Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
I know I said I was not going to write a blog today but I changed my mind. It will be a short blog only. I was considering the continued dogmatic assertions that mainstream economists make that the central bank still controls the money supply and that money multiplier is alive and well but has just disappeared for a while. This recent mainstream post is typical of these on-going erroneous assertions by mainstream macroeconomists about the way the monetary system and the institutions within it operate. The fact is that the monetary multiplier is not dead – I can say that confidently because I know it was never alive!
The mainstream theory alleges that the money multiplier m transmits changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) into changes in the money supply (M). Students then labour through algebra of varying complexity depending on their level of study (they get bombarded with this nonsense several times throughout a typical economics degree) to derive the m, which is most simply expressed as the inverse of the required reserve ratio. So if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio (RRR) would be 0.10 and m would equal 1/0.10 = 10. More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story.
The formula for the determination of the money supply is: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):
- A person deposits say $100 in a bank.
- To make money, the bank then loans the remaining $90 to a customer.
- They spend the money and the recipient of the funds deposits it with their bank.
- That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
- And so on until the loans become so small that they dissolve to zero.
So you should expect a fairly constant relationship between the monetary base and the measures of the money supply. Indeed, mainstream theory claims that the central bank uses this relationship to control the money supply.
In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way, you won’t learn very much at all from reading it.
In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.
The second “and more important job”:
… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).
And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:
Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.
More recently, our polite friend Mark Thoma wrote, under the heading “The Fed’s Control of the Money Supply” that:
To control the money supply, the Fed takes the multiplier as given, and then sets the MB at a level that gives it the Ms it desires.
In the September 2008 edition of the Federal Reserve Bank of New York Economic Policy Review there was an interesting article published entitled – Divorcing Money from Monetary Policy.
It demonstrated why the account of monetary policy in mainstream macroeconomics textbooks (such as Mankiw etc) from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed. This is the stuff that Mark Thoma also pumps out into cyber space as some sort of truth.
The FRBNY article states clearly that:
In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target.
This is practice is not confined to the US. All central banks operate in this way and I have shown in other blogs that central banks cannot control the “money supply”.
However, the FRBNY try to build a bridge between the two viewpoints by claiming that “the quantity of money and monetary policy remain fundamentally linked”.
How do they construct that argument?
They say that because commercial banks hold “reserve balances at the central bank” and demand “reserve balances – inversely …. [to] … the short-term interest rate”, which is the “the opportunity cost of holding reserves” then the central bank can “manipulate the supply of reserve balances” by exchanging “reserve balances for bond” (open market operations) to ensure that the “marginal value of a unit of reserves to the banking sector equals the target interest rate”.
This allows the interbank market (for overnight funds) to clear and maintain the policy rate.
The FRBNY say that “(i)n other words, the quantity of money (especially reserve balances) is chosen by the central bank in order to achieve its interest rate target”. This is, in fact, fairly loose language. It is clear that the level of reserve balances in the system are chosen by the central bank to maintain the policy rate. But using terminology like the “quantity of money” is misleading and doesn’t match the concept of the “money supply” that the likes of Friedman and Mankiw were referring to. They were in fact referring to a close relationship between the monetary base and broad money as captured by the money multiplier model.
However, that construction of banking dynamics is false. There is in fact no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.
You will note that in Modern Monetary Theory (MMT) there is very little spoken about the money supply. In an endogenous money world there is very little meaning in the aggregate concept of the “money supply”.
Central banks do still publish data on various measures of “money”. The RBA, for example, provides data for:
- Currency – Private non-bank sector’s holdings of notes and coins.
- Current deposits with banks (which exclude Australian and State Government and inter-bank deposits).
- The M1 measure – Currency plus bank current deposits of the private non-bank sector.
- The M3 measure – M1 plus all other Australian Deposit-taking Institutions’ deposits of the private non-ADI sector. So a broader measure than M1.
- Broad money – M3 plus non-deposit borrowings from the private sector by AFIs, less the holdings of currency and bank deposits by RFCs and cash management trusts.
- Money base – Holdings of notes and coins by the private sector, plus central bank reserves (deposits of banks with the Reserve Bank and other Reserve Bank liabilities to the private non-bank sector.
The US Federal Reserve no longer publish M3 time series. In the US, M2 is the M1` plus saving deposits, small time-deposits, money market mutual funds and some other small components.
To some extent the idea that the central banks controls the money supply is a residual from the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.
The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).
The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit. Please read my blog – Understanding central bank operations – for more discussion on this point.
So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept. Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves.
Further expanding the monetary base (bank reserves) as I argued in these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.
