:

    Here’s a quote from p. 56 of Thomas Tooke’s “Inquiry Into the Currency Principle”, where a committee member (Grote) interviews a banker (Anderson):

    “(Mr Grote) But during the period which elapses between the time of your making the advance originally in your own notes and the time when you give the order on London in consequence of the notes coming back to you during that interval whether it be long or whether it be short must there not be an increase of the circulation of the country generally?

    (Mr. Anderson) I think that brings us back to the question which has been so much discussed here viz whether deposits form a part of the circulation Those notes which we pay out do not remain out; they must be paid back either to us or to some other bank in the shape of deposits till they are to be used and they do not increase the permanent circulation of the country unless for a day or two scarcely for even a day.”

    There are endless examples (Lots in Tooke and Fullarton) of bankers explaining that their excess issues of notes will immediately reflux upon them. In the simplest case, a banker that prints 100 new dollar notes and uses them to buy $100 worth of gold makes notes a little more abundant, and gold a little more scarce, and someone will find it profitable to bring notes back to the bank for gold.

    Disagree about seignorage too, (naturally!) but one thing at a time.

  18. 18 JP Koning April 12, 2012 at 10:44 am

    “It can choose to supply the currency freely at a particular price…”

    I guess that’s the point I wanted to nail you down on. If a central bank is supplying currency at a particular price, how is this any different from a commercial bank which supplies its own currency at a particular price?

  19. 19 Nick Rowe April 12, 2012 at 10:59 am

    Unlearningecon: “Yes, although that’s linked with what I meant by interest rates. I should have added ‘interest rate expectations’.”

    Yep. Good answer. Now we are very close to being on the same page (provided I take my personal unorthodox hat off).

    Consider this hypothetical:

    Suppose the central bank has inflation on target (or thinks it does), and output at (what it thinks is) potential output. Then all of a sudden banks start creating loans and deposits out of thin air. If the central bank lets them do it, aggregate demand will increase past potential output, and inflation will rise above target (or, at least, the central bank thinks it will). So the central bank must stop them creating loans and deposits out of thin air. The central bank will raise its rate of interest by whatever it takes to stop banks creating loans and deposits out of thin air. It is exactly as if the banks were reserve-constrained and couldn’t create money out of thin air. Whether you think of the central bank targeting the price (interest rate) on reserves or the quantity of reserves doesn’t make any difference. These are just two different ways of telling the same story about the central bank controlling the supply *curve* (or supply *function*) of reserves. You can think of “supply” as quantity as a function of price and other things, or its inverse, price as a function of quantity and other things.

    If the central bank is keeping inflation on target (or thinks it is), the only way that all the banks can expand is if they persuade some people to save more so they can lend more to other people to invest more. Because if banks try to create loans and deposits out of thin air the central bank will stop them (unless of course the central bank wants them to do this because it thinks inflation would fall below target otherwise).

  20. 20 David Glasner April 12, 2012 at 11:03 am

    JP, I think the difference is that the CB, as a monopoly supplier of currency, has wide discretion in choosing the terms on which it will make its currency available, while commercial banks are constrained by competition to make their own liabilities convertible at par into currency. Central banks under a gold standard, except for the Fed after WWI and perhaps the Bank of England before WWI were in many ways similar to commercial banks in having very limited discretion in conducting monetary policy.

  21. 21 Nick Rowe April 12, 2012 at 11:13 am

    Mike: but those are bankers, trying to say that they cannot be held responsible for any overissue. To misquote Mandy Rice-Davies, “They would say that, wouldn’t they?” http://en.wikipedia.org/wiki/Mandy_Rice-Davies Plus, what is true for an individual bank may not be true for the banking system as a whole, and those are individual bankers talking about individual bank experiments.

    David: Dunno. If arbitrage transactions were so quick and easy, across all asset classes, I don’t think we would even need monetary exchange.

  22. 22 Kevin Donoghue April 12, 2012 at 11:27 am

    David: “[Keynes's] liquidity preference theory of interest really does depend on an exogenously fixed quantity of money, otherwise it wouldn’t make sense to say that the demand for money determines the interest rate.”

    Sorry if I’m being thick but I don’t see that. Can’t the demand be for real balances? Mostly Keynes thinks of the money-wage W as being exogenous. So the demand for real balances (M/W since he likes to think in wage-units) can determine the money stock given the interest-rate or the interest-rate given the money stock, taking other arguments of the money-demand function as given. He didn’t like regimes in which wages, prices and the stock of money were allowed to spiral up or down together, but he certainly didn’t think that his theory was inapplicable to such situations.

