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Marc Lavoie — Advances In The Post-Keynesian Analysis Of Money And Finance

There’s a new article by Marc Lavoie in a newly released book which is an interesting read. Abstract:

This chapter focuses on the various monetary themes that have been emphasized by post-Keynesian economists and that turned out to have been validated by the events that occurred during and after the subprime financial crisis. These include interest rate targeting by the central bank, interest rate spreads, endogenous money, the reversed causality between reserves and money, the defensive role of central banks, the links between the central bank and the government, banks as very special financial institutions, the different role of the shadow banking system, and whether there are limits to the amounts of credit that banks can create. The chapter analyzes unconventional monetary policies, including quantitative easing (QE), QE for the people and 100% reserves. It also discusses the consequences, for the theory of endogenous central bank money, of the adoption of a system where the target interest rate is the interest rate on reserves.

Louis-Philippe Rochon On Basil Moore And The Supply Of Credit

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Basil Moore passed away recently, as I mentioned a few days back in this blog.

One of the criticisms of Moore’s work was the passive role of banks. Louis-Philippe Rochon has an excellent article in his Festschrift Complexity, Endogenous Money and Macroeconomic Theory — Essays in Honour Of Basil J. Moore, Edward Elgar, 2006, to further develop Moore’s views.

Below is the scan of the full article, provided to me by LP for posting here.

The object below is an embed of the pdf. If the embed doesn’t display, or to get a better view, you can open it in a separate browser tab here.



Basil Moore, R.I.P.

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Basil Moore passed away yesterday. 💐

Post-Keynesian economics greatly influenced Post-Keynesian monetary theory. Although his work was present in Cambridge Keynesians work, such as Joan Robinson, Nicholas Kaldor, Wynne Godley and Francis Cripps, they didn’t influence the thinking on monetary matters as much as Moore did with his great book Horizontalists And Verticalists — The Macroeconomics Of Credit Money.

He does recognise Kaldor’s work in that book:

The obvious lesson to be learned from the experience with the General Theory in the past fifty years is that .. revolutionizing the way the world thinks about economic problems” is an enormously difficult task. In spite of the mountains of Keynesian exegesis that has been produced, Nicholas Kaldor was the sole English-speaking economist of the first rank to have endorsed what is here termed the Horizontalist position (1970, 1981, 1982, 1983, 1985a, b). This book represents my attempt to enlist the support of other scholars in what has at times seemed a quixotic crusade by a member of the lunatic fringe against the prevailing orthodoxy.

I regret not having met him. My only interaction was to ask him via email, where I can buy his book Horizontalists And Verticalists because it cost $450 on Amazon at the time! He didn’t know but replied recommending his book Shaking the Invisible Hand: Complexity, Endogenous Money and Exogenous Interest Rates. But later I managed to get the book. He also said that

It was my attempt to introduce endogenous money into the Macro literature, but no one has heard of it since the mainstream never reviewed it. (They gave H&V to Phil Kagan, a leading Monetarist, who didn’t much like it, but at least it was reviewed.

Noechartalists will be surprised to know that Moore also endorsed Chartalism in his 1988 book:

[page 8] Soft or fiat money refers to unbacked paper or token coins. It maintains its value because it is legally tenderable (by fiat) in settlement of debts and taxes.

…

[page 18] Currency (fiat money) is the physical embodiment of the n,onetary unit of account (numeraire) defined by the sovereign government. It is a sure and perfectly liquid store of value in units of account. It is legal tender for the payment of taxes and for the discharge of private debt obligations enforceable in courts of law. In consequence it is generally accepted as a means of payment.

…

[page 294] Money of any kind allows the breaking of the barter quid pro quo that is imposed by lack of trust and for which money is not a substitute. Even though intrinsically worthless, money is acceptable to me provided that it is also acceptable to you and to everyone else. Trust in money now comes from government guarantee of its acceptability as legal tender. “Today all civilized money is beyond the possibility of dispute, chartalist” (JMK, 5, p. 4).

