Archive for the 'endogenous money' Category

Graeber Against Economics

David Graeber’s vitriolic essay “Against Economics” in the New York Review of Books has generated responses from Noah Smith and Scott Sumner among others. I don’t disagree with much that Noah or Scott have to say, but I want to dig a little deeper than they did into some of Graeber’s arguments, because even though I think he is badly misinformed on many if not most of the subjects he writes about, I actually have some sympathy for his dissatisfaction with the current state of economics. Graeber wastes no time on pleasantries.

There is a growing feeling, among those who have the responsibility of managing large economies, that the discipline of economics is no longer fit for purpose. It is beginning to look like a science designed to solve problems that no longer exist.

A serious polemicist should avoid blatant mischaracterizations, exaggerations and cheap shots, and should be well-grounded in the object of his critique, thereby avoiding criticisms that undermine his own claims to expertise. I grant that  Graeber has some valid criticisms to make, even agreeing with him, at least in part, on some of them. But his indiscriminate attacks on, and caricatures of, all neoclassical economics betrays a superficial understanding of that discipline.

Graeber begins by attacking what he considers the misguided and obsessive focus on inflation by economists.

A good example is the obsession with inflation. Economists still teach their students that the primary economic role of government—many would insist, its only really proper economic role—is to guarantee price stability. We must be constantly vigilant over the dangers of inflation. For governments to simply print money is therefore inherently sinful.

Every currency unit, or banknote issued by a central bank, now in circulation, as Graeber must know, has been “printed.” So to say that economists consider it sinful for governments to print money is either a deliberate falsehood, or an emotional rhetorical outburst, as Graeber immediately, and apparently unwittingly, acknowledges!

If, however, inflation is kept at bay through the coordinated action of government and central bankers, the market should find its “natural rate of unemployment,” and investors, taking advantage of clear price signals, should be able to ensure healthy growth. These assumptions came with the monetarism of the 1980s, the idea that government should restrict itself to managing the money supply, and by the 1990s had come to be accepted as such elementary common sense that pretty much all political debate had to set out from a ritual acknowledgment of the perils of government spending. This continues to be the case, despite the fact that, since the 2008 recession, central banks have been printing money frantically [my emphasis] in an attempt to create inflation and compel the rich to do something useful with their money, and have been largely unsuccessful in both endeavors.

Graeber’s use of the ambiguous pronoun “this” beginning the last sentence of the paragraph betrays his own confusion about what he is saying. Central banks are printing money and attempting to “create” inflation while supposedly still believing that inflation is a menace and printing money is a sin. Go figure.

We now live in a different economic universe than we did before the crash. Falling unemployment no longer drives up wages. Printing money does not cause inflation. Yet the language of public debate, and the wisdom conveyed in economic textbooks, remain almost entirely unchanged.

Again showing an inadequate understanding of basic economic theory, Graeber suggests that, in theory if not practice, falling unemployment should cause wages to rise. The Philips Curve, upon which Graeber’s suggestion relies, represents the empirically observed negative correlation between the rate of average wage increase and the rate of unemployment. But correlation does not imply causation, so there is no basis in economic theory to assert that falling unemployment causes the rate of increase in wages to accelerate. That the empirical correlation between unemployment and wage increases has not recently been in evidence provides no compelling reason for changing textbook theory.

From this largely unfounded and attack on economic theory – a theory which I myself consider, in many respects, inadequate and unreliable – Graeber launches a bitter diatribe against the supposed hegemony of economists over policy-making.

Mainstream economists nowadays might not be particularly good at predicting financial crashes, facilitating general prosperity, or coming up with models for preventing climate change, but when it comes to establishing themselves in positions of intellectual authority, unaffected by such failings, their success is unparalleled. One would have to look at the history of religions to find anything like it.

The ability to predict financial crises would be desirable, but that cannot be the sole criterion for whether economics has advanced our understanding of how economic activity is organized or what effects policy changes have. (I note parenthetically that many economists defensively reject the notion that economic crises are predictable on the grounds that if economists could predict a future economic crisis, those predictions would be immediately self-fulfilling. This response, of course, effectively disproves the idea that economists could predict that an economic crisis would occur in the way that astronomers predict solar eclipses. But this response slays a strawman. The issue is not whether economists can predict future crises, but whether they can identify conditions indicating an increased likelihood of a crisis and suggest precautionary measures to reduce the likelihood that a potential crisis will occur. But Graeber seems uninterested in or incapable of engaging the question at even this moderate level of subtlety.)

In general, I doubt that economists can make more than a modest contribution to improved policy-making, and the best that one can hope for is probably that they steer us away from the worst potential decisions rather than identifying the best ones. But no one, as far as I know, has yet been burned at the stake by a tribunal of economists.

To this day, economics continues to be taught not as a story of arguments—not, like any other social science, as a welter of often warring theoretical perspectives—but rather as something more like physics, the gradual realization of universal, unimpeachable mathematical truths. “Heterodox” theories of economics do, of course, exist (institutionalist, Marxist, feminist, “Austrian,” post-Keynesian…), but their exponents have been almost completely locked out of what are considered “serious” departments, and even outright rebellions by economics students (from the post-autistic economics movement in France to post-crash economics in Britain) have largely failed to force them into the core curriculum.

I am now happy to register agreement with something that Graeber says. Economists in general have become overly attached to axiomatic and formalistic mathematical models that create a false and misleading impression of rigor and mathematical certainty. In saying this, I don’t dispute that mathematical modeling is an important part of much economic theorizing, but it should not exclude other approaches to economic analysis and discourse.

As a result, heterodox economists continue to be treated as just a step or two away from crackpots, despite the fact that they often have a much better record of predicting real-world economic events. What’s more, the basic psychological assumptions on which mainstream (neoclassical) economics is based—though they have long since been disproved by actual psychologists—have colonized the rest of the academy, and have had a profound impact on popular understandings of the world.

That heterodox economists have a better record of predicting economic events than mainstream economists is an assertion for which Graeber offers no evidence or examples. I would not be surprised if he could cite examples, but one would have to weigh the evidence surrounding those examples before concluding that predictions by heterodox economists were more accurate than those of their mainstream counterparts.

Graeber returns to the topic of monetary theory, which seems a particular bugaboo of his. Taking the extreme liberty of holding up Mrs. Theresa May as a spokesperson for orthodox economics, he focuses on her definitive 2017 statement that there is no magic money tree.

The truly extraordinary thing about May’s phrase is that it isn’t true. There are plenty of magic money trees in Britain, as there are in any developed economy. They are called “banks.” Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans. Almost all of the money circulating in Britain at the moment is bank-created in this way.

What Graeber chooses to ignore is that banks do not operate magically; they make loans and create deposits in seeking to earn profits; their decisions are not magical, but are oriented toward making profits. Whether they make good or bad decisions is debatable, but the debate isn’t about a magical process; it’s a debate about theory and evidence. Graeber describe how he thinks that economists think about how banks create money, correctly observing that there is a debate about how that process works, but without understanding those differences or their significance.

Economists, for obvious reasons, can’t be completely oblivious to the role of banks, but they have spent much of the twentieth century arguing about what actually happens when someone applies for a loan. One school insists that banks transfer existing funds from their reserves, another that they produce new money, but only on the basis of a multiplier effect). . . Only a minority—mostly heterodox economists, post-Keynesians, and modern money theorists—uphold what is called the “credit creation theory of banking”: that bankers simply wave a magic wand and make the money appear, secure in the confidence that even if they hand a client a credit for $1 million, ultimately the recipient will put it back in the bank again, so that, across the system as a whole, credits and debts will cancel out. Rather than loans being based in deposits, in this view, deposits themselves were the result of loans.

The one thing it never seemed to occur to anyone to do was to get a job at a bank, and find out what actually happens when someone asks to borrow money. In 2014 a German economist named Richard Werner did exactly that, and discovered that, in fact, loan officers do not check their existing funds, reserves, or anything else. They simply create money out of thin air, or, as he preferred to put it, “fairy dust.”

Graeber is right that economists differ in how they understand banking. But the simple transfer-of-funds view, a product of the eighteenth century, was gradually rejected over the course of the nineteenth century; the money-multiplier view largely superseded it, enjoying a half-century or more of dominance as a theory of banking, still remains a popular way for introductory textbooks to explain how banking works, though it would be better if it were decently buried and forgotten. But since James Tobin’s classic essay “Commercial banks as creators of money” was published in 1963, most economists who have thought carefully about banking have concluded that the amount of deposits created by banks corresponds to the quantity of deposits that the public, given their expectations about the future course of the economy and the future course of prices, chooses to hold. The important point is that while a bank can create deposits without incurring more than the negligible cost of making a book-keeping, or an electronic, entry in a customer’s account, the creation of a deposit is typically associated with a demand by the bank to hold either reserves in its account with the Fed or to hold some amount of Treasury instruments convertible, on very short notice, into reserves at the Fed.

Graeber seems to think that there is something fundamental at stake for the whole of macroeconomics in the question whether deposits created loans or loans create deposits. I agree that it’s an important question, but not as significant as Graeber believes. But aside from that nuance, what’s remarkable is that Graeber actually acknowledges that the weight of professional opinion is on the side that says that loans create deposits. He thus triumphantly cites a report by Bank of England economists that correctly explained that banks create money and do so in the normal course of business by making loans.

Before long, the Bank of England . . . rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply.