  23. 23 Nick Rowe April 12, 2012 at 11:48 am

    Sort of in support of Kevin, I have always thought it an easy extension of the liquidity preference theory to redefine it as “the demand *and supply* of money determine the interest rate”.

  24. 24 David Glasner April 12, 2012 at 12:11 pm

    Nick, Arbitrage transaction are facilitated precisely by the commitments of central banks to maintain a fixed conversion rate between their currencies and an ounce of gold. Without such a simultaneous commitment, the scope for profitable arbitrage transactions, carried out by professional traders, not the likes of you and me, is greatly enhanced compared to ordinary monetary exchange much less to barter.

    Kevin, What I am thinking of is that with a competitive banking sector adjusting the quantity of money to the demand (and therefore paying competitive interest on deposits), the cost of holding money is not the interest rate on some short term instrument, but the spread between the short-term interest rate and the deposit rate. If banks operate with constant costs, then the cost of holding money doesn’t change, because changes in the short-term interest rate are always matched by an equal change in the deposit rate. I know that this is an oversimplification, but this is the model I have in mind, and every model involves some degree of simplification.

    Nick, So in my model, the demand for and the supply of money (i.e., bank deposits or money market fund shares) determines the spread between the interest rate and the deposit rate.

  25. 25 Mike Sproul April 12, 2012 at 3:35 pm

    Nick:
    David’s point about arbitrage is on the mark. I think you and I must be thinking about completely different things, because when gold convertibility is maintained at 1 oz/$, there is just no way that dollars can trade for anything other than 1 oz./$. If the central bank goes ahead and issues $100 new dollars anyway, that can’t change the peg of 1 oz/$. So banks are in the position of being completely passive, only issuing new dollars when customers want them, and taking the dollars back in when people return them.

    David (and Nick): The Currency School had the idea that as paper money DISPLACES gold from circulation, then the gold would be exported. But if it’s happening in many countries at once, the value of GOLD will fall relative to other goods and the dollar, being pegged to gold, will fall in step. So a dollar will buy less at the grocery store, but it’s still worth 1 oz. This is a valid point, and it’s an important exception to the backing theory. But suppose that dollars are initially pegged to 1 square foot of farm land. In this case, the creation of paper money doesn’t reduce the demand for land. Each dollar is still worth 1 square foot, and each square foot still buys the same goods as before. No inflation of any kind.

  26. 26 mart April 12, 2012 at 3:52 pm

    > No doubt that it would be a fascinating book, but what would be even more fascinating would be an, explanation of how Irving Fisher – yes, that Irving Fisher – could possibly be considered as anything other than a neo-classical economist.

    Did you read “Boom and depression”?

  27. 27 Frank Restly April 12, 2012 at 6:31 pm

    David,

    I think where we disagree is in the root cause of inflation (defined as a rise in the price level). In my mind inflation is caused by the nonproductive use of debt. You might argue from a monetarist standpoint that it comes from too much money chasing too few goods.

    “That is an oversimplification of course because all economic variables are simultaneously determined in a system of equations, but it is useful analytically to isolate a particular equation in which the variable is determined given all the other equations.”

    From this statement you seem to agree that arguing from a strict monetarist point of view – money / debt growth always leads to higher inflation – is wrongheaded.

    And so, I think part of it is a gross misunderstanding of what supply side economics is really about. Make no mistake, the Laffer Curve and supply side economics are not to be confused with one another.

    The Laffer Curve is a government revenue game – at some point in the curve you realize this much revenue – are you at the maximum level of revenue at that point or can you adjust taxes higher or lower to realize the same or greater revenue.

    Supply side economics could care less about how much revenue the federal government takes in. Supply side economics is about costs incurred by businesses and individuals, specifically the cost of money. Taxes are a cost on money in the same way that interest rates are a cost on money.

    And so in my mind to get low (0%) inflation you keep the pretax cost of money at the real potential growth rate, and keep the after tax cost of money at 0% (or negative in the case of deflation).

    And the way you lower the after tax cost of money is by selling tax breaks with a duration and rate of appreciation.

  28. 28 Benjamin Cole April 12, 2012 at 8:15 pm

    All well and good, but really, right now the Fed should set a target nominal GDP and conduct $100 billion a month in QE until we hit that target six quarters straight. About 7 percent growth would be a good target.

    He trades economic prosperity for price stability will soon have neither.