…

[page 372] Fiat money represents a bridge between the world of commodity money and credit money. In its liquidity characteristics it is virtually identical to commodity money, except that it is chartalist.

There were many places I disagreed with Moore. I don’t think he was a fan of the use of expansionary fiscal policy. I don’t know why he claimed that the Keynesian multiplier doesn’t exist. But as Geoff Harcourt says in the foreword to the book Complexity, Endogenous Money and Macroeconomic Theory — Essays in Honour Of Basil J. Moore:

But, important as these contributions have been, Basil has influenced many other topics, sometimes by his innovative thinking, sometimes by being the irritant that has led other oysters to create pearls of their own. Especially is this true of his highly individual approach to the true meaning of the Keynes–Kahn–Meade multiplier concept and also to the validity of Keynes’s concept of effective demand as presented in The General Theory. Basil has made us think anew about our understanding of the natures of saving and investment, their relationship to each other, to the concept of an under-employment rest state, and also of the relationship of the macroeconomic income and expenditure accounts, balance sheets and funds statements to the behavioral relationships originally developed by Keynes and his followers. To sometimes disagree with Basil’s arguments is not at all to detract from the great stimulus he has provided for fundamental rethinks of basic, central, core concepts and relationships.

Post-Keynesian Economics has lost a giant. R.I.P., Basil Moore.

New Enhanced Financial Accounts In The Federal Reserve’s Flow Of Funds (Z.1) Report

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The Federal Reserve produces quarterly data for the financial accounts of the United States (earlier called “flow of funds”). There are a few notable additions termed enhanced financial accounts, which are in the process of being added. Some additions are details about money market mutual funds, off-balance sheet items of depository institutions, such as unused commitments, letters of credit and derivatives. This is the chart from the Federal Reserve’s FEDS note Off-Balance Sheet Items of Depository Institutions in the Enhanced Financial Accounts

 

meisenzahl-fig1-20150828-624x652This data is probably not new but has been added in the report. Indeed it was one of the important points of Basil Moore’s book Horizontalists and Verticalists.

Basil Moore - Horizontalists And Verticalists - Loan Commitments

Moore has a sophisticated way of saying things (pages 24-25):

In making a loan commitment a bank should be viewed as a participant in forward rather than spot lending markets. Viewed as a seller of contingent claims, banks themselves obviously can excercise only limited control over the volume of their lending.

On page 186 of Moore’s book, he also notes that Keynes talks about this in his book A Treatise On Money:

Keynes insists that cash facilities of the public includes unused overdraft facilities, “of which we have no statistical record whatever” (JMK, 5, p. 37). He then concludes, “Thus the cash facilities, which are truly cash for the purposes of the theory of the value of money, by no means correspond to the bank deposits which are published” (JMK, 5, p. 38).

Tracking Keynes’ writing Moore concludes that although Keynes talked of unused overdraft facilities, he fails to recognize its importance in theory. Moore says (p. 203):

Keynes then returned to the issue of unused overdraft facilities, without, however, recognizing that this was the key to the endogeneity of the money stock:

[Keynes]: In Great Britain the banks pay great attention to the amount of their outstanding loans and deposits, but not to the amount of their customers’ overdraft faclities … it means that there is no effective pressure on the resources of the banking system until the finance is employed … there is no superimposed pressure resulting for planned activity over and above the pressure resulting from actual activity. (JMK, 14, pp. 222-23).

Honestly, I am not sure what Keynes is trying to say in all this. Moore is quite clear in his book. It’s still nice to know that Keynes discussed all this. Perhaps he wanted to say something more but couldn’t translate his thoughts in words. But if you can interpret Keynes, do tell me!