Graeber, I regret to say, is simply exposing the inadequacy of his knowledge of the history of economics. Adam Smith in The Wealth of Nations explained that banks create money who, in doing so, saved the resources that would have been wasted on creating additional gold and silver. Subsequent economists from David Ricardo through Henry Thornton, J. S. Mill and R. G. Hawtrey were perfectly aware that banks can supply money — either banknotes or deposits — at less than the cost of mining and minting new coins, as they extend their credit in making loans to borrowers. So what is at issue, Graeber to the contrary notwithstanding, is not a dispute between orthodoxy and heterodoxy.

In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create.

Central banks set a rental price for reserves, thereby controlling the quantity of reserves into which bank deposits are convertible that is available to the economy. One way to think about that quantity is that the quantity of reserves along with the aggregate demand to hold reserves determines the exchange value of reserves and hence the price level; another way to think about it is that the interest rate or the implied policy stance of the central bank helps to determine the expectations of the public about the future course of the price level which is what determines – within some margin of error or range – what the future course of the price level will turn out to be.

Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

This is just silly. Funds may or may not be diverted from the private sector, but the total available resources to society is finite. If the central bank creates additional money, it creates additional claims to those resources and the creation of additional claims to resources necessarily has an effect on the prices of inputs and of outputs.

One might have imagined that such an admission would create something of a splash, and in certain restricted circles, it did. Central banks in Norway, Switzerland, and Germany quickly put out similar papers. Back in the UK, the immediate media response was simply silence. The Bank of England report has never, to my knowledge, been so much as mentioned on the BBC or any other TV news outlet. Newspaper columnists continued to write as if monetarism was self-evidently correct. Politicians continued to be grilled about where they would find the cash for social programs. It was as if a kind of entente cordiale had been established, in which the technocrats would be allowed to live in one theoretical universe, while politicians and news commentators would continue to exist in an entirely different one.

Even if we stipulate that this characterization of what the BBC and newspaper columnists believe is correct, what we would have — at best — is a commentary on the ability of economists to communicate their understanding of how the economy works to the intelligentsia that communicates to ordinary citizens. It is not in and of itself a commentary on the state of economic knowledge, inasmuch as Graeber himself concedes that most economists don’t accept monetarism. And that has been the case, as Noah Smith pointed out in his Bloomberg column on Graeber, since the early 1980s when the Monetarist experiment in trying to conduct monetary policy by controlling the monetary aggregates proved entirely unworkable and had to be abandoned as it was on the verge of precipitating a financial crisis.

Only after this long warmup decrying the sorry state of contemporary economic theory does Graeber begin discussing the book under review Money and Government by Robert Skidelsky.

What [Skidelsky] reveals is an endless war between two broad theoretical perspectives. . . The crux of the argument always seems to turn on the nature of money. Is money best conceived of as a physical commodity, a precious substance used to facilitate exchange, or is it better to see money primarily as a credit, a bookkeeping method or circulating IOU—in any case, a social arrangement? This is an argument that has been going on in some form for thousands of years. What we call “money” is always a mixture of both, and, as I myself noted in Debt (2011), the center of gravity between the two tends to shift back and forth over time. . . .One important theoretical innovation that these new bullion-based theories of money allowed was, as Skidelsky notes, what has come to be called the quantity theory of money (usually referred to in textbooks—since economists take endless delight in abbreviations—as QTM).

But these two perspectives are not mutually exclusive, and, depending on time, place, circumstances, and the particular problem that is the focus of attention, either of the two may be the appropriate paradigm for analysis.

The QTM argument was first put forward by a French lawyer named Jean Bodin, during a debate over the cause of the sharp, destablizing price inflation that immediately followed the Iberian conquest of the Americas. Bodin argued that the inflation was a simple matter of supply and demand: the enormous influx of gold and silver from the Spanish colonies was cheapening the value of money in Europe. The basic principle would no doubt have seemed a matter of common sense to anyone with experience of commerce at the time, but it turns out to have been based on a series of false assumptions. For one thing, most of the gold and silver extracted from Mexico and Peru did not end up in Europe at all, and certainly wasn’t coined into money. Most of it was transported directly to China and India (to buy spices, silks, calicoes, and other “oriental luxuries”), and insofar as it had inflationary effects back home, it was on the basis of speculative bonds of one sort or another. This almost always turns out to be true when QTM is applied: it seems self-evident, but only if you leave most of the critical factors out.

In the case of the sixteenth-century price inflation, for instance, once one takes account of credit, hoarding, and speculation—not to mention increased rates of economic activity, investment in new technology, and wage levels (which, in turn, have a lot to do with the relative power of workers and employers, creditors and debtors)—it becomes impossible to say for certain which is the deciding factor: whether the money supply drives prices, or prices drive the money supply.

As a matter of logic, if the value of money depends on the precious metals (gold or silver) from which coins were minted, the value of money is necessarily affected by a change in the value of the metals used to coin money. Because a large increase in the stock of gold and silver, as Graeber concedes, must reduce the value of those metals, subsequent inflation then being attributable, at least in part, to the gold and silver discoveries even if the newly mined gold and silver was shipped mainly to privately held Indian and Chinese hoards rather than minted into new coins. An exogenous increase in prices may well have caused the quantity of credit money to increase, but that is analytically distinct from the inflationary effect of a reduced value of gold or silver when, as was the case in the sixteenth century, money is legally defined as a specific weight of gold or silver.

Technically, this comes down to a choice between what are called exogenous and endogenous theories of money. Should money be treated as an outside factor, like all those Spanish dubloons supposedly sweeping into Antwerp, Dublin, and Genoa in the days of Philip II, or should it be imagined primarily as a product of economic activity itself, mined, minted, and put into circulation, or more often, created as credit instruments such as loans, in order to meet a demand—which would, of course, mean that the roots of inflation lie elsewhere?

There is no such choice, because any theory must posit certain initial conditions and definitions, which are given or exogenous to the analysis. How the theory is framed and which variables are treated as exogenous and which are treated as endogenous is a matter of judgment in light of the problem and the circumstances. Graeber is certainly correct that, in any realistic model, the quantity of money is endogenously, not exogenously, determined, but that doesn’t mean that the value of gold and silver may not usefully be treated as exogenous in a system in which money is defined as a weight of gold or silver.

To put it bluntly: QTM is obviously wrong. Doubling the amount of gold in a country will have no effect on the price of cheese if you give all the gold to rich people and they just bury it in their yards, or use it to make gold-plated submarines (this is, incidentally, why quantitative easing, the strategy of buying long-term government bonds to put money into circulation, did not work either). What actually matters is spending.

Graeber is talking in circles, failing to distinguish between the quantity theory of money – a theory about the value of a pure medium of exchange with no use except to be received in exchange — and a theory of the real value of gold and silver when money is defined as a weight of gold or silver. The value of gold (or silver) in monetary uses must be roughly equal to its value in non-monetary uses. which is determined by the total stock of gold and the demand to hold gold or to use it in coinage or for other uses (e.g., jewelry and ornamentation). An increase in the stock of gold relative to demand must reduce its value. That relationship between price and quantity is not the same as QTM. The quantity of a metallic money will increase as its value in non-monetary uses declines. If there is literally an unlimited demand for newly mined gold to be immediately sent unused into hoards, Graeber’s argument would be correct. But the fact that much of the newly mined gold initially went into hoards does not mean that all of the newly mined gold went into hoards.

In sum, Graeber is confused between the quantity theory of money and a theory of a commodity money used both as money and as a real commodity. The quantity theory of money of a pure medium of exchange posits that changes in the quantity of money cause proportionate changes in the price level. Changes in the quantity of a real commodity also used as money have nothing to do with the quantity theory of money.

Relying on a dubious account of the history of monetary theory by Skidelsky, Graeber blames the obsession of economists with the quantity theory for repeated monetary disturbances starting with the late 17th century deflation in Britain when silver appreciated relative to gold causing prices measured in silver to fall. Graeber thus fails to see that under a metallic money, real disturbances do have repercussion on the level of prices, repercussions having nothing to do with an exogenous prior change in the quantity of money.

According to Skidelsky, the pattern was to repeat itself again and again, in 1797, the 1840s, the 1890s, and, ultimately, the late 1970s and early 1980s, with Thatcher and Reagan’s (in each case brief) adoption of monetarism. Always we see the same sequence of events:

(1) The government adopts hard-money policies as a matter of principle.

(2) Disaster ensues.

(3) The government quietly abandons hard-money policies.

(4) The economy recovers.

(5) Hard-money philosophy nonetheless becomes, or is reinforced as, simple universal common sense.

There is so much indiscriminate generalization here that it is hard to know what to make of it. But the conduct of monetary policy has always been fraught, and learning has been slow and painful. We can and must learn to do better, but blanket condemnations of economics are unlikely to lead to better outcomes.

How was it possible to justify such a remarkable string of failures? Here a lot of the blame, according to Skidelsky, can be laid at the feet of the Scottish philosopher David Hume. An early advocate of QTM, Hume was also the first to introduce the notion that short-term shocks—such as Locke produced—would create long-term benefits if they had the effect of unleashing the self-regulating powers of the market:

Actually I agree that Hume, as great and insightful a philosopher as he was and as sophisticated an economic observer as he was, was an unreliable monetary theorist. And one of the reasons he was led astray was his unwarranted attachment to the quantity theory of money, an attachment that was not shared by his close friend Adam Smith.