  29. 29 Marko April 12, 2012 at 10:21 pm

    As noted above , we can stipulate that :

    Banks are constrained by:

    - Interest rates
    – Capital
    – Regulation
    – Their own risk perceptions

    Thus , we would also stipulate that banks can’t create money “without limit”.

    None of those stipulations diminish the significance of banks money-creation abilities , however , because while acting within those constraints , banks nearly blew up the global economy.

    The interest constraint proved to be particularly impotent for an extended period , during the “Greenspan conundrum” phase , as the FED raised the FF rate by 400 basis points with no significant effect on mortgage rates , or , for that matter , on 10-yr treasuries.

    The capital constraint would never be binding as long as mortgages were being bundled and sold as fast as they were being produced , and thus converted right back into the most potent form of “capital”.

    Regulation could have an impact , but when the top regulator – the FED chairman – doesn’t believe that fraud even exists , you can’t rely on this constraint too much.

    Banks , ideally at least , do evaluate risk. However , we have to accept that their ability to do so in a diligent manner can disappear for extended periods , based on recent experience. They lost not only the risk perception of loans they made , but their “death perception” of their own firms.

    If you don’t accept the premise of endogenous money , even of a constrained sort , you limit the types of fixes that you can justify to prevent the next disaster. You rely instead only on a CB that has shown itself to be unreliable.

    It’s best to believe in endogenous money even if you don’t believe in it.

  30. 30 W. Peden April 12, 2012 at 11:16 pm

    Yes, this is the limited sense in which I think that money is endogenous. It’s different from, say, Kaldorian endogeneity where the quantity of money is determined by the needs of trade.

    Scott Fullwiler,

    “Please note that in my post I was very clear that our position is that the CB can have some control but that this control is through price (i.e., the interest rate target) not through directly targeting quantity”

    I think that this is true up to a point i.e. up until bank rate approaches 0%, as it is at present in the US and the UK. Then, it becomes half true: the central bank still has control (more or less unlimited in the long run if it has no other contraints) over the price of assets, since OMOs give the CB the ability to reduce the supply of assets.

    When asset prices rise as a result of a permanent OMO programme, like QE2, this increases the ability of borrowers to borrow (for example, if stock prices are high then it is easier for companies to finance themselves through selling corporate bonds to banks which increases the quantity of money) and so, while sticking with an endogenous view of money, we have a situation where the central bank has an influence over the quantity of money & NGDP even when interest rates at near 0%.

    PS: As a historical note, since part of the interpretative problem is that “endogenous money” is being used to cover at least two positions (MMT and non-money multiplier quantity theory) it’s interesting to recall what British monetarists called the non-money multiplier quantity theory view of the determination of the money supply: the “credit counterparts” view-

    http://books.google.co.uk/books?id=cNeDGL_7WGYC&pg=PA9&lpg=PA9&dq=%22credit+counterparts%22&source=bl&ots=a_gdF2W-9G&sig=B6mesYdJBY2-jFtzsjRVN2fQfJA&hl=en&sa=X&ei=m8OHT736AqS80QXoof26CQ&ved=0CEkQ6AEwADgK#v=onepage&q=%22credit%20counterparts%22&f=false

    http://tcbh.oxfordjournals.org/content/8/1/49.extract

    I like this view because it provides the basis a causal story of the central bank’s influence on the money supply and NGDP, while at the same time avoiding the nihilistic wasteland of taking the banking system out of monetary theory.

  31. 31 Geoff April 13, 2012 at 10:23 am

    Ben, what does QE have to do with NGDP? Swapping Treasury bonds for reserves hasn’t done much to increase inflation or GDP so far. It is difficult to see why it would do so in the future.

  32. 32 Unlearningecon April 14, 2012 at 4:31 am

    Nick,

    So at full employment banks act as if they are constrained by savings? I’m not sure if I’m convinced but I’d need to see some evidence either way.

    I’m not sure about your mentality – ‘banks don’t behave how we say they should but it doesn’t matter because they act like they do’. Why not change all the textbooks so that they actually teach the mechanics correctly?

    And if you endorse the view that banks simply respond to demand for loans with some constraints rather than ‘lending out excess reserves’, there’s no reason to believe increasing reserves will result in more lending. There’s also a reason to believe that, a la Keen, the level of private debt plays a crucial role in an economy, as banks are not simply redistributing from borrowers to savers.