Kaldor’s Reflux Mechanism

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The recent debates of Post Keynesians with Neoclassical/New Keynesians has highlighted that the latter group continues to hold Monetarists’ intuitions. Somehow the exogeneity of money is difficult for them to get rid of, in spite of their statements and rhetoric that money is endogenous in their models.

So there is an excess of money in their models and this gets resolved by a series of buy and sell activities in the “market” (mixing up decisions of consumption and portfolio allocation) until a new “equilibrium” is reached where there is no excess money.

Two-Stage Decision

While the following may sound obvious, it is not to most economists. Keynes talked of a two-stage decision – how much households save out of their income and how they decide to allocate their wealth. In the incorrect “hot potato” model of Neoclassical economists and their New “Keynesian” cousins, these decisions get mixed up without any respect for the two-stage decision. It is as if there enters an excess money in the economy from somewhere and people may consume more (as if consumption is dependent on the amount of deposits and not on income) till prices rise to bring the demand for money equal to what has been “supplied” (presumably by the central bank).

In their book Monetary Economics, Wynne Godley and Marc Lavoie have this to say (p 103):

A key behavioural assumption made here, as well as in the chapters to follow, is that households make a twostage decision (Keynes 1936: 166). In the first step, households decide how much they will save out of their income. In the second step, households decide how they will allocate their wealth, including their newly acquired wealth. The two decisions are made within the same time frame in the model. However, the two decisions are distinct and of a hierarchical form. The consumption decision determines the size of the (expected) end-of-period stock of wealth; the portfolio decision determines the allocation of the (expected) stock of wealth. This behavioural hypothesis makes it easier to understand the sequential pattern of household decisions.

[Footnote]: In his simulation work, but not in his theoretical work, Tobin endorsed the sequential decision that has been proposed here: ‘In the current version of the model households have been depicted as first allocating income between consumption and savings and then making an independent allocation of the saving among the several assets’ (Backus et al. 1980: 273). Skott (1989: 57) is a concrete example where such a sequential process is not followed in a model that incorporates a Keynesian multiplier and portfolio choice.

Constant Money?

So even if one agrees that loans make deposits, there is still a question of deposits just being moved around and the (incorrect) intuition is that someone somewhere must be holding the deposit and hence similar to the hot potato effect. The error in this reasoning is the ignorance that repayment of loans extinguishes money (meant to be deposits in this context).

Nicholas Kaldor realized this Monetarist error early and had this to say

Given the fact that the demand for money represents a stable function of incomes (or expenditures), Friedman and his associates conclude that any increase in the supply of money, however brought about (for example, through open-market operations that lead to the substitution of cash for short-term government debt in the hands of discount houses or other financial institutions), will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will “find themselves” with more money than they wish to hold). This defect, in their view, will be remedied, and can only be remedied, by an increase in expenditures that will raise incomes sufficiently to eliminate the excess of supply over the demand for money.

As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of “credit money” brought about by the creation of public or private debt, this is a fallacious piece of reasoning. It is an illegitimate application of the original propositions of the quantity theory of money, which (by the theory’s originators at any rate) were applied to situations in which money consisted of commodities, such as gold or silver, where the total quantity in existence could be regarded as exogenously given at any one time as a heritage of the past; and where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities. Until that happened, someone was always holding more gold (or silver) than he desired, and since all the gold (and silver) that is anywhere must be somewhere, the total quantity of precious metals to be held by all money-users was independent of the demand for it. The only way supply could be brought into conformity, and kept in conformity, with demand was through changes in the value of the commodity used as money.

[boldening: mine]

from Nicholas Kaldor wrote a major article in 1985 titled How Monetarism Failed (Challenge, Vol. 28, No. 2, link).

In his essay Keynesian Economics After Fifty Years, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983), Kaldor wrote:

The excess supply would automatically be extinguished through the repayment of bank loans, or what comes to the same thing, through the purchase of income yielding financial assets from the banks.