Ever since Hume, economists have distinguished between the short-run and the long-run effects of economic change, including the effects of policy interventions. The distinction has served to protect the theory of equilibrium, by enabling it to be stated in a form which took some account of reality. In economics, the short-run now typically stands for the period during which a market (or an economy of markets) temporarily deviates from its long-term equilibrium position under the impact of some “shock,” like a pendulum temporarily dislodged from a position of rest. This way of thinking suggests that governments should leave it to markets to discover their natural equilibrium positions. Government interventions to “correct” deviations will only add extra layers of delusion to the original one.

I also agree that focusing on long-run equilibrium without regard to short-run fluctuations can lead to terrible macroeconomic outcomes, but that doesn’t mean that long-run effects are never of concern and may be safely disregarded. But just as current suffering must not be disregarded when pursuing vague and uncertain long-term benefits, ephemeral transitory benefits shouldn’t obscure serious long-term consequences. Weighing such alternatives isn’t easy, but nothing is gained by denying that the alternatives exist. Making those difficult choices is inherent in policy-making, whether macroeconomic or climate policy-making.

Although Graeber takes a valid point – that a supposed tendency toward an optimal long-run equilibrium does not justify disregard of an acute short-term problem – to an extreme, his criticism of the New Classical approach to policy-making that replaced the flawed mainstream Keynesian macroeconomics of the late 1970s is worth listening to. The New Classical approach self-consciously rejected any policy aimed at short-run considerations owing to a time-inconsistency paradox was based almost entirely on the logic of general-equilibrium theory and an illegitimate methodological argument rejecting all macroeconomic theories not rigorously deduced from the unarguable axiom of optimizing behavior by rational agents (and therefore not, in the official jargon, microfounded) as unscientific and unworthy of serious consideration in the brave New Classical world of scientific macroeconomics.

It’s difficult for outsiders to see what was really at stake here, because the argument has come to be recounted as a technical dispute between the roles of micro- and macroeconomics. Keynesians insisted that the former is appropriate to studying the behavior of individual households or firms, trying to optimize their advantage in the marketplace, but that as soon as one begins to look at national economies, one is moving to an entirely different level of complexity, where different sorts of laws apply. Just as it is impossible to understand the mating habits of an aardvark by analyzing all the chemical reactions in their cells, so patterns of trade, investment, or the fluctuations of interest or employment rates were not simply the aggregate of all the microtransactions that seemed to make them up. The patterns had, as philosophers of science would put it, “emergent properties.” Obviously, it was necessary to understand the micro level (just as it was necessary to understand the chemicals that made up the aardvark) to have any chance of understand the macro, but that was not, in itself, enough.

As an aisde, it’s worth noting that the denial or disregard of the possibility of any emergent properties by New Classical economists (of which what came to be known as New Keynesian economics is really a mildly schismatic offshoot) is nicely illustrated by the un-self-conscious alacrity with which the representative-agent approach was adopted as a modeling strategy in the first few generations of New Classical models. That New Classical theorists now insist that representative agency is not an essential to New Classical modeling is true, but the methodologically reductive nature of New Classical macroeconomics, in which all macroeconomic theories must be derived under the axiom of individually maximizing behavior except insofar as specific “frictions” are introduced by explicit assumption, is essential. (See here, here, and here)

The counterrevolutionaries, starting with Keynes’s old rival Friedrich Hayek . . . took aim directly at this notion that national economies are anything more than the sum of their parts. Politically, Skidelsky notes, this was due to a hostility to the very idea of statecraft (and, in a broader sense, of any collective good). National economies could indeed be reduced to the aggregate effect of millions of individual decisions, and, therefore, every element of macroeconomics had to be systematically “micro-founded.”

Hayek’s role in the microfoundations movement is important, but his position was more sophisticated and less methodologically doctrinaire than that of the New Classical macroeconomists, if for no other reason than that Hayek didn’t believe that macroeconomics should, or could, be derived from general-equilibrium theory. His criticism, like that of economists like Clower and Leijonhufvud, of Keynesian macroeconomics for being insufficiently grounded in microeconomic principles, was aimed at finding microeconomic arguments that could explain and embellish and modify the propositions of Keynesian macroeconomic theory. That is the sort of scientific – not methodological — reductivism that Hayek’s friend Karl Popper advocated: a theoretical and empirical challenge of reducing a higher level theory to its more fundamental foundations, e.g., when physicists and chemists search for theoretical breakthroughs that allow the propositions of chemistry to be reduced to more fundamental propositions of physics. The attempt to reduce chemistry to underlying physical principles is very different from a methodological rejection of all chemistry that cannot be derived from underlying deep physical theories.

There is probably more than a grain of truth in Graeber’s belief that there was a political and ideological subtext in the demand for microfoundations by New Classical macroeconomists, but the success of the microfoundations program was also the result of philosophically unsophisticated methodological error. How to apportion the share of blame going to mistaken methodology, professional and academic opportunism, and a hidden political agenda is a question worthy of further investigation. The easy part is to identify the mistaken methodology, which Graeber does. As for the rest, Graeber simply asserts bad faith, but with little evidence.

In Graeber’s comprehensive condemnation of modern economics, the efficient market hypothesis, being closely related to the rational-expectations hypothesis so central to New Classical economics, is not spared either. Here again, though I share and sympathize with his disdain for EMH, Graeber can’t resist exaggeration.

In other words, we were obliged to pretend that markets could not, by definition, be wrong—if in the 1980s the land on which the Imperial compound in Tokyo was built, for example, was valued higher than that of all the land in New York City, then that would have to be because that was what it was actually worth. If there are deviations, they are purely random, “stochastic” and therefore unpredictable, temporary, and, ultimately, insignificant.

Of course, no one is obliged to pretend that markets could not be wrong — and certainly not by a definition. The EMH simply asserts that the price of an asset reflects all the publicly available information. But what EMH asserts is certainly not true in many or even most cases, because people with non-public information (or with superior capacity to process public information) may affect asset prices, and such people may profit at the expense of those less knowledgeable or less competent in anticipating price changes. Moreover, those advantages may result from (largely wasted) resources devoted to acquiring and processing information, and it is those people who make fortunes betting on the future course of asset prices.

Graeber then quotes Skidelsky approvingly:

There is a paradox here. On the one hand, the theory says that there is no point in trying to profit from speculation, because shares are always correctly priced and their movements cannot be predicted. But on the other hand, if investors did not try to profit, the market would not be efficient because there would be no self-correcting mechanism. . .

Secondly, if shares are always correctly priced, bubbles and crises cannot be generated by the market….

This attitude leached into policy: “government officials, starting with [Fed Chairman] Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble.” The EMH made the identification of bubbles impossible because it ruled them out a priori.

So the apparent paradox that concerns Skidelsky and Graeber dissolves upon (only a modest amount of) further reflection. Proper understanding and revision of the EMH makes it clear that bubbles can occur. But that doesn’t mean that bursting bubbles is a job that can be safely delegated to any agency, including the Fed.

Moreover, the housing bubble peaked in early 2006, two and a half years before the financial crisis in September 2008. The financial crisis was not unrelated to the housing bubble, which undoubtedly added to the fragility of the financial system and its vulnerability to macroeconomic shocks, but the main cause of the crisis was Fed policy that was unnecessarily focused on a temporary blip in commodity prices persuading the Fed not to loosen policy in 2008 during a worsening recession. That was a scenario similar to the one in 1929 when concern about an apparent stock-market bubble caused the Fed to repeatedly tighten money, raising interest rates, thereby causing a downturn and crash of asset prices triggering the Great Depression.

Graeber and Skidelsky correctly identify some of the problems besetting macroeconomics, but their indiscriminate attack on all economic theory is unlikely to improve the situation. A pity, because a focused and sophisticated critique of economics than they have served up has never been more urgently needed than it is now to enable economists to perform the modest service to mankind of which they might be capable.

Nick Rowe Ignores, But Does Not Refute, the Law of Reflux

In yet another splendid post, Nick Rowe once again explains what makes money – the medium of exchange – so special. Money – the medium of exchange – is the only commodity that is traded in every market. Unlike every other commodity, each of which has a market of its very own, in which it – and only it – is traded (for money!), money has no market of its own, because money — the medium of exchange — is traded in every other market.

This distinction is valid and every important, and Nick is right to emphasize it, even obsess about it. Here’s how Nick described it his post:

1. If you want to increase the stock of land in your portfolio, there’s only one way to do it. You must increase the flow of land into your portfolio, by buying more land.

If you want to increase the stock of bonds in your portfolio, there’s only one way to do it. You must increase the flow of bonds into your portfolio, by buying more bonds.

If you want to increase the stock of equities in your portfolio, there’s only one way to do it. You must increase the flow of equities into your portfolio, by buying more equities.

But if you want to increase the stock of money in your portfolio, there are two ways to do it. You can increase the flow of money into your portfolio, by buying more money (selling more other things for money). Or you can decrease the flow of money out of your portfolio, by selling less money (buying less other things for money).

An individual who wants to increase his stock of money will still have a flow of money out of his portfolio. But he will plan to have a bigger flow in than flow out.

OK, let’s think about this for a second. Again, I totally agree with Nick that money is traded in every market. But is it really the case that there is no market in which only money is traded? If there is no market in which only money is traded, how do we explain the quantity of money in existence at any moment of time as the result of an economic process? Is it – I mean the quantity of money — just like an external fact of nature that is inexplicable in terms of economic theory?

Well, actually, the answer is: maybe it is, and maybe it’s not. Sometimes, we do just take the quantity of money to be an exogenous variable determined by some outside – noneconomic – force, aka the Monetary Authority, which, exercising its discretion, determines – judiciously or arbitrarily, take your pick – The Quantity of Money. But sometimes we acknowledge that the quantity of money is actually determined by economic forces, and is not a purely exogenous variable; we say that money is endogenous. And sometimes we do both; we distinguish between outside (exogenous) money and inside (endogenous) money.