  33. 33 teageegeepea April 14, 2012 at 10:13 am

    This internet Austrian had an argument that Fisher is the founder of the Chicago branch of “new economics”, which together with Keynesianism contrasts with the “orthodox economics” of Ludwig von Mises. The irony is that Fisher never taught at Chicago, he introduced many Americans to “Austrian” ideas (being written in German, they tended to be unknown in the Anglosphere) and Ludwig von Mises had some positive things to say about him. Still, the Austrian aversion to math gives them more claim to the term “non-neoclassical”, not that it’s a desirable label to have.

  34. 34 Bill Woolsey April 14, 2012 at 12:28 pm

    David:

    Any individual bank must fund assets with liabilities or equity. Usually, I short hand that by saying banks must fund loans with deposits. In a growing economy each bank sets loan interest rates and deposit interst rates so growing demand for loans from the bank is matched by a growing supply of deposits to the bank. In equilibrium, this does imply that a growing demand for loans from banks is matched by a growing supply of deposits to banks. Each bank is funding its own loans. The banking system is funding its loans.

    On the other hand, if we imagine an unplanned increase in loan demand, so that demand for loans grows more quickly at all banks, then as the banks supply those loans and the funds are spent, they will all find that they receive growing deposits too. Each bank is still funding its own loans. And there are deposits to match the lending of the banking system, but there is no reason to believe that those holding the deposits want to hold them.

    The banks could raise the intereset rates they pay so that everyone is willing to hold those deposits. But they receive no signal to do so. They have no incentive to do so. Those with the larger deposits (because they sold someting to those who borrowed) don’t go and pay back the loans of their customers.

    Now, to the degree that this process, more rapid increase in spending on output, raises the demand for base money, and the quantity of base money does not grow any faster, then banks will be short on reserves. Banks will lend less overnight and borrow more, sell securities, and so on. This will raise money market rates, and the banks will raise deposit rates and loan rates. The growth in loans will shrink, and the growth in deposits expand, and we are back to equilibirum.

    But this required that the process (initially more rapid growth in loan demand) somehow generate more rapid increases in the demand for base money. And, of course, that the quantity of base money not grow more rapidly in response to that demand.

    To me, however, the more interesting thought experiement is the increase in the demand for deposits. When people demand more deposits, they don’t go to the bank and buy more deposits or borrow more money. Unless they are choose to substitute away from base money in the form of currency to deposits, which is not what I am talking about, they accumulate more depostits by slowing their expenditures on output or selling other assets. The banks receive no signal that they can lower the interest rates they pay on deposits.

    To the degree those demanding more deposits sell bonds to get them, this tends to raise the interest rates on money market instruments. Through a variety of channels, this creates an incentive for banks to perversely raise deposit rates! For example, banks who would otherwise lend overnight buy higher yielding bonds. Banks who were funding loans by overnight borrowing need to fund them some other way, perhaps paying higher interset rates on deposits.

    But I don’t worry much about these perverse effects. Instead, the problem is that spending on output falls.

    Now, to the degree that spending falls (or maybe sales of other assets) leads to a lower demand for base money, one way or another, and the quantity of base money doesn’t fall, then the results will be an excess supply of base money. This would most directly impact yields on money market instruments, including overnight lending. Interest rates on loans and deposits would fall appropriately.

    But again, it is the impact of the excess supplies or demands for bank money on the demand for base money that forces the banking system to adjust interest rates on deposits according to interest rates on earrning assets.

    If you imagine a Walrasian auctioneer, calling out bank loan rates and deposit rates, and then allowing banks to issue deposits and loans when the two match, then each bank and the banking system will always issue deposits to fund loans.

    But there is no Walrasian auctioneer. And because bank deposits serve as money, there is no signal created for banks to respond to shortages or surpluses by approprate changes in deposit interest rates.

    Another way to see this is that the preferences of depositors, influences perhaps by the deposit rates paid, force the total quantity of bank deposits to reflect the shares desired by depositors. But there is no guarantee that the total quantity of bank deposits is equal to the total quantity that depositors want to hold.

    Except, of course, to the degree that any excess supply of demand for bank money impacts the demand for base money, and the quantity of base money doesn’t adjust inappropriately.

    Finally, the excess demand for bank money, leading to lower expenditures on output, can easily lead to a perverse increase in the demand for base money. In my view, the solution is for the quantity of base money to rise to match the demand. If the quantity of base money is fixed, then the problem, in my view, isn’t reallly the private banking system, but rather with the fixed quantity of base money.