Here’s the Google Books preview of the page:

click to view on Google Books

In his article, Circuit And Coherent Stock-Flow Accounting, (in Money, Credit, and the Role of the State: Essays in Honour of Augusto Graziani, 2004. Google Books link) Marc Lavoie showed how this precisely works using Godley’s transactions flow matrix. (Paper available at UMKC’s course site). See Section 9.3.1

The fact that the supply of credit and demand for money appeared to be independent

 … has led some authors to claim that there could be a discrepancy between the amount or loans supplied by banks to firms and the amount or bank deposits demanded by households. This view of the money creation process is however erroneous. It omits the fact that while the credit supply process and the money-holding process are apparently independent, they actually are not, due to the constraints or coherent macroeconomic accounting. In other words, the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding on the production side.

So if households wish to hold more deposits, firms will have to borrow more from banks. If households wish to hold less deposits, they will purchase more equities (in the model) and hence firms will borrow lesser from banks and/or retire their debt toward banks.

Other References

  1. Lavoie, M. 1999. The Credit-Led Supply Of Deposits And The Demand For Money – Kaldor’s Reflux Mechanism As Previously Endorsed By Joan Robinson, Cambridge Journal Of Economics. (journal link)
  2. Kaldor N. and Trevithick J. 1981. A Keynesian Perspective On Money, Lloyd’s Bank Review.

Open Mouth Operations

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In the previous post Is Paul Krugman A Verticalist?, I discussed the confusions economists and market commentators have on open market operations. Even top economists such as Krugman suffer from confusions on central banking and monetary matters.

I also mentioned the work of Alfred Eichner on bringing out more clarity on the defensive nature of open market operations. Let’s look at these matters more closely.

Before this let’s look at what people in general think. Most people think of open market operations as some kind of extra activity on the part of the central bank in collaboration with the bureau of engraving and printing and think of it as operational implementation of Milton Friedman’s helicopter drops! So when a central bank such as the Federal Reserve changes its target on interest rates – such as lowering the “Fed Funds target rate”, people start commenting as if the Federal Reserve is undertaking a mystical operation.

This is Monetarist or Verticalist intuition. It is easy to show that open market operations have nothing to do with fiscal policy and as we saw in the previous blog – very little with monetary policy itself. The open market operation of the central bank is not an income/expenditure flow such as government expenditure flows or tax flows and the former does not affect the net worth of the change the net worth of either the domestic private or the foreign sector. Hence it is hardly fiscal. Yet commentators and economists keep arguing that the central bank is “injecting money” into the economy!

Even Paul Krugman erred on some of these matters and was shown how to do good economics by Scott Fullwiler in his post Krugman’s Flashing Neon Sign. Missing everything Fullwiler was saying, Krugman wrote another post A Teachable Money Moment which has the following diagram:

Below we will see how Krugman’s Neoclassical/New Keynesian (whichever) intuition is flawed.

Setting Interest Rates

These matters (the public understanding) have become worse ever since the Federal Reserve and other central banks around the world started purchasing government debt in the open markets on a large scale – in programs called Large Scale Asset Purchases (also called “QE”). In the following I will consider cases when there is no “asset purchase program” by the central bank and tackle this issue later in another post.

A simple case to highlight how a central bank defends an interest rate (as opposed to changing it) is considering the corridor system. There target for overnight rates is usually at the midpoint of this “corridor”. At the lower end of the corridor banks get paid interest on their settlement balances they keep at the central bank while at the upper end it is the rate at which the central bank lends.

Because banks settle among each other on the books of the central bank, this gives the latter to fix the short-term rates and indirectly influence long term rates.

Why do banks need to settle with each other?

One of the first economists to understand the endogenous nature of money was Sir Dennis Holme Roberston who used to work for the Bank of England. In 1922, he wrote a nice book simply titled Money.