But if we do acknowledge that there is – or that there might be – an economic process that determines what the quantity of money is, how can we not also acknowledge that there is – or might be — some market – a market dedicated to money, and nothing but money – in which the quantity of money is determined? Let’s now pick up where I left off in Nick’s post:

2. There is a market where land is exchanged for money; a market where bonds are exchanged for money; a market where equities are exchanged for money; and markets where all other goods and services are exchanged for money. “The money market” (singular) is an oxymoron. The money markets (plural) are all those markets. A monetary exchange economy is not an economy with one central Walrasian market where anything can be exchanged for anything else. Every market is a money market, in a monetary exchange economy.

An excess demand for land is observed in the land market. An excess demand for bonds is observed in the bond market. An excess demand for equities is observed in the equity market. An excess demand for money might be observed in any market.

Yes, an excess demand for money might be observed in any market, as people tried to shed, or to accumulate, money by altering their spending on other commodities. But is there no other way in which people wishing to hold more or less money than they now hold could obtain, or dispose of, money as desired?

Well, to answer that question, it helps to ask another question: what is the economic process that brings (inside) money – i.e., the money created by a presumably explicable process of economic activity — into existence? And the answer is that ordinary people exchange their liabilities with banks (or similar entities) and in return they receive the special liabilities of the banks. The difference between the liabilities of ordinary individuals and the special liabilities of banks is that the liabilities of ordinary individuals are not acceptable as payment for stuff, but the special liabilities of banks are acceptable as payment for stuff. In other words, special bank liabilities are a medium of exchange; they are (inside) money. So if I am holding less (more) money than I would like to hold, I can adjust the amount I am holding by altering my spending patterns in the ways that Nick lists in his post, or I can enter into a transaction with a bank to increase (decrease) the amount of money that I am holding. This is a perfectly well-defined market in which the public exchanges “money-backing” instruments (their IOUs) with which the banks create the monetary instruments that the banks give the public in return.

Whenever the total amount of (inside) money held by the non-bank public does not equal the total amount of (inside) money in existence, there are market forces operating by which the non-bank public and the banks can enter into transactions whereby the amount of (inside) money is adjusted to eliminate the excess demand for (supply of) (inside) money. This adjustment process does not operate instantaneously, and sometimes it may even operate dysfunctionally, but, whether it operates well or not so well, the process does operate, and we ignore it at our peril.

The rest of Nick’s post dwells on the problems caused by “price stickiness.” I may try to write another post soon about “price stickiness,” so I will just make a brief further comment about one further statement made by Nick:

Unable to increase the flow of money into their portfolios, each individual reduces the flow of money out of his portfolio.

And my comment is simply that Nick is begging the question here. He is assuming that there is no market mechanism by which individuals can increase the flow of money into their portfolios. But that is clearly not true, because most of the money in the hands of the public now was created by a process in which individuals increased the flow of money into their portfolios by exchanging their own “money-backing” IOUs with banks in return for the “monetary” IOUs created by banks.

The endogenous process by which the quantity of monetary IOUs created by the banking system corresponds to the amount of monetary IOUs that the public wants to hold at any moment of time is what is known as the Law of Reflux. Nick may believe — and may even be right — that the Law of Reflux is invalid, but if that is what Nick believes, he needs to make an argument, not assume a conclusion.

Can There Really Be an Excess Supply of Commercial Bank Money?

Nick Rowe has answered the question in the affirmative. Nick mistakenly believes that I have argued that there cannot be an excess supply of commercial bank money. In fact, I agree with him that there can be an excess supply of commercial bank money, and, for that matter, that there can be an excess demand for commercial bank money. Our disagreement concerns a slightly different, but nonetheless important, question: is there a market mechanism whereby an excess supply of commercial bank money can be withdrawn from circulation, or is the money destined to remain forever in circulation, because, commercial bank money, once created, must ultimately be held, however unwillingly, by someone? That’s the issue. I claim that there is a market mechanism that tends to equilibrate the quantity of bank money created with the amount demanded, so that if too much bank money is created, the excess will tend to be withdrawn from circulation without generating an increase in total expenditure. Nick denies that there is any such mechanism.

Nick and I have been discussing this point for about two and a half years, and every time I think we inch a bit closer to agreement, it seems that the divide separating us seems unbridgeable. But I’m not ready to give up yet. On the other hand, James Tobin explained it all over 50 years ago (when the idea seemed so radical it was called the New View) in his wonderful, classic (I don’t have enough adjectives superlatives to do it justice) paper “Commercial Banks and Creators of Money.” And how can I hope to improve on Tobin’s performance? (Actually there was a flaw in Tobin’s argument, which was not to recognize a key distinction between the inside (beta) money created by banks and the outside (alpha) money created by the monetary authority, but that has nothing to do with the logic of Tobin’s argument about commercial banks.)

Message to Nick: You need to write an article (a simple blog post won’t do, but it would be a start) explaining what you think is wrong with Tobin’s argument. I think that’s a hopeless task, but I’m sorry that’s the challenge you’ve chosen for yourself. Good luck, you’ll need it.

With that introduction out of the way, let me comment directly on Nick’s post. Nick has a subsequent post defending both the Keynesian multiplier and the money multiplier. I reserve the right (but don’t promise) to respond to that post at a later date; I have my hands full with this post. Here’s Nick:

Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It’s asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money. (Nor can there be an excess demand for alpha money in terms of beta money.) Because people would convert their beta money into alpha money if there were. But there can be an excess supply of beta money in terms of goods, just as there can be an excess supply of alpha money in terms of goods. If beta money is in excess supply in terms of goods, so is alpha money, and vice versa. If commercial and central bank monies are perfect or imperfect substitutes, an increased supply of commercial bank money will create an excess supply of both monies against goods. The Law of Reflux will not prevent this.

The primary duty of a central bank is not to make a profit. It is possible to analyze and understand its motivations and its actions in terms of policy objectives that do not reflect the economic interests of its immediate owners. On the other hand, commercial banks are primarily in business to make a profit, and it should be possible to explain their actions in terms of their profit-enhancing effects. As I follow Nick’s argument, I will try to point where I think Nick fails to keep this distinction in mind. Back to Nick:

Money, the medium of exchange, is not like other goods, because if there are n goods plus one money, there are n markets in which money is traded, and n different excess supplies of money. Money might be in excess supply in the apple market, and in excess demand in the banana market.

If there are two monies, and n other goods, there are n markets in which money is traded against goods, plus one market in which the two monies are traded for each other. If beta money is convertible into alpha money, there can never be an excess supply of beta money in the one market where beta money is traded for alpha money. But there can be an excess supply of both beta and alpha money in each or all of the other n markets.

Sorry, I don’t understand this at all. First of all, to be sure, there can be n different excess demands for money; some will be positive, some negative. But it is entirely possible that the sum of those n different excess demands is zero. Second, even if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services. The process is equilibrated by adjustments in the spreads between interests on loans and deposits governing the profitability of the banks loans and deposits. This is what I meant in the first paragraph when I said that I agree that it is possible for there to an excess demand for or supply of beta money. But the existence of that excess demand or excess supply can be equilibrated via the equilibration of market for beta money and the market for assets (IOUs) providing money-backing services. If there is a market process equilibrating the quantity of beta money, the adjustment can take place independently of the n markets for real goods and services that Nick is concerned with. On the other hand, if there is an excess demand for or supply of alpha money, it is not so clear that there are any market forces that cause that excess demand or supply to be equilibrated without impinging on the n real markets for goods and services.

Nick goes on to pose the following question:

Start in equilibrium, where the existing stocks of both alpha and beta money are willingly held. Hold constant the stock of alpha money. Now suppose the issuers of beta money create more beta money. Could this cause an excess supply of money and an increase in the price level?

That’s a great question. Just the question that I would ask. Here’s how Nick looks at it:

If alpha and beta money were perfect substitutes for each other, people would be indifferent about the proportions of alpha to beta monies they held. The desired share or ratio of alpha/beta money would be indeterminate, but the desired total of alpha+beta money would still be well-defined. If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods. But no individual would choose to go to the beta bank to convert his beta money into alpha money, because, by assumption, he doesn’t care about the share of alpha/beta money he holds. The Law of Reflux will not work to eliminate the excess supply of alpha+beta money against all other goods.

The assumption of perfect substitutability doesn’t seem right, as Nick himself indicates, inasmuch as people don’t seem to be indifferent between holding currency (alpha money) and holding deposits (beta money). And Nick focuses mainly on the imperfect-substitutes case. But, aside from that point, I have another problem with Nick’s discussion of perfect substitutes, which is that he seems to be conflate the assumption that alpha and beta moneys are perfect substitutes with the assumption that they are indistinguishable. I may be indifferent between holding currency and deposits, but if I have more deposits than I would like to hold, and I can tell the difference between a unit of currency and a deposit and there is a direct mechanism whereby I can reduce my holdings of deposits – by exchanging the deposit at the bank for another asset – it would seem that there is a mechanism whereby the excess supply of deposits can be eliminated without any change in overall spending. Now let’s look at Nick’s discussion of the more relevant case in which currency and deposits are imperfect substitutes.