    Anyway, if you think about monetary systems with no base money, the impact of monetary disequilibrium with bank money cannot be “solved” by some impact on the demand for base money. There is none. The notion that interest on deposits will just automatically adjust is an illusion. It is my focus on pure inside money systems that causes me to focus on this question.

    Nick:

    I think you are right that excess supplies of money being spent on gold “immediately” is wrongheaded. On the other hand, David is right that the expectation that there will be an increase in the demand for gold, sooner rather than later, does create speculation that will dampen and reserse an excess supply of money. I don’t think arbitrage, whoever, is the best way to look at it. In the end, there must be some process by which an excess supply of money results in an increase in the demand for gold. You might not want more bling, but there is someone from whom that was the next thing on their list. And an excess demand for gold at the fixed price brings a reversal of any excessive expansion.

  35. 35 pilkingtonphil April 16, 2012 at 9:57 am

    “The central bank may not be trying to target a particular quantity of currency or of the monetary base, but it can target a price level by varying its lending rate or by taking steps to vary the interbank overnight rate on bank reserves. This, it seems to me, is not very different from trying to control the domestic value of an imported commodity by setting a tariff on imports rather than controlling the quantity of imports directly. Endogeneity of bank money does not necessarily mean that a central bank cannot control the price level. If it can, I am not so sure that the post-Keynesian, MMT critique of more conventional macroeconomics is quite as powerful as they seem to think.”

    Right. CBs set price and let demand adjust. Yes, this has significant consequences for how the banking sector operates. Krugman’s debt model falls apart, for one. There are other important implications which Godley and Lavoie outline at length in their ‘Monetary Economics’ which I strongly suggest you read if you have not already. It just came out in paperback.


    Yet, the IS-LM model’s assumption of a fixed nominal quantity of money determined by the monetary authority was taken straight from the General Theory, a point made by, among others, Jacques Rueff in his 1948 critique of the General Theory and the liquidity-preference theory of interest, and by G.L.S. Shackle in his writings on Keynes, e.g., The Years of High Theory. Thus, in arguing for an endogenous model of the money supply, it is the anti-IS-LM post-Keynesians who are departing from Keynes’s analysis in the GT.”

    Don’t buy into the caricatures that paint post-Keynesians as fundamentalists. We all know that Keynes assumed loanable funds in the GT. But he was wrong. PKers don’t defend the GT avante le letter. They simply point out that there was much the mainstream missed in it. If Keynes were alive today I’m sure he would think the endogenous theory a breath of fresh air and an extension of his analysis.

    “No doubt that it would be a fascinating book, but what would be even more fascinating would be an, explanation of how Irving Fisher – yes, that Irving Fisher – could possibly be considered as anything other than a neo-classical economist.”

    He ceased being a neoclassical when he went bankrupt and published his paper on debt deflation. This paper is clearly not a paper that adheres to an equilibrium view of the economy. Accepting its fundamental premises negates much of Fisher’s earlier neoclassical work. I think Fisher recognised this — and so the paper should be seen as a remarkably brave piece of writing. It is the economists that came after him that kept thinking he adhered to his earlier work after this. A bit like people who use ISLM even though John Hicks abandoned it in the seventies. The difference between Great Minds and the ‘herd’. The herd keep marching on as if nothing happened.

  36. 36 JP Koning April 16, 2012 at 4:29 pm

    “JP, I think the difference is that the CB, as a monopoly supplier of currency, has wide discretion in choosing the terms on which it will make its currency available, while commercial banks are constrained by competition to make their own liabilities convertible at par into currency.”

    David, thanks for your response. I am still groping towards understanding exactly where you stand.

    Would you agree that the gold standard arbitrage mechanism you described earlier applies just as well to a modern standard? For instance, you said earlier: “under convertibility into gold as soon as an excess supply of money starts to increase commodity prices ever so slightly there is a whole range of arbitrage transactions that become profitable.”

    Likewise, it seems to me that given a modern inflation-targeting CB, as soon as an excess supply of money starts to increase asset prices ever so slightly, and this includes bond prices, then traders can arbitrage the bond market by buying bonds from the Fed (for dollars) and selling them at the higher price in the open market. This happens until prices are again equal, the net effect being to drain money out of the system.

    Because of convertibility, in neither the gold standard nor the modern standard can a central bank create hot potato money. What do you think?