The following graph uses US Federal Reserve data for Money Stock Measures and plots the ratio between M1 and the monetary base since 1959. M1 is the sum of issued currency, traveller cheques, demand deposits and other cheque deposits.
The ratio which is the estimated “multiplier” is clearly not constant.
The behaviour of this ratio led our favourite macroeconomics textbook writer to write in January 2009 that the Money multiplier had disappeared. He of-course didn’t realise that it never existed.
The next graph shows the relationship between the monetary base, M1 and M2 from January 1959 to May 2010. The sharp spike is the base (bank reserves) which occurred in December 2008 after a major Federal Reserve intervention is clear and drives the behaviour of the other series ($-for-$ virtually).
To see the more recent behaviour more clearly, this graph is constructed for the sample January 2007 to May 2010.
And finally, here is the movement in the monetary base over the same period (January 2007 and May 2010).
Obviously missing the security blanket that the money multiplier provides (what else would you write on the blackboard?), our friend Mark Thoma has offered the following explanation by way of reassurance:
The multiplier falls when excess reserves increase, and the dramatic increase in excess reserves during the crisis has caused the multiplier to fall substantially, enough to offset the increase in MB. The result is that the quantity of money actually circulating in the economy, (mult)(MB), has remained relatively constant.
So for all you addicts who need to know there “is” a money multiplier, Mark assures us that its absence is only temporary and it will be back around 2 before we get too uncomfortable. Just adopt a meditative pose and as your mantra recite “m will return”.
The problem with the current explanations of the “disappearing” money multiplier is that they are just made up. These sham-type defences of a flawed theory, remind me of the message that David M. Gordon (in his great book from 1972 – Theories of poverty and underemployment, Lexington, Mass: Heath, Lexington Books) wrote about in relation to neoclassical human capital theory. My copy of the book is in another office at present so I cannot quote from it. But the message that Gordon provided was one of continual ad hoc response to anomaly by the mainstream economists.
So whenever the mainstream paradigm is confronted with empirical evidence that appears to refute its basic predictions it creates an exception by way of response to the anomaly and continues on as if nothing had happened.
This is very notable in the way the NAIRU literature evolved. The NAIRU literature began (in the mid-1970s) with the position that the NAIRU was constant and cyclically-invariant despite early challenges from the theories of hysteresis. My early published work (from my PhD) was part of this challenge. Influenced by this literature, governments deflated their economies and pushed unemployment up.
Empirical (econometric) tests soon found that the estimates of the NAIRU were anything but constant and seemed to vary with the cycle – so rose when unemployment rose. Faced with mounting criticism, the NAIRU theorists progressively moved to a position where time variation in the steady-state was allowed but this variation is seemingly not driven by the state of demand – the so-called TV-NAIRUs.
This intermediate phase has spawned a frenetic period of estimation using a range of technical methodologies including state space techniques (Kalman filter); univariate extrapolation methods (filters and smoothers), and spline estimation.
Like the original concept, the attempts to model the time variation have been based on shaky theoretical grounds. The theory that generated the NAIRU in the first place provides no guidance about its evolution. Presumably, the evolution of unspecified structural factors have played a role, if we are to be faithful to the original (flawed) idea.
In this theoretical void, econometricians have assumed that a smooth evolution is plausible but these slowly evolving NAIRUs bear little relation to actual economic factors. The extrapolation and smoothing approaches are particularly blighted here. Some authors have the temerity to merely run a smoothing filter through the actual series and assert that this captures the NAIRU.
Most of the research output confidently asserted that the NAIRU had changed over time but very few authors dared to publish the confidence intervals around their point estimates (Staiger, Stock and Watson, 1997 were exceptions). The evidence is illuminating. Some models yield 95 percent confidence intervals of 2.9 percent to 8.3 percent which makes the range of NAIRU estimates too large to be useful.
We cover these developments in detail in my recent book with Joan Muysken – Full Employment abandoned.
The point is that the response to the anomaly was ad hoc and could not be guided by theory. The basic theory failed and so layers of fudges were added.
We are now seeing that sort of ad hocery when it comes to trying to defend the money multiplier. The bottom line is that there is nothing in the theory that tells you what is happening at present. The reason is that the theory is simply inapplicable.
Even the Federal Reserve reluctantly admits this. In a July 2009 paper, they answer their question – Why Are Banks Holding So Many Excess Reserves? in this way:
The total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions. The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up
being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves depicted in Figure 1 reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly.
This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier … we discuss the traditional view of the money multiplier and why it does not apply in the current environment …
Their conclusion is based on the decision of the central bank to pay the target policy rate on excess reserves. In fact, the inapplicability of the money multiplier is not dependent on whether the central bank does have a support rate in place.
