{"id":20091,"date":"2012-07-05T11:51:10","date_gmt":"2012-07-05T01:51:10","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=20091"},"modified":"2012-07-05T11:51:10","modified_gmt":"2012-07-05T01:51:10","slug":"if-only-they-were-operating-in-the-tradition-of-minsky","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=20091","title":{"rendered":"If only they were operating in the tradition of Minsky!"},"content":{"rendered":"

\t\t\t\tIn the last week, it was alleged that economists such as the IMFs Olivier Blanchard were alleged to be working in the tradition of Hyman Minsky, which by association inferred that they were on top of the crisis – foresaw it, understand why it occurred and offer the best ways out of the mess. Please read my earlier blog – Revisionism is rife and ignorance is being elevated to higher levels<\/a> – for an introduction to this issue. I argued that this attempted association is plainly false and Blanchard’s monetary economics is more in the Monetarist tradition, which is the anathema to the endogenous money framework that Hyman Minsky worked within. This is no small issue. The economists mentioned are often in leading positions (media, universities, policy) and influence the way the public (and students) think about the policy choices available. By promoting erroneous understandings of the way the monetary system operates, such economists become part of the problem not the solution, no matter if they are currently opposing fiscal austerity. If only they were operating in the tradition of Minsky!
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\nThere was an article in the Wall Street Journal (December 17, 1997) – Rx for Japan: Back to the Future<\/em>, which was reprinted in the Hoover Digest (April 30, 1998) with the revised title of – Reviving Japan<\/a>. The article was written by Milton Friedman, the doyen of the free market Monetarists – the antipathy of the Minsky-type tradition.<\/p>\n

Milton Friedman was providing “step-by-step instructions for resuscitating the Japanese economy” to the Bank of Japan. It should be noted that Milton Friedman’s reputation had taken a severe dent during this period as central banks abandoned their attempts at monetary targetting, a policy approach that was at the core of the Monetarist myth.<\/p>\n

One after another central banks learned that no matter what nominal monetary growth targets they set they were unable to control the growth of broad money. This finding was in contradiction with the textbook models that students were taught and the prognostications from upon high by Milton Friedman and his Chicago acolytes.<\/p>\n

In this article Milton Friedman was telling the Bank of Japan that:<\/p>\n

\nThe surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it.\t<\/p>\n

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”<\/p>\n

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.<\/p>\n

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.\n<\/p><\/blockquote>\n

So the myths in order:<\/p>\n

1. The central bank is alleged to be able to control the money supply via open market operations.<\/p>\n

2. It does this by buying bonds and expanding the monetary base (“high-powered money”). Note that Friedman says that it would buy the bonds either with “currency or deposits at the Bank of Japan”. Later I will explain why that is an important difference.<\/p>\n

3. This will add to the reserves of the commercial banks.<\/p>\n

4. In turn, they will be in a better position to lend out the reserves but the money supply will increase irrespective of that because the monetary base has increased.<\/p>\n

This is the standard mainstream approach that students in economics courses are forced to learn – it is indoctrination rather than education.<\/p>\n

And now let’s consider what Olivier Blanchard’s Macroeconomics textbook imparts to his students. Part Two of the Text is headed The Basics<\/em>.<\/p>\n

Any reasonable interpretation of that would suggest that the material covered in that section of the book would be the essential elements of macroeconomic theory that the students should become familiar with and understand. If they are to “learn” anything then it should be at least “The Basics”<\/p>\n

In a Chapter 5 Financial Markets of that part of the Text, students come across a section – The Determination of the Money Supply<\/em>, which again has a straight-forward meaning.<\/p>\n

Two balance sheets are presented – one of the central bank and the other of an aggregate called “banks”. The central bank assets are government bonds and its liabilities are the sum of what Olivier Blanchard calls “central bank money”. We learn that this is the sum of bank reserves and currency (notes and coins).<\/p>\n

The banks’ assets are its reserves (at the central bank), the outstanding loans and any government bonds it holds. It liabilities are its deposits.<\/p>\n

There is nothing problematic about any of that.<\/p>\n

Blanchard defines the money supply as currency held by the public plus the deposits held by banks and clearly it is different to the central bank money.<\/p>\n