  37. 37 David Glasner April 16, 2012 at 6:10 pm

    Mike, I agree that monetary disturbances can alter the value of gold under a gold standard, and that a land standard like you describe would be less vulnerable to such fluctuations in the value of the standard induced by monetary factors. But there would still be changes in the value of money if there were real changes in the value of land.

    mart, No

    Frank, Not wrongheaded, just over-simplified, so I am not yet ready to buy into your theory of inflation either.

    Benjamin, I agree with you about the right policy as of now, but I am not so sure that we can conclude that a pro-inflation policy is right under all circumstances.

    Marko, I agree that banks messed up, hugely. The discussion about endogenous money refers to banks’ creation of liabilities. I maintain that banks only create as many liabilities as the public wants to hold. The problem in the financial crisis was not that banks created too many liabilities, but that they irresponsibly exchanged their liabilities for assets that turned out to be worthless. That is a different issue from whether their creation of liabilities is constrained. I agree that that there are serious issues of regulating banks to avoid the misbehavior that we saw, but those issues seem to me to be orthogonal to the question of the endogeneity of money.

    W. Peden, Thanks for the references to non-money-multiplier quantity theory.

    Geoff, Two answers. Near the zero lower bound, monetary policy has to work harder. That doesn’t mean it can’t be effective, you just get less bang for the buck. Second, gotta stop paying interest on reserves.

    Unlearningecon, The problem that I have with Keen is that he assumes that a correlation between debt and recessions means that debt causes recessions. I would put it differently, debt results from excessive optimism about future income prospects, which also lead to asset price inflation. As long as expectations are realized, it’s ok. But at some point, future income and profit expectations are not realized and then the debt burden becomes unsustainable.

    teageegeepea, Von Mises generally subscribed to Fisher’s theory of interest, and he was enough of a scholar to acknowledge Fisher’s greatness in pure theory. But Mises didn’t care for Fisher’s views on monetary theory because he advocated “managed money.”

    Bill, You are positing a general increase in loan demand. To me that sounds like there is an increase in interest rates, which should be reflected in market rates. If banks are able to raise their rates on loans, then, unless banks are not competing, it would seem to me that they would have an incentive to offer increased rates to depositors in order to be able to fund an increase in lending that is now more profitable than it used to be. Banks as a group have no incentive to raise rates, but individual banks, seeking to maximize profits by increasing market share when the profitability of lending has just increased, do have an incentive to compete for deposits by raising deposit rates to match the increase in lending rates.

    pilkingtonphil, Care to spell out why Krugman’s debt model falls apart? Thanks for the reference to Godley and Lavoie. I have no problem with your take on Keynes, I was just pointing out that Keynes in the GT was definitely operating with an assumption of an exogenous quantity of money. Fisher may have changed his views on money to some extent, but I don’t think that he ever disavowed his main theoretical work which was pure neo-classicism. Nor do I think that the debt-deflation theory is in any way inconsistent with neo-classical theory, properly understood. But perhaps you can explain to me where the contradictions are that I haven’t picked up on.

    JP, No I would not agree that the arbitrage mechanism applies to a modern standard, because there is no commitment, much less a legal obligation for the CB to maintain convertibility at a fixed rate between dollars and bonds. I maintain that CBs can create hot potato money.

  38. 38 JP Koning April 19, 2012 at 8:42 am

    David: “I would not agree that the arbitrage mechanism applies to a modern standard, because there is no commitment, much less a legal obligation for the CB to maintain convertibility at a fixed rate between dollars and bonds. I maintain that CBs can create hot potato money.”

    If I understand you correctly, you are saying that arbitrage can’t be resorted to in our modern system since convertibility between dollars and bonds doesn’t occur at a fixed rate but at a floating rate. What do you think about Fisher’s compensated dollar plan? The latter obligates the central bank to maintain convertibility into gold at a floating rate. But it seems to me that arbitrage would still possible under a compensated dollar standard, even though the convertibility rate floats, and therefore hot potato money could not be created.

    Like the compensated dollar standard, the modern standard (and I am thinking about the Bank of Canada, an inflation targeter) offers convertibility into bonds at a floating rate, not a fixed one, and therefore provides those who hold its liabilities with an arbitrage mechanism.

  39. 39 David Glasner April 19, 2012 at 12:52 pm

    JP, I guess that you have not (yet?) read the final chapter of my book in which I discuss Fisher’s compensated dollar plan and point out some of the mechanical defects that would beset his proposal for changing the gold content of the dollar. The problem being that it would often be obvious in advance how the gold content of the dollar would be changed creating perverse incentives to buy or sell gold in advance of the change in the gold price. To get around that problem you would have to, as Scott Sumner likes to say, target the expectation.