Now suppose that alpha and beta money are close but imperfect substitutes. If beta banks want to prevent the Law of Reflux from reducing the stock of beta money, they would need to make beta money slightly more attractive to hold relative to alpha money. Suppose they do that, by paying slightly higher interest on beta money. This ensures that the desired share of alpha/beta money equals the actual share. No individual wants to reduce his share of beta/alpha money. But there will be an excess supply of both alpha and beta monies against all other goods. If apples and pears are substitutes, an increased supply of pears reduces the demand for apples.

What does it mean for “beta banks to want to prevent the Law of Reflux from reducing the stock of beta money?” Why would beta banks want to do such a foolish thing? Banks want to make profits for their owners. Does Nick think that by “prevent[ing] the Law of Reflux from reducing the stock of beta money” beta banks are increasing their profitability? The method by which he suggests that they could do this is to increase the interest they pay on deposits? That does not seem to me an obvious way of increasing the profits of beta banks. So starting from what he called an equilibrium, which sounds like a position in which beta banks were maximizing their profits, Nick is apparently positing that they increased the amount of deposits beyond the profit-maximizing level and, then, to keep that amount of deposits outstanding, he assumes that the banks increase the interest that they are paying on deposits.

What does this mean? Is Nick saying something other than that if banks collectively decide on a course of action that is not profit-maximizing either individually or collectively that the outcome will be different from the outcome that would have resulted had they acted with a view to maximize profits? Why should anyone be interested in that observation? At any rate, Nick concludes that because the public would switch from holding currency to deposits, the result would be an increase in total spending, as people tried to reduce their holdings of currency. It is not clear to me that people would be trying to increase their spending by reducing their holdings of deposits, but I can see that there is a certain ambiguity in trying to determine whether there is an excess supply of deposits or not in this case. But the case seems very contrived to say the least.

A more plausible way to look at the case Nick has in mind might be the following. Suppose banks perceive that their (marginal) costs of intermediation have fallen. Intermediation costs are very hard to measure, and banks aren’t necessarily very good at estimating those costs either. That may be one reason for the inherent instability of credit, but that’s a whole other discussion. At any rate, under the assumption that marginal intermediation costs have fallen, one could posit that the profit-maximizing response of beta banks would be to increase their interest payments on deposits to support an increase in their, suddenly more profitable than heretofore, lending. With bank deposits now yielding higher interest than before, the public would switch some of their holdings of currency to deposits. The shift form holding currency to holding deposits would initially involve an excess demand for deposits and an excess supply of currency. If the alpha bank was determined not to allow the quantity of currency to fall, then the excess supply of currency could be eliminated only through an increase in spending that would raise prices sufficiently to increase the demand to hold currency. But Nick would apparently want to say that even in this case there was also an excess supply of deposits, even though we saw that initially there was an excess demand for deposits when banks increased the interest paid on deposits, and it was only because the alpha bank insisted on not allowing the quantity of currency to fall that there was any increase in total spending.

So, my conclusion remains what it was before. The Law of Reflux works to eliminate excess supplies of bank money, without impinging on spending for real goods and services. To prove otherwise, you have to find a flaw in the logic of Tobin’s 1963 paper. I think that that is very unlikely. On the other hand, if you do find such a flaw, you just might win the Nobel Prize.

The Uselessness of the Money Multiplier as Brilliantly Elucidated by Nick Rowe

Not long after I started blogging over two and a half years ago, Nick Rowe and I started a friendly argument about the money multiplier. He likes it; I don’t. In his latest post (“Alpha banks, beta banks, fixed exchange rates, market shares, and the money multiplier”), Nick attempts (well, sort of) to defend the money multiplier. Nick has indeed figured out an ingenious way of making sense out of the concept, but in doing so, he has finally and definitively demonstrated its total uselessness.

How did Nick accomplish this remarkable feat? By explaining that there is no significant difference between a commercial bank that denominates its deposits in terms of a central bank currency, thereby committing itself to make its deposits redeemable on demand into a corresponding amount of central bank currency, and a central bank that commits to maintain a fixed exchange rate between its currency and the currency of another central bank — the commitment to a fixed exchange rate being unilateral and one-sided, so that only one of the central banks (the beta bank) is constrained by its unilateral commitment to a fixed exchange rate, while the other central bank (the alpha bank) is free from commitment to an exchange-rate peg.

Just suppose the US Fed, for reasons unknown, pegged the exchange rate of the US dollar to the Canadian dollar. The Fed makes a promise to ensure the US dollar will always be directly or indirectly convertible into Canadian dollars at par. The Bank of Canada makes no commitment the other way. The Bank of Canada does whatever it wants to do. The Fed has to do whatever it needs to do to keep the exchange rate fixed.

For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar. The Fed’s promise to fix the exchange rate makes the Bank of Canada the alpha bank and the Fed the beta bank. Both Canadian and US monetary policy would be decided in Ottawa. It’s asymmetric redeemability that gives the Bank of Canada its power over the Fed.

Absolutely right! Under these assumptions, the amount of money created by the Fed would be governed, among other things, by its commitment to maintain the exchange-rate peg between the US dollar and the Canadian dollar. However, the numerical relationship between the quantity of US dollars and quantity of Canadian dollars would depend on the demand of US (and possibly Canadian) citizens and residents to hold US dollars. The more US dollars people want to hold, the more dollars the Fed can create.

Nick then goes on to make the following astonishing (for him) assertion.

Doubling the Canadian price level would mean approximately doubling the supplies of all Canadian monies, including the money issued by the Bank of Canada. Doubling the US price level would mean approximately doubling the supplies of all US monies, including the money issued by the Fed. Because the demand for money is proportional to the price level.

In other words, given the price level, the quantity of money adjusts to whatever is the demand for it, the price level being determined unilaterally by the unconstrained (aka “alpha”) central bank.

To see how astonishing (for Nick) this assertion is, consider the following passage from Perry Mehrling’s superb biography of Fischer Black. Mehrling devotes an entire chapter (“The Money Wars”) to the relationship between Black and Milton Friedman. Black came to Chicago as a professor in the Business School, and tried to get Friedman interested in his idea the quantity of money supplied by the banking system adjusted passively to the amount demanded. Friedman dismissed the idea as preposterous, a repetition of the discredited “real bills doctrine,” considered by Friedman to be fallacy long since refuted (definitively) by his teacher Lloyd Mints in his book A History of Banking Theory. Friedman dismissed Black and told him to read Mints, and when Black, newly arrived at Chicago in 1971, presented a paper at the Money Workshop at Chicago, Friedman introduced Black as follows:

Fischer Black will be presenting his paper today on money in a two-sector model. We all know that the paper is wrong. We have two hours to work out why it is wrong.

Mehrling describes the nub of the disagreement between Friedman and Black this way:

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond.The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money casues prices to rise, as Friedman insisted, but it could also mean that an increase in prices casues the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (p. 160)

Well, we now see that Nick Rowe has come down squarely on the side of, gasp, Fischer Black against Milton Friedman. “Wonder of wonders, miracle of miracles!”

But despite making that break with his Monetarist roots, Nick isn’t yet quite ready to let go, lapsing once again into money-multiplier talk.

The money issued by the Bank of Canada (mostly currency, with a very small quantity of reserves) is a very small share of the total Canadian+US money supply. What exactly that share would be would depend on how exactly you define “money”. Let’s say it’s 1% of the total. The total Canadian+US money supply would increase by 100 times the amount of new money issued by the Bank of Canada. The money multiplier would be the reciprocal of the Bank of Canada’s share in the total Canadian+US money supply. 1/1%=100.

Maybe the US Fed keeps reserves of Bank of Canada dollars, to help it keep the exchange rate fixed. Or maybe it doesn’t. But it doesn’t matter.

Do loans create deposits, or do deposits create loans? Yes. Neither. But it doesn’t matter.

The only thing that does matter is the Bank of Canada’s market share, and whether it stays constant. And which bank is the alpha bank and which bank is the beta bank.

So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.

The point of the money multiplier is to provide a rationale for saying: “sure, we know that banks create a lot of money, and we don’t really understand what governs the amount of money banks create, but whatever amount of money banks create, that amount is ultimately under the control of the monetary authority, the amount being some multiple of the monetary base. So it’s still as if the central bank decides what M is, so that it really is OK to say that the central bank can control the price level even though M in the quantity equation is not really produced by the central bank. M is exogenously determined, because there is a money multiplier that relates M to B. If that is unclear, I’m sorry, but that’s what the Monetarists have been saying all these years.

Who cares, anyway? Well, all the people that fell for Friedman’s notion (traceable to the General Theory by the way) that monetary policy works by controlling the quantity of money produced by the banking system. Somehow Monetarists like Friedman who was pushing his dumb k% rule for monetary growth thought that it was important to be able to show that the quantity of money could be controlled by the monetary authority. Otherwise, the whole rationale for the k% rule would be manifestly based based on a faulty — actually vacuous — premise. The post-Keynesian exogenous endogenous-money movement was an equally misguided reaction to Friedman’s Monetarist nonsense, taking for granted that if they could show that the money multiplier and the idea that the central bank could control the quantity of money were unfounded, it would follow that inflation is not a monetary phenomenon and is beyond the power of a central bank to control. The two propositions are completely independent of one another, and all the sturm und drang of the last 40 years about endogenous money has been a complete waste of time, an argument about a non-issue. Whether the central bank can control the price level has nothing to do with whether there is or isn’t a multiplier. Get over it.