He then examines “the relation between central bank money and the money supply and says:<\/p>\n

\nWe shall see that the money supply is given by<\/p>\n

\tmoney supply = money multiplier x central bank money<\/p>\n

You can think of what we do now as deriving the value of the money multiplier<\/strong>.\n<\/p><\/blockquote>\n

What follows is some definitions – central bank money become the monetary base<\/strong> or alternatively high-powered money<\/strong>. He explains that the “origin of this expression is that an increase in central bank money leads, because of the money multiplier, to a more than one-for-one increase in the money supply, and thus is ‘high-powered'”.<\/p>\n

Note the causality – “because of”. There is no hint that the money supply might cause the monetary base.<\/p>\n

What follows is the tortured algebra\/arithmetic that students are forced to learn which shows how changes in the reserve ratio (the ratio of reserves to deposits) and the ratio of currency to deposits (which is influenced by habits, convenience, the cost of getting cash out of the bank etc) influence the money multiplier.<\/p>\n

He then speculates on “the size of the money multiplier in the United States” (noting that I am quoting here from the first edition 1997). AFter some arithmetic he derives a value of 2.7 and concludes that:<\/p>\n

\nAn increase in the monetary base of $1 increases the money supply by $2.70.\n<\/p><\/blockquote>\n

There is a joke among economics lecturers (at the expense of their students). It relates to the expenditure multiplier but could equally be applied to the money multiplier. It goes like this – when a student is asked what is the multiplier, the response is an immediate and confident 5. The joke for those who haven’t studied economics is that the students get so drilled in the algebra and arithmetic (with exercises etc) and rote learn that the expenditure multiplier is equal to 5 rather than understand the concept. The 5, by the way, comes from the assumption that there is not trade or government sector and the households save 20 cents in each extra dollar they receive.<\/p>\n

The US Federal Reserve reports<\/a> that its broad money supply measure (M2) increased by 9.5 per cent in the 12 months from May 2011 to May 2012, rising from 9017.6 billion US dollars to 9874.9 billion.<\/p>\n

Over the same period, the US Federal Reserve reports<\/a> that the monetary base rose from $US2,559,321 million to $US2,614,323 million (at as May 30) an increase of 2.1 per cent.<\/p>\n

The alleged money multiplier is given by M = m x H, where the symbols are M is the money supply, m is the multiplier and H is the monetary base, then m = M\/H.<\/p>\n

The following graph shows the M1 multiplier (the ratio of M1 to the St. Louis Adjusted Monetary Base) taken from the St. Louis Federal Reserve Bank Fred2 Database<\/a>. While M1 is a narrower measure of the money supply than M2, this graph for the M2\/H ratio would be similar.<\/p>\n

\"\"<\/a><\/p>\n

<\/div>\n

The point is that there is no explanatory value in the concept of the money multiplier. Why is this important? Answer: because Olivier Blanchard talks about the central bank controlling the money supply via open market operations:<\/p>\n

\nNow, think of the central bank as changing the stock of money in the economy by buying and selling bonds in the bond market. It it wants to increase the stock of money, the central bank buys bonds and pays for them by creating money. If it wants to decrease the stock of money, the central bank sells bonds and removes from circulation the money it receives in exchange for the bonds.\n<\/p><\/blockquote>\n

Later in the Chapter, he says “we can think of the ultimate increase in the money supply as the result of successive rounds of open market operations<\/em> …” The successive rounds are as the alleged money multipliers works its way through the banking system.<\/p>\n

The derivation presented to students by Olivier Blanchard is consistent with the standard mainstream macroeconomics approach that appears in most textbooks. No person operating in the Minskyian tradition would proceed down that route when discussing the role of the central bank or the credit-creation capacity of commercial banks.<\/p>\n

The idea that there is a money multiplier m<\/em> that transmits changes in the so-called monetary base (H<\/em>) (the sum of bank reserves and currency at issue) into changes in the money supply (M<\/em>) is at odds with the way the modern monetary system actually works.<\/p>\n

The standard treatment (followed by Blanchard) alleges that multiplier works as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):<\/p>\n