  40. 40 JP Koning April 19, 2012 at 1:21 pm

    David, you caught me red-handed. I only just finished chapter 9. Perhaps I’ll wait till I finish the book before I push further with my questions.

    I’ll just say that I think my line of questioning is inspired by Nick’s provocative post

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/from-gold-standard-to-cpi-standard.html

    in which he points out that nothing fundamentally changes when one moves from a gold standard to a modern inflation targeting regime.

  41. 41 pilkingtonphil July 6, 2012 at 6:37 am

    @ David Glasner

    Stumbled across this just now. Better a late answer than no answer, I guess.

    “Care to spell out why Krugman’s debt model falls apart?”

    Krugman’s debt model relies on the idea that lending is a redistributive process. In his model the money of ‘patient’ savers is transferred to ‘impatient’ borrowers. But this is not what happens in a modern money system. Instead, banks create loans largely ex nihilo and do not rely on prior deposits for their reserves base.

    Krugman’s misrepresentation gives the illusion that money is simply being moved from one part of the economy to the other, but this is not at all what is happening. This is very important because his model aspires to be Minskian. But Minsky’s work is all about dynamism, banking and the perpetual growth and contraction of the money supply through credit booms and busts. If you use Krugman’s static model you completely misrepresent what is actually taking place.

    “Nor do I think that the debt-deflation theory is in any way inconsistent with neo-classical theory, properly understood. But perhaps you can explain to me where the contradictions are that I haven’t picked up on.”

    It really is quite simple. The debt deflation paper was based on an economy that is tending toward total disequilibrium and whose only means to move back toward equilibrium is through a vicious and lengthy period of unemployment and misery. Perhaps you can make a case that you can fit this in with neoclassical theory, but is an enormous stretch.

    In other sciences when a fundamental assumption is challenged to such an extent it is simply dropped. But economists are very reluctant to drop the equilibrium hypothesis and so they maneuver around any problems with it they encounter. This is very unscientific and tends to blind them towards many real world problems. It also tends to lead them to teach students a certain way of looking at the world that is completely at odds with reality.

    Take the example of the caloric (substance-based) theory of heat in the early 19th century. It was eroded because engineers began encountering more and more real-world phenomena that were becoming increasingly difficult to explain through the theory. Thus they began to move toward the energy theory of heat and a fundamental reorganization of the physical sciences resulted.

    Nevertheless, many die-hards continued using the caloric theory and were able to bend many arguments in order to accommodate it. Neoclassicals, I would argue, have been doing something similar since Keynes, Fisher’s debt deflation theory and the Great Depression. It gives them remarkable blind spots when looking at many economic issues. However, I get the impression that many younger students no longer buy into the theory and are increasingly shying away from it.

  42. 42 David Glasner July 8, 2012 at 7:26 pm

    plkingtonphil, Agreed, better late than never.

    I will pass on Krugman’s debt model which I have not really looked at. But I agree that there is a lot more going on in Minky’s model than Krugman probably took account of. At the recent History of Economics Society meeting, June Flanders of Tel Aviv University presented a very insightful survey of Minsky’s most recent work, much of it never published, that throws a great deal of light on recent developments.

    About Fisher, I am sorry I don’t agree that debt-deflation is fundamentally inconsistent with neo-classical theory, of which Fisher was an archetypical exponent. He was pointing out that a severe monetary disturbance could have very powerful real consequences. Neoclassical theory did not generally discuss that possibility, but that doesn’t prove that Fisher rejected all the neo-classical economics he had done so much to develop over the course of his career. I don’t see it as an all or nothing proposition.

  43. 43 pilkingtonphil July 9, 2012 at 5:44 am

    David,

    Good to hear that economists are going beyond Krugman in looking into Minsky’s work. However, Minsky was 100% not a neoclassical and I suspect that if he is integrated into the doctrines he will be misinterpreted and squeezed into a ill-fitting pair of intellectual trousers that he thought rather ugly.

    As for Fisher, neither you nor I can read minds. However, with the correct historical perspective I believe we can tease out what direction he was headed. Prior to the ’29 crash Fisher was a very wealthy man (having invented the Rolodex). However, he put all his money in stocks. As is well-known, he was the leading champion of the stock market boom which he opined about regularly from his perch at the Wall Street Journal.

