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.