When central bankers debunk mainstream monetary theory

Somehow research gets published which contradicts the basic propositions of mainstream monetary theory yet it just gets buried and the commentariat continue on as before sprouting the myths that now occupy us on a daily basis. In February 2010, the Bank of International Settlements (BIS) published a working paper (No. 297)- The Bank Lending Channel Revisited – which falls into this category. It argues categorically that the mainstream propositions about money and banking are incorrect and uninformative. Its essential insights confirm the fundamental propositions of Modern Monetary Theory (MMT) – which when translated into the policy space – would suggest that monetary policy is not the ideal tool to resolve a major collapse in private aggregate spending and that fiscal policy will not drive up interest rates and crowd out private spending. Why these papers are suppressed in the public domain by the commentators makes for interesting speculation – all of which impugns the motives of those who hold themselves out as experts but, in fact, just peddle lies. The problem for all of us – but more so the unemployed and poor – is that they are influential lies.

The BIS paper addresses what the author calls a “central proposition” in the money and banking literature that:

… monetary policy imparts a direct impact on deposits and that deposits, insofar as they constitute the supply of loanable funds, act as the driving force of bank lending.

So “tight monetary policy is assumed to drain deposits from the system and will reduce lending if banks face frictions in issuing uninsured liabilities to replace the shortfall in deposits. Essentially, much of the driving force behind bank lending is attributed to policy-induced quantitative changes on the liability structure of bank balance sheets”.

For example, the central bank is assumed to control the money supply via its open market operations. If it wants to “drain deposits” it sells bonds to the banks which then, as the story goes, restricts their capacity to lend.

The mainstream narrative that is taught to students all around the world is based on that sort of proposition. Banks need deposits in order to make loans and if the central bank conduct policy that shrinks those deposits then lending will fall. Thus monetary policy becomes an effective counter-stabilisation tool which can reduce aggregate demand growth by reducing the money supply and vice versa.

Mainstream monetary theory has two ways of developing this monetary policy impact.

First, they use the money multiplier concept and construct the central bank as increasing or decreasing the monetary base (adding or draining reserves via open market operations) which in turn dictate “the amount of deposits through the reserve requirement”.

Second, the so-called “portfolio-rebalancing view of households’ assets” posits that monetary policy changes alter the yield on money (deposits) relative to other assets which then influences the household portfolio choices. So if the central bank wants to restrict the desire of households to hold deposits then it can push up the opportunity cost of holding low interest-bearing money via a money supply contraction.

The BIS paper says that:

Either way, the underlying mechanism is one in which a policy tightening induces a fall in deposits that then forces banks to substitute towards more expensive forms of market funding, contracting loan supply. Changes in deposits are seen to drive bank loans.

That is a fairly concise statement of the mainstream position. Regular readers will identify these propositions as being central to the way the public debate has been carried on during the crisis.

For example, financial commentators are continually stating that quantitative easing has the purpose of putting more liquidity into the banking system (more reserves) so they can lend more easily.

We also often read dire warnings about the explosion of the money supply and its inevitable inflationary impacts that arise from the recent and signficant growth in the asset side of the central bank balance sheets (as a result of their quantitative or credit easing strategies during the crisis).

Astute readers will know the data as well I as I do – which means they will know that the growth in the broad measures of the money supply bear no stable or even identifiable relation to the growth in the monetary bases in most nations over the last 5 years. That observation alone would seem to empirically negate the veracity of the money multiplier concept.

But to really get to the bottom of the myths a thorough understanding of the way the banking system operates is essential. In part, this BIS paper helps advance our understanding of some of the essential operational principles of modern banking. And – you won’t find these understandings in tha vast majority of literature that gets rammed down the throats of unsuspecting undergraduates in economics in universities around the world.

To say that the dislocation between what is taught and what actually happens is a disgrace is an understatement.

It reminds me of a statement that Noam Chomsky made during an interview in 1992 (Source)

Propaganda is to a democracy what the bludgeon is to a totalitarian state.

Mainstream money and banking courses in most universities are not much more than propaganda.

The BIS paper argues that:

… the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular … the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.

Which is a central proposition in Modern Monetary Theory (MMT) and in direct contradistinction (and conflict) with the mainstream approach.

Mainstream theory has a number of interlinked ideas that relate monetary policy to economic activity via the money supply. An essential part of the “transmission mechanism” is the concept of the money multiplier, m which states that changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) are “multiplied” into changes in the money supply (M).

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.
• The loan recipient spends 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. The crucial link between this view of banking and policy is that mainstream theory claims that the central bank uses this relationship to control the money supply. That is, it manipulates base money to gain desired and predictable changes in the money supply – and hence lending and economic activity.

In Greg Mankiw’s Principles of Economics, which is a very popular text around the world, he claims that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”.

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).

He then describes how the central bank goes about fulfilling this most important role:

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.

You will read statements all the time along the lines 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” (Source).

All these conceptions of the banking dynamics bear no relation to what happens in the real world. That is, they are propaganda and lead to outrageous inferences about the impact of certain central bank decisions (such as the much vaunted inflation fears when quantitative easing was introduced). The Japanese have been waiting for the predicted hyperinflation for nigh on 20 years now! It must just be around the corner!