Nick recognizes this:

The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank. If all banks expand together, their market shares stay the same. But if one bank expands alone, it must persuade the market to be willing to hold an increased share of its money and a reduced share of some other banks’ monies, otherwise it will be forced to redeem its money for other banks’ monies, or else suffer a depreciation of its exchange rate. Unless that bank is the alpha bank, to which all the beta banks fix their exchange rates. It is the beta banks’ responsibility to keep their exchange rates fixed to the alpha bank. The Law of Reflux ensures that an individual beta bank cannot overissue its money beyond the share the market desires to hold. The alpha bank can do whatever it likes, because it makes no promise to keep its exchange rate fixed.

It’s all about the public’s demand for money, and their relative preferences for holding one money or another. The alpha central bank may or may not be able to achieve some targeted value for its money, but whether it can or can not has nothing to do with its ability to control the quantity of money created by the beta banks that are committed to an exchange rate peg against  the money of the alpha bank. In other words, the money multiplier is a completely useless concept, as useless as a multiplier between, say, the quantity of white Corvettes the total quantity of Corvettes. From now on, I’m going to call this Rowe’s Theorem. Nick, you’re the man!

The Irrelevance of QE as Explained by Three Bank of England Economists

An article by Michael McLeay, Amara Radia and Ryland Thomas (“Money Creation in the Modern Economy”) published in the Bank of England Quarterly Bulletin has gotten a lot of attention recently. JKH, who liked it a lot, highlighting it on his blog, and prompting critical responses from, among others, Nick Rowe and Scott Sumner.

Let’s look at the overview of the article provided by the authors.

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

I start with a small point. What the authors mean by a “modern economy” is unclear, but presumably when they speak about the money created in a modern economy they are referring to the fact that the money held by the non-bank public has increasingly been held in the form of deposits rather than currency or coins (either tokens or precious metals). Thus, Scott Sumner’s complaint that the authors’ usage of “modern” flies in the face of the huge increase in the ratio of base money to broad money is off-target. The relevant ratio is that between currency and the stock of some measure of broad money held by the public, which is not the same as the ratio of base money to the stock of broad money.

I agree that the reality of how money is created differs from the textbook money-multiplier description. See my book on free banking and various posts I have written about the money multiplier and endogenous money. There is no meaningful distinction between “normal times” and “exceptional circumstances” for purposes of understanding how money is created.

Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.

I agree that commercial banks cannot create money without limit. They are constrained by the willingness of the public to hold their liabilities. Not all monies are the same, despite being convertible into each other at par. The ability of a bank to lend is constrained by the willingness of the public to hold the deposits of that bank rather than currency or the deposits of another bank.

Monetary policy acts as the ultimate limit on money creation. The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans.

Monetary policy is certainly a constraint on money creation, but I don’t understand why it is somehow more important (the constraint of last resort?) than the demand of the public to hold money. Monetary policy, in the framework suggested by this article, affects the costs borne by banks in creating deposits. Adopting Marshallian terminology, we could speak of the two blades of a scissors. Which bade is the ultimate blade? I don’t think there is an ultimate blade. In this context, the term “normal times” refers to periods in which interest rates are above the effective zero lower bound (see the following paragraph). But the underlying confusion here is that the authors seem to think that the amount of money created by the banking system actually matters. In fact, it doesn’t matter, because (at least in the theoretical framework being described) the banks create no more and no less money that the amount that the public willingly holds. Thus the amount of bank money created has zero macroeconomic significance.

In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing’ (QE). QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.

Again the underlying problem with this argument is the presumption that the amount of money created by banks – money convertible into the base money created by the central bank – is a magnitude with macroeconomic significance. In the framework being described, there is no macroeconomic significance to that magnitude, because the value of bank money is determined by its convertibility into central bank money and the banking system creates exactly as much money as is willingly held. If the central bank wants to affect the price level, it has to do so by creating an excess demand or excess supply of the money that it — the central bank — creates, not the money created by the banking system.

QE initially increases the amount of bank deposits those companies hold (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy.

If the amount of bank deposits in the economy is the amount that the public wants to hold, QE cannot affect anything by increasing the amount of bank deposits; any unwanted bank deposits are returned to the banking system. It is only an excess of central-bank money that can possibly affect spending.

As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism. This article explains how, just as in normal times, these reserves cannot be multiplied into more loans and deposits and how these reserves do not represent ‘free money’ for banks.

The problem with the creation of new central-bank reserves by QE at the zero lower bound is that, central-bank reserves earn a higher return than alternative assets that might be held by banks, so any and all reserves created by the central bank are held willingly by the banking system. The demand of the banking for central bank reserves is unbounded at the zero-lower bound when the central bank pays a higher rate of interest than the yield on the next best alternative asset the bank could hold. If the central bank wants to increase spending, it can only do so by creating reserves that are not willingly held. Thus, in the theortetical framework described by the authors, QE cannot possibly have any effect on any macroeconomic variable. Now that’s a problem.

Why Hawtrey and Cassel Trump Friedman and Schwartz

This year is almost two-thirds over, and I still have yet to start writing about one of the two great anniversaries monetary economists are (or should be) celebrating this year. The one that they are already celebrating is the fiftieth anniversary of the publication of The Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz; the one that they should also be celebrating is the 100th anniversary of Good and Bad Trade by Ralph Hawtrey. I am supposed to present a paper to mark the latter anniversary at the Southern Economic Association meetings in November, and I really have to start working on that paper, which I am planning to do by writing a series of posts about the book over the next several weeks.

Good and Bad Trade was Hawtrey’s first publication about economics. He was 34 years old, and had already been working at the Treasury for nearly a decade. Though a Cambridge graduate (in mathematics), Hawtrey was an autodidact in economics, so it is really a mistake to view him as a Cambridge economist. In Good and Bad Trade, he developed a credit theory of money (money as a standard of value in terms of which to discharge debts) in the course of presenting his purely monetary theory of the business cycle, one of the first and most original instances of such a theory. The originality lay in his description of the transmission mechanism by which money — actually the interest rate at which money is lent by banks — influences economic activity, through the planned accumulation or reduction of inventory holdings by traders and middlemen in response to changes in the interest rate at which they can borrow funds. Accumulation of inventories leads to cumulative increases of output and income; reductions in inventories lead to cumulative decreases in output and income. The business cycle (under a gold standard) therefore was driven by changes in bank lending rates in response to changes in lending rate of the central bank. That rate, or Bank Rate, as Hawtrey called it, was governed by the demand of the central bank for gold reserves. A desire to increase gold reserves would call for an increase in Bank Rate, and a willingness to reduce reserves would lead to a reduction in Bank Rate. The basic model presented in Good and Bad Trade was, with minor adjustments and refinements, pretty much the same model that Hawtrey used for the next 60 years, 1971 being the year of his final publication.

But in juxtaposing Hawtrey with Friedman and Schwartz, I really don’t mean to highlight Hawtrey’s theory of the business cycle, important though it may be in its own right, but his explanation of the Great Depression. And the important thing to remember about Hawtrey’s explanation for the Great Depression (the same explanation provided at about the same time by Gustav Cassel who deserves equal credit for diagnosing and explaining the problem both prospectively and retrospectively as explained in my paper with Ron Batchelder and by Doug Irwin in this paper) is that he did not regard the Great Depression as a business-cycle episode, i.e., a recurring phenomenon of economic life under a functioning gold standard with a central bank trying to manage its holdings of gold reserves through manipulation of Bank Rate. The typical business-cycle downturn described by Hawtrey was caused by a central bank responding to a drain on its gold reserves (usually because expanding output and income increased the internal monetary demand for gold to be used as hand-to-hand currency) by raising Bank Rate. What happened in the Great Depression was not a typical business-cycle downturn; it was characteristic of a systemic breakdown in the gold standard. In his 1919 article on the gold standard, Hawtrey described the danger facing the world as it faced the task of reconstructing the international gold standard that had been effectively destroyed by World War I.

We have already observed that the displacement of vast quantities of gold from circulation in Europe has greatly depressed the world value of gold in relation to commodities. Suppose that in a few years’ time the gold standard is restored to practically universal use. If the former currency systems are revived, and with them the old demands for gold, both for circulation in coin and for reserves against note issues, the value of gold in terms of commodities will go up. In proportion as it goes up, the difficulty of regaining or maintaining the gold standard will be accentuated. In other words, if the countries which are striving to recover the gold standard compete with one another for the existing supply of gold, they will drive up the world value of gold, and will find themselves burdened with a much more severe task of deflation than they ever anticipated.

And at the present time the situation is complicated by the portentous burden of the national debts. Except for America and this country, none of the principal participants in the war can see clearly the way to solvency. Even we, with taxation at war level, can only just make ends meet. France, Italy, Germany and Belgium have hardly made a beginning with the solution of their financial problems. The higher the value of the monetary unit in which one of these vast debts is calculated, the greater will be the burden on the taxpayers responsible for it. The effect of inflation in swelling the nominal national income is clearly demonstrated by the British income-tax returns, and by the well-sustained consumption of dutiable commodities notwithstanding enormous increases in the rates of duty. Deflation decreases the money yield of the revenue, while leaving the money burden of the debt undiminished. Deflation also, it is true, diminishes the ex-penses of Government, and when the debt charges are small in proportion to the rest, it does not greatly increase the national burdens. But now that the debt charge itself is our main pre-occupation, we may find the continuance of some degree of inflation a necessary condition of solvency.

So 10 years before the downward spiral into the Great Depression began, Hawtrey (and Cassel) had already identified the nature and cause of the monetary dysfunction associated with a mishandled restoration of the international gold standard which led to the disaster. Nevertheless, in their account of the Great Depression, Friedman and Schwartz paid almost no attention to the perverse dynamics associated with the restoration of the gold standard, completely overlooking the role of the insane Bank of France, while denying that the Great Depression was caused by factors outside the US on the grounds that, in the 1929 and 1930, the US was accumulating gold.