 From page 52:

. . . If A who banks at bank X pays a cheque for £10 to B who banks at bank Y, then Bank Y, when it gets the cheque from B, will present it for payment to Bank X: and bank X will meet its obligation by drawing a cheque for £10 on its chequery at the Bank of England. As a matter of fact, the stream of transactions of this nature between big banks is so large and steady in all directions that the banks are enabled to cancel most of them out by an institution called the clearing-house:  but the existence of these chequeries at the Bank of England facilitates the payment of any balance which it may not be possible at the moment to deal with in this way …

Because banks finally settle at the central bank finally, central banks have learned since their creation that they can set interest rates. This is strongest at the short end of the “yield curve” but directly or indirectly central banks also influence long term rates.

At the end of each day, some banks will be left with excess of settlement balances (if they see more inflows than outflows) and some banks will face the opposite situation. Because they need to satisfy a reserve requirement at the central bank (which can be zero as well), some banks would need to borrow funds from others. Borrowing means paying back with interest and this is where the central bank’s ability to target rates comes enters the picture.

For suppose some bank X needs funds and other banks wish to lend bank X at a very high interest rate. In this scenario bank X can simply borrow from the central bank, while other banks who demanded higher interest will see themselves with excess settlement balances earning less than the target rate. So it would have been better for the latter to have lent than keep excess balances. (Of course the qualifier is that these things are valid under scenarios when there is less stress on the financial system). Also with the same logic, the rate at which banks lend each other will not fall below the corridor because it will be foolish of a bank to have lent settlement balances to another bank when it could have earned higher by just keeping excess settlement balances at the central bank.

Here is a diagram from the post Corridors And Floors In Monetary Policy from FRBNY’s blog which explains central bank’s operations:

The other system as per this post is the floor system – in which the central bank’s target is the interest paid on settlement balances itself, rather than the midpoint of any corridor. This is what has been followed by the US Federal Reserve in recent times.

Back to the corridor system, an important question arises. Hopefully the reader is convinced that the overnight rate at which banks lend each other is between the corridor. However it is still unclear how and why the central bank can keep it at the midpoint.

If the central bank and the bankers understand the system well, it is possible for the central bank to be quite perfect in this. This happens for example in the case of Canada, where the bank is quite accurate in its objective.

The reason is that the central bank can easily add and subtract settlement balances by various means.

Take an example. Suppose the interest on reserves is 2.25%, the target is 3.00% and the discount rate – the rate at which the central bank lends overnight – 3.75%. If the central bank observes that banks are lending each other at 3.25% – slightly away from the target of 3.00%, it can simply create excess balances. Among the many ways, there are two –

  1. purchase/sale of government securities and/or repurchase/reverse repurchase agreements.
  2. shifts of government deposits from the central bank account into the Treasury’s account at banks or the opposite.

So the central bank knows how the curve in the figure above looks like and adds/subtracts settlement balances by the above methods (mainly). So banks are lending each other at 3.25%, the central bank will add settlement balances; if they are lending each other at 2.75% – the central bank will drain settlement balances.

More generally the “threat” by the central bank is reasonably sufficient to make banks lend at the target!

Open Mouth Operations

Let us suppose the central bank had been targeting 3.00% for three months now and decides to decrease rates.

What does it do?

Almost nothing!

The announcement itself will make banks gravitate toward the new target!

In his paper Monetary Base Endogeneity And The New Features Of The Asset-Based Canadian And American Monetary Systems, Marc Lavoie says:

When they [central banks] are not accommodating—that is, when they are pursuing “dynamic” operations as Victoria Chick (1977, p. 89) calls them—central banks will increase (or decrease) interest rates. As shown above, to do so, they now need to simply announce a new higher target overnight rate. The actual overnight rate will gravitate toward this new anchor within the day of the announcement. No open-market operation and no change whatsoever in the supply of high-powered money are required.

Hence the term “open mouth operations” which was coined by Julian Wright and Greame Guthrie in their paper Market-Implemented Monetary Policy with Open Mouth Operations.

Open Market Operations

The above