As the BIS paper points out:

… monetary policy implementation nowadays focused predominantly on achieving a target for a short term interest rate …

Which means that the “money multiplier” does not provide a meaningful framework. In a footnote, the BIS paper (Page 5) points out the irony that even though it provides no meaningful information “the money multiplier view of credit determination is still pervasive in standard macroeconomic textbooks” including”.

Other central bankers have also agreed with this view. The Federal Reserve Bank of New York Economic Policy Review (September 2008) article – Divorcing Money from Monetary Policy – clearly stated:

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. What this means is that central banks cannot control the “money supply” in any predictable manner and do not try to do so.

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”.

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 fiat currency, 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 “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.

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 but always stand ready to provide the necessary reserves on demand from the banks.

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 reality is the monetary base responds to the broader, demand-determined money supply – the opposite of the money multiplier causality – as the BIS paper correctly points out.

What about reserves? The mainstream position is that banks lend out reserves – a proposition refuted by MMT.

The BIS paper says:

Banks hold reserves for two main reasons: i) to meet any reserve requirement; and ii) to provide a cushion against uncertainty related to payments flows. The quantity of reserves demanded is then typically interest-inelastic, dictated largely by structural characteristics of the payments system and the monetary operating framework, particularly the reserve requirement. When reserves are remunerated at a rate below the market rate, as is generally the case, achieving the desired interest rate target entails that the central bank supply reserves as demanded by the system. In the case where reserves are remunerated at the market rate, they become a close substitute for other short-term liquid assets and the amount of reserves in the system is a choice of the central bank. In either case, the interest rate can be set quite independently of the amount of reserves in the system and changes in the stance of policy need not involve any change in this amount.

Note you didn’t read that banks hold reserves in order to lend them out.

The BIS paper says this means that there is “no direct link between monetary policy and the level of reserves, and hence no causal relationship from reserves to bank lending”.

These are powerful statements which not only undermine the vast majority of mainstream money and banking theory but also negate the policy statements that flow from them.

I advise all readers who are uncertain to create some flash cards which the various mainstream statements on them and on the flip side the MMT reality. Then play games at dinner time with your neo-liberal friends although that raises the question of why you would have such friends!

The BIS paper notes that whenever the banks need more reserves (the above-mentioned exogenous structural facts change)

… central banks simply accommodate whatever new level of reserves is required by the system. For example, when a central bank raises reserve requirements, the level of reserves must be increased to allow the system to meet this requirement. Deposits are unaffected and the money multiplier simply falls. This reduction has no economic significance.

The money multiplier concept here is simply the ratio of broad money to base money. It has to fall as the central bank adds more reserves to accommodate the demand by banks given that the broad money measure is determined by other factors discussed above.

The author then goes on to refute the second way in which monetary policy allegedly controls the deposits in the system – the so-called “portfolio rebalancing” mechanisms.

So households are allegedly motivated to demand money (cash balances or deposits) for a number of reasons (to facilitate transactions, allow for contingencies – precautionary motive) but overall the quantity demanded is said to be inversely related to the interest rate. This is because deposits earn zero interest and as yields on alternative assets rise, the opportunity cost of holding zero earning money rises.

The BIS paper says:

There are a number of reasons to be skeptical of this mechanism. For one, deposit rates in many countries are closely linked to money market rates so that changes in policy would not significantly change the opportunity cost of holding deposits. For deposit accounts that pay little or no interest (for example, checking accounts), it would stand to reason these funds are not interest-sensitive to begin with anyway, being held primarily for transaction purposes.

They offer other reasons which you can research yourself if interested.

The upshot is that “quantitative constraints on bank lending should be de-emphasized”. The BIS paper supports the fundamental MMT observation that:

… since banks are able to create deposits that are the means by which the non-bank private sector achieves final settlement of transactions, the system as a whole can never be short of funds to finance additional loans. When a loan is granted, banks in the first instance create a new liability that is issued to the borrower. This can be in the form of deposits or a cheque drawn on the bank, which when redeemed, becomes deposits at another bank. A well-functioning interbank market overcomes the asynchronous nature of loan and deposit creation across banks. Thus loans drive deposits rather than the other way around.

Please create a flash card to reflect that essential real world insight which is in contradistinction to what students are taught in mainstream money and banking courses.

You should now know that loans create deposits and banks then cover any reserve requirements and clearing house needs by either accessing the interbank market (shuffling reserves around the member banks) or if there is a system-wide shortage of desired reserves – they get them from the central bank.

Moreover, as the BIS paper points out “banks nowadays are able to easily access wholesale money markets to meet their funding liquidity needs.” If they cannot access those funding sources – then the central bank stands ready to ensure the funds are provided.

What constrains the banks in their lending is their “own capital”. Please read my blog – Lending is capital- not reserve-constrained – for more discussion on this point.

The BIS paper then develops a new model of the transmission mechanism which is outside the ambit of today’s blog (time and focus).

Conclusion

Given that almost every day you will read some financial story peddling policy analysis based upon these monetary myths. And given that government policy is being directly influenced by these myths.

And given that our future commentators and decision-makers are sitting in universities around the world being assaulted by these lies – I think it is important to provide regular refutation.

Yes, it is repetitive but so is the wall of propaganda that we are up against.

My last day in Maastricht tomorrow (Wednesday). I am then off to London town by train and unfortunately the tickets to Billy Bragg’s Woody Guthrie concert on Sunday night are all sold out!

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.