We saw in Chapter 5 that there is good reason to regard the 1920-21 contraction as having been initiated primarily in the United States. The initial step – the sharp rise in discount rates in January 1920 – was indeed a consequence of the prior gold outflow, but that in turn reflected the United States inflation in 1919. The rise in discount rates produced a reversal of the gold movements in May. The second step – the rise in discount rates in June 1920 go the highest level in history – before or since [written in 1963] – was a deliberate act of policy involving a reaction stronger than was needed, since a gold inflow had already begun. It was succeeded by a heavy gold inflow, proof positive that the other countries were being forced to adapt to United States action in order to check their loss of gold, rather than the reverse.

The situation in 1929 was not dissimilar. Again, the initial climactic event – the stock market crash – occurred in the United States. The series of developments which started the stock of money on its accelerated downward course in late 1930 was again predominantly domestic in origin. It would be difficult indeed to attribute the sequence of bank failures to any major current influence from abroad. And again, the clinching evidence that the Unites States was in the van of the movement and not a follower is the flow of gold. If declines elsewhere were being transmitted to the United States, the transmission mechanism would be a balance of payments deficit in the United States as a result of a decline in prices and incomes elsewhere relative to prices and incomes in the United States. That decline would lead to a gold outflow from the United States which, in turn, would tend – if the United States followed gold-standard rules – to lower the stock of money and thereby income and prices in the United States. However, the U.S. gold stock rose during the first two years of the contraction and did not decline, demonstrating as in 1920 that other countries were being forced adapt to our monetary policies rather than the reverse. (p. 360)

Amazingly, Friedman and Schwartz made no mention of the accumulation of gold by the insane Bank of France, which accumulated almost twice as much gold in 1929 and 1930 as did the US. In December 1930, the total monetary gold reserves held by central banks and treasuries had increased to $10.94 billion from $10.06 billion in December 1928 (a net increase of $.88 billion), France’s gold holdings increased by $.85 billion while the holdings of the US increased by $.48 billion, Friedman and Schwartz acknowledge that the increase in the Fed’s discount rate to 6.5% in early 1929 may have played a role in triggering the downturn, but, lacking an international perspective on the deflationary implications of a rapidly tightening international gold market, they treated the increase as a minor misstep, leaving the impression that the downturn was largely unrelated to Fed policy decisions, let alone those of the IBOF. Friedman and Schwartz mention the Bank of France only once in the entire Monetary History. When discussing the possibility that France in 1931 would withdraw funds invested in the US money market, they write: “France was strongly committed to staying on gold, and the French financial community, the Bank of France included, expressed the greatest concern about the United States’ ability and intention to stay on the gold standard.” (p. 397)

So the critical point in Friedman’s narrative of the Great Depression turns out to be the Fed’s decision to allow the Bank of United States to fail in December 1930, more than a year after the stock-market crash, almost a year-and-a-half after the beginning of the downturn in the summer of 1929, almost two years after the Fed raised its discount rate to 6.5%, and over two years after the Bank of France began its insane policy of demanding redemption in gold of much of its sizeable holdings of foreign exchange. Why was a single bank failure so important? Because, for Friedman, it was all about the quantity of money. As a result Friedman and Schwartz minimize the severity of the early stages of the Depression, inasmuch as the quantity of money did not begin dropping significantly until 1931. It is because the quantity of money did not drop in 1928-29, and fell only slightly in 1930 that Friedman and Schwartz did not attribute the 1929 downturn to strictly monetary causes, but rather to “normal” cyclical factors (whatever those might be), perhaps somewhat exacerbated by an ill-timed increase in the Fed discount rate in early 1929. Let’s come back once again to the debate about monetary theory between Friedman and Fischer Black, which I have mentioned in previous posts, after Black arrived at Chicago in 1971.

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond. The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money causes prices to rise, as Friedman insisted, but it could also mean that an increase in prices causes the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (Mehrling, Fischer Black and the Revolutionary Idea of Finance, p. 160)

So Black obviously understood the possibility that, at least under some conditions, it was possible for prices to change exogenously and for the quantity of money to adjust endogenously to the exogenous change in prices. But Friedman was so ideologically committed to the quantity-theoretic direction of causality from the quantity of money to prices that he would not even consider an alternative, and more plausible, assumption about the direction of causality when the value of money is determined by convertibility into a constant amount of gold.

This obliviousness to the possibility that prices, under convertibility, could change independently of the quantity of money is probably the reason that Friedman and Schwartz also completely overlooked the short, but sweet, recovery of 1933 following FDR’s suspension of the gold standard in March 1933, when, over the next four months, the dollar depreciated by about 20% in terms of gold, and the producer price index rose by almost 15% as industrial production rose by 70% and stock prices doubled, before the recovery was aborted by the enactment of the NIRA, imposing, among other absurdities, a 20% increase in nominal wages. All of this was understood and explained by Hawtrey in his voluminous writings on the Great Depression, but went unmentioned in the Monetary History.

Not only did Friedman get both the theory and the history wrong, he made a bad move from his own ideological perspective, inasmuch as, according to his own narrative, the Great Depression was not triggered by a monetary disturbance; it was just that bad monetary-policy decisions exacerbated a serious, but not unusual, business-cycle downturn that had already started largely on its own. According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I. The instability of the private sector played no part in this explanation. This is not to say that stability of the private sector is entailed by the Hawtrey-Cassel explanation, just that the explanation accounts for both the downturn and the subsequent prolonged deflation and high unemployment, with no need for an assumption, one way or the other, about the stability of the private sector.

Of course, whether the private sector is stable is itself a question too complicated to be answered with a simple yes or no. It is one thing for a car to be stable if it is being steered on a paved highway; it is quite another for the car to be stable if driven into a ditch.

Another Nail in the Money-Multiplier Coffin

It’s been awhile since my last rant about the money multiplier. I am not really feeling up to another whack at the piñata just yet, but via Not Trampis, I saw this post on the myth of the money multiplier by the estimable Barkley Rosser. Rosser discusses a recent unpublished paper by two Fed economists, Seth Carpenter and Selva Demiralp, entitled “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?”

Rosser concludes his post as follows:

That Fed control over the money supply has become a phantom has been quite clear since the Minsky moment in 2008, with the Fed massively expanding its balance sheet without much resulting increase in measured money supply.  This of course has made a hash of all the people ranting about the Fed “printing money,” which presumably will lead to hyperinflation any minute (eeek!).  But the deeper story that some of us were unaware of is that apparently this disjuncture happened a long time ago.  Even so, one of our number pointed out that official Fed literature and even many Fed employees still sell the reserve base story tied to a money multiplier to the public, just as one continues to find it in the textbooks,  But apparently most of them know better, and the money multiplier became a myth a long time ago.

Here’s the abstract of the Carpenter and Demiralp paper.

With the use of nontraditional policy tools, the level of reserve balances has risen significantly in the United States since 2007. Before the financial crisis, reserve balances were roughly $20 billion whereas the level has risen well past $1 trillion. The effect of reserve balances in simple macroeconomic models often comes through the money multiplier, affecting the money supply and the amount of lending in the economy. Most models currently used for macroeconomic policy analysis, however, either exclude money or model money demand as entirely endogenous, thus precluding any causal role for money. Nevertheless, some academic research and many textbooks continue to use the money multiplier concept in discussions of money. We explore the institutional structure of the transmissions mechanism beginning with open market operations through to money and loans. We then undertake empirical analysis of the relationship among reserve balances, money, and bank lending. We use aggregate as well as bank-level data in a VAR framework and document that the mechanism does not work through the standard multiplier model or the bank lending channel. In particular, if the level of reserve balances is expected to have an impact on the economy, it seems unlikely that the standard multiplier analysis will explain the effect.

And here’s my take from 25 years ago in my book Free Banking and Monetary Reform (p. 173)

The conventional models break down the money supply into high-power money [the monetary base] and the money multiplier. The money multiplier summarizes the supposedly stable numerical relationship between high-powered money and the total stock of money. Thus an injection of reserves, by increasing high-powered money, is supposed to have a determinate multiplier effect on the stock of money. But in Tobin’s analysis, the implications of an injection of reserves were ambiguous. The result depended on how the added reserves affected interest rates and, in turn, the costs and revenues from creating deposits. It was only a legal prohibition of paying interest on deposits, which kept marginal revenue above marginal cost, that created an incentive for banks to expand whenever they acquired additional reserves.

When regulation Q was abolished, it meant lights out for the money-multiplier.

It’s the Endogeneity, [Redacted]

A few weeks ago, just when I was trying to sort out my ideas on whether, and, if so, how, the Chinese engage in currency manipulation (here, here, and here), Scott Sumner started another one of his periodic internet dustups (continued here, here, and here) this one about whether the medium of account or the medium of exchange is the essential characteristic of money, and whether monetary disequilibrium is the result of a shock to the medium of account or to the medium exchange? Here’s how Scott put it (here):

Money is also that thing we put in monetary models of the price level and the business cycle.  That . . . raises the question of whether the price level is determined by shocks to the medium of exchange, or shocks to the medium of account.  Once we answer that question, the business cycle problem will also be solved, as we all agree that unanticipated price level shocks can trigger business cycles.