Why is that?
As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.
The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.
The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).
The reality is that the central bank does not have the capacity to control the money supply. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.
The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.
The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.
The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
Modern monetary theorists consider the credit creation process by banks to be the “leveraging of high powered money”. The only way you can understand why all this non-government leveraging activity (borrowing, repaying etc) can take place is to consider the role of the Government initially – that is, as the centrepiece of the macroeconomic theory.
Banks clearly do expand the money supply endogenously – that is, without the ability of the central bank to control it. But all this activity is leveraging the high powered money (HPM) created by the interaction between the government and non-government sectors.
HPM or the monetary base is the sum of the currency issued by the State (notes and coins) and bank reserves (which are liabilities of the central bank). HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them! All Government spending involves the same process – the reserve accounts that the commercial banks keep with the central bank are credited in HPM (an IOU is created). This is why the “printing money” claims are so ignorant.
The reverse happens when taxes are paid – the reserves are debited in HPM and the assets are drained from the system (an IOU is destroyed). Keep this in mind.
HPM enters the economy via so-called vertical transactions. Please refer back to Deficit spending 101 – Part 1; Deficit spending 101 – Part 2 and Deficit spending 101 – Part 3 for the details and supporting diagrams.
So HPM enters the system through government spending and exits via taxation. When the government is running a budget deficit, net financial assets (HPM) are entering the banking system. Fiscal policy therefore directly influences the supply of HPM. The central bank also creates and drains HPM through its dealings with the commercial banks which are designed to ensure the reserve positions are commensurate with the interest rate target the central bank desires. They also create and destroy HPM in other ways including foreign exchange transactions and gold sales.
We can think of the accumulated sum of the vertical transactions as being reflected in an accounting sense in the store of wealth that the non-government sector has. When the government runs a deficit there is a build up of wealth (in $A) in the non-government sector and vice-versa. Budget surpluses force the private sector to “run down” the wealth they accumulated from previous deficits.
One we understand the transactions between the government and non-government then we can consider the non-government credit creation process. The important point though is that all transactions at the non-government level balance out – they “net to zero”. For every asset that is created so there is a corresponding liability – $-for-$. So credit expansion always nets to zero! In previous blogs I have called the credit creation process the “horizontal” level of analysis to distinguish it from the vertical transactions that mark the relationship between the government and non-government sectors.
The vertical transactions introduce the currency into the economy while the horizontal transactions “leverage” this vertical component. Private capitalist firms (including banks) try to profit from taking so-called asset positions through the creation of liabilities denominated in the unit of account that defines the HPM ($A for us). So for banks, these activities – the so-called credit creation – is leveraging the HPM created by the vertical transactions because when a bank issues a liability it can readily be exchanged on demand for HPM.
When a bank makes a $A-denominated loan it simultaneously creates an equal $A-denominated deposit. So it buys an asset (the borrower’s IOU) and creates a deposit (bank liability). For the borrower, the IOU is a liability and the deposit is an asset (money). The bank does this in the expectation that the borrower will demand HPM (withdraw the deposit) and spend it. The act of spending then shifts reserves between banks. These bank liabilities (deposits) become “money” within the non-government sector. But you can see that nothing net has been created.
Only vertical transactions create/destroy assets that do not have corresponding liabilities.
But what gives the unit of account chosen by the Government its primacy. Why do all the banks and customers demand it? The answer is that state money (in our case the $A) is demanded because the Government will only allow it to be used to extinguish tax liabilities. So the tax liability can only be met by getting hold of the Governments own IOU – the $A. Further, the only way that we can get hold of that unit of account is by offering to supply goods and services to the Government in return for their spending. The Government spending provides the funds that allow us to pay our taxes! That is the reverse of what most people think.
This process is how the Government ensures it can get private resources in sufficient quantities to conduct its own socio-economic policy mandate. It buys labour and other resources and creates public infrastructure and services. We are eager to supply our goods and services in return for the spending because we can get hold of $A.
So the private money creation activity that is central to many progressive models misses the essential point – that the credit creation activity is leveraging of the HPM – and is acceptable for clearing private liabilities (repaying loans) only because it is the only vehicle for extinguishing one’s tax liabilities to the state.
It was meant to be a short blog. Sorry!
The Saturday Quiz will appear tomorrow (EAST) and the answers and discussion will appear Sunday.
I am off for 2 days to have fun – haunt some bookshops, drink cups of tea beside Sydney Harbour, and see some films etc.
That is enough for today!