    Fisher saw his neoclassical theories as proof that the boom was based on sound fundamentals. Since Fisher essentially believed in Walrasian market equilibrium (which is basically efficient markets) he argued that the boom was due to technological innovation and unprecedented productivity growth.

    When it blew up Fisher lost his shirt. It also proved to him that the boom was based on irrational expectations and not on sound fundamentals. After this Fisher stopped publishing the sort of work he did before the crash — as it had, due to his believing those theories explained reality, lost him all his money. Instead he published a few pieces of work that are characterised by (a) mild disorientation and (b) an emphasis on disequilibrium. I strongly believe that, having been cast into poverty by his earlier theories, he no longer believed in them — and this is why he stopped publishing neoclassical work.

    Ever since Fisher and Keynes neoclassicals have been trying to tinker with the theory to integrate all this. Frankly, I think it fails — and fails rather miserably at that. As I said above, it’s like trying to integrate mid-19th century engineering discoveries into the old caloric theory of heat. You can do it. But its clumsy and basically just defending an outmoded paradigm for the sake of defending it.

  44. 44 David Glasner July 11, 2012 at 10:17 am

    pilkingtonphil, You said:

    “When it blew up Fisher lost his shirt. It also proved to him that the boom was based on irrational expectations and not on sound fundamentals. After this Fisher stopped publishing the sort of work he did before the crash — as it had, due to his believing those theories explained reality, lost him all his money. Instead he published a few pieces of work that are characterised by (a) mild disorientation and (b) an emphasis on disequilibrium. I strongly believe that, having been cast into poverty by his earlier theories, he no longer believed in them — and this is why he stopped publishing neoclassical work.”

    Is this based on any documented source or are you speculating here? It’s ok to speculate, I just would like to know which it is. Fisher lost a fortune in the stock market crash, but he was not impoverished. I believe that he blamed the bad policies of the Hoover administration and the Fed for the crash, not the defects of neo-classical theory. So we have different understandings of what Fisher was thinking after 1930. If you have evidence to prove that my understanding is wrong, I would like to see it. Otherwise we will just have to agree to disagree.

  45. 45 pilkingtonphil July 11, 2012 at 10:39 am

    @ David Glasner

    Perhaps ‘impoverished’ was too strong a word. But he lost his fortune.

    As to what he consciously blamed the depression on, I don’t think this matters much. Fisher definitely believed that neoclassical theory could explain the boom in terms of productivity increases and technological developments. This is why he was so sure of himself about the boom.

    This fits in with Fisher’s character. The man was an intellectual fanatic. His strange eugenicist theories on mental illness led him to submit his daughter to the dangerous and pointless surgery that killed her. His beliefs regarding social engineering carry the same flavor. This was a man who believed that he had an intellectual picture in his head that fully grasped the real world. When that fell apart, as it did in a very real way after ’29, he stopped writing neoclassical work and published his debt deflation theory. I don’t think these circumstances are coincidental.

    So, am I speculating? Yes. I am reading Fisher as I would read anyone else: as a person with a certain intellectual style whose thinking was motivated by a belief system that they he related to in a very specific way. I don’t think he stopped publishing what I would consider neoclassical work after the crash by coincidence. There was a rupture. And you can read it in his writings.


  1. 1 Friedman and Schwartz on James Tobin « Uneasy Money Trackback on April 15, 2012 at 9:37 pm
  2. 2 Economists & ‘New Economic Thinking’ « Unlearning Economics Trackback on April 16, 2012 at 10:40 am
  3. 3 Caffeine Links Tax Day: 4-17-2012 | Modern Monetary Realism Trackback on April 17, 2012 at 5:26 am
  4. 4 Nick Rowe’s Gold Standard, and Mine « Uneasy Money Trackback on April 24, 2012 at 7:40 pm
  5. 5 James Tobin Got It Right « Uneasy Money Trackback on May 6, 2012 at 7:11 pm
  6. 6 Yeager v. Tobin « Uneasy Money Trackback on May 9, 2012 at 7:21 pm
  7. 7 Endogenous Versus Exogenous Money, One More Time « Unlearning Economics Trackback on September 22, 2012 at 9:20 am
  8. 8 Exogenous and Endogenous Money: Room for Reconciliation? « Unlearning Economics Trackback on September 27, 2012 at 8:52 am
  9. 9 It’s the Endogeneity, [Redacted] « Uneasy Money Trackback on November 25, 2012 at 8:59 pm
  10. 10 18 Signs Economists Haven’t the Foggiest | Unlearning Economics Trackback on January 19, 2014 at 9:27 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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