Scott answers the question unequivocally in favor of the medium of account. When we say that money matters, Scott thinks that what we mean is that the medium of account (and only the medium of account) matters. The medium of exchange is just an epiphenomenon (or something of that ilk), because often the medium of exchange just happens to be the medium of account as well. However, Scott maintains, the price level depends on the medium of account, and because the price level (in a world of sticky prices and wages) has real effects on output and employment, it is the medium-of-account characteristic of money that  is analytically crucial.  (I don’t like “sticky price” talk, as I have observed from time to time on this blog. As Scott, himself, might put it: you can’t reason from a price (non-)change, at least not without specifying what it is that is causing prices to be sticky and without explaining what would characterize a non-sticky price. But that’s a topic for a future post, maybe).

And while I am on a digression, let me also say a word or two about the terminology. A medium of account refers to the ultimate standard of value; it could be gold or silver or copper or dollars or pounds. All prices for monetary exchange are quoted in terms of the medium of account. In the US, the standard of value has at various times been silver, gold, and dollars. When the dollar is defined in terms of some commodity (e.g., gold or silver), dollars may or may not be the medium of account, depending on whether the definition is tied to an operational method of implementing the definition. That’s why, under the Bretton Woods system, the nominal definition of the dollar — one-35th of an ounce of gold — was a notional definition with no operational means of implementation, inasmuch as American citizens (with a small number of approved exceptions) were prohibited from owning gold, so that only foreign central banks had a quasi-legal right to convert dollars into gold, but, with the exception of those pesky, gold-obsessed, French, no foreign central bank was brazen enough to actually try to exercise its right to convert dollars into gold, at least not whenever doing so might incur the displeasure of the American government. A unit of account refers to a particular amount of gold that defines a standard, e.g., a dollar or a pound. If the dollar is the ultimate medium of account, then medium of account and the unit of account are identical. But if the dollar is defined in terms of gold, then gold is the medium account while the dollar is a unit of account (i.e., the name assigned to a specific quantity of gold).

Scott provoked the ire of blogging heavyweights Nick Rowe and Bill Woolsey (not to mention some heated comments on his own blog) who insist that the any monetary disturbance must be associated with an excess supply of, or an excess demand for, the medium of exchange. Now the truth is that I am basically in agreement with Scott in all of this, but, as usual, when I agree with Scott (about 97% of the time, at least about monetary theory and policy), there is something that I can find to disagree with him about. This time is no different, so let me explain why I think Scott is pretty much on target, but also where Scott may also have gone off track.

Rather than work through the analysis in terms of a medium of account and a medium of exchange, I prefer to talk about outside money and inside money. Outside money is either a real commodity like gold, also functioning as a medium of exchange and thus combining both the medium-of-exchange and the medium-of-account functions, or it is a fiat money that can only be issued by the state. (For the latter proposition I am relying on the proposition (theorem?) that only the state, but not private creators of money, can impart value to an inconvertible money.) The value of an outside money is determined by the total stock in existence (whether devoted to real or monetary uses) and the total demand (real and monetary) for it. Since, by definition, all prices are quoted in terms of the medium of account and the price of something in terms of itself must be unity, changes in the value of the medium of account must correspond to changes in the money prices of everything else, which are quoted in terms of the medium of account. There may be cases in which the medium of account is abstract so that prices are quoted in terms of the abstract medium of account, but in such cases there is a fixed relationship between the abstract medium of account and the real medium of account. Prices in Great Britain were once quoted in guineas, which originally was an actual coin, but continued to be quoted in guineas even after guineas stopped circulating. But there was a fixed relationship between pounds and guineas: 1 guinea = 1.05 pounds.

I understand Scott to be saying that the price level is determined in the market for the outside money. The outside money can be a real commodity, as it was under a metallic standard like the gold or silver standard, or it can be a fiat money issued by the government, like the dollar when it is not convertible into gold or silver. This is certainly right. Changes in the price level undoubtedly result from changes in the value of outside money, aka the medium of account. When Nick Rowe and Bill Woolsey argue that changes in the price level and other instances of monetary disequilibrium are the result of excess supplies or excess demands for the medium of exchange, they can have in mind only two possible situations. First, that there is an excess monetary demand for, or excess supply of, outside money. But that situation does not distinguish their position from Scott’s, because outside money is both a medium of exchange and a medium of account. The other possible situation is that there is zero excess demand for outside money, but there is an excess demand for, or an excess supply of, inside money.

Let’s unpack what it means to say that there is an excess demand for, or an excess supply of, inside money. By inside money, I mean money that is created by banks or by bank-like financial institutions (money market funds) that can be used to settle debts associated with the purchase and sale of goods, services, and assets. Inside money is created in the process of lending by banks when they create deposits or credit lines that borrowers can spend or hold as desired. And inside money is almost always convertible unit for unit with some outside money.  In modern economies, most of the money actually used in executing transactions is inside money produced by banks and other financial intermediaries. Nick Rowe and Bill Woolsey and many other really smart economists believe that the source of monetary disequilibrium causing changes in the price level and in real output and employment is an excess demand for, or an excess supply of, inside money. Why? Because when people have less money in their bank accounts than they want (i.e., given their income and wealth and other determinants of their demand to hold money), they reduce their spending in an attempt to increase their cash holdings, thereby causing a reduction in both nominal and real incomes until, at the reduced level of nominal income, the total amount of inside money in existence matches the amount of inside money that people want to hold in the aggregate. The mechanism causing this reduction in nominal income presupposes that the fixed amount of inside money in existence is exogenously determined; once created, it stays in existence. Since the amount of inside money can’t change, it is the rest of the economy that has to adjust to whatever quantity of inside money the banks have, in their wisdom (or their folly), decided to create. This result is often described as the hot potato effect. Somebody has to hold the hot potato, but no one wants to, so it gets passed from one person to the next. (Sorry, but the metaphor works in only one direction.)

But not everyone agrees with this view of how the quantity of inside money is determined. There are those (like Scott and me) who believe that the quantity of inside money created by the banks is not some fixed amount that bears no relationship to the demand of the public to hold it, but that the incentives of the banks to create inside money change as the demand of the public to hold inside money changes. In other words, the quantity of inside money is determined endogenously. (I have discussed this mechanism at greater length here, here, here, and here.) This view of how banks create inside money goes back at least to Adam Smith in the Wealth of Nations. Almost 70 years later, it was restated in greater detail and with greater rigor by John Fullarton in his 1844 book On the Regulation of Currencies, in which he propounded his Law of Reflux. Over 100 years after Fullarton, the Smith-Fullarton view was brilliantly rediscovered, and further refined, by James Tobin, apparently under the misapprehension that he was propounding a “New View,” in his wonderful 1962 essay “Commercial Banks as Creators of Money.”

According to the “New View,” if there is an excess demand for, or excess supply of, money, there is a market mechanism by which the banks are induced to bring the amount of inside money that they have created into closer correspondence with the amount of money that the public wants to hold. If banks change the amount of inside money that they create when the amount of inside money demanded by the public doesn’t match the amount in existence, then nominal income doesn’t have to change at all (or at least not as much as it otherwise would have) to eliminate the excess demand for, or the excess supply of, inside money. So when Scott says that the medium of exchange is not important for changes in prices or for business cycles, what I think he means is that the endogeneity of inside money makes it unnecessary for an economy to undergo a significant change in nominal income to restore monetary equilibrium.

There’s just one problem: Scott offers another, possibly different, explanation than the one that I have just given. Scott says that we rarely observe an excess demand for, or an excess supply of, the medium of exchange. Now the reason that we rarely observe that an excess demand for, or an excess supply of, the medium of exchange could be because of the endogeneity of the supply of inside money, in which case, I have no problem with what Scott is saying. However, to support his position that we rarely observe an excess demand for the medium of exchange, he says that anyone can go to an ATM machine and draw out more cash. But that argument is irrelevant for two reasons. First, because what we are (or should be) talking about is an excess demand for inside money (i.e., bank deposits) not an excess demand for currency (i.e., outside money). And second, the demand for money is funny, because, as a medium of exchange, money is always circulating, so that it is relatively easy for most people to accumulate or decumulate cash, either currency or deposits, over a short period. But when we talk about the demand for money what we usually mean is not the amount of money in our bank account or in our wallet at a particular moment, but the average amount that we want to hold over a non-trivial period of time. Just because we almost never observe a situation in which people are literally unable to find cash does not mean that people are always on their long-run money demand curves.

So whether Nick Rowe and Bill Woolsey are right that inflation and recession are caused by a monetary disequilibrium involving an excess demand for, or an excess supply of, the medium of exchange, or whether Scott Sumner is right that monetary disequilibrium is caused by an excess demand for, or an excess supply of, the medium of account depends on whether the supply of inside money is endogenous or exogenous. There are certain monetary regimes in which various regulations, such as restrictions on the payment of interest on deposits, may gum up the mechanism (the adjustment of interest rates on deposits) by which market forces determine the quantity of inside money thereby making the supply of inside money exogenous over fairly long periods of time. That was what the US monetary system was like after the Great Depression until the 1980s when those regulations lost effectiveness because of financial innovations designed to circumvent the regulations.  As a result the regulations were largely lifted, though the deregulatory process introduced a whole host of perverse incentives that helped get us into deep trouble further down the road. The monetary regime from about 1935 to 1980 was the kind of system in which the correct way to think about money is the way Nick Rowe and Bill Woolsey do, a world of exogenous money.  But, one way or another, for better or for worse, that world is gone.  Endogeneity of the supply of inside money is here to stay.  Better get used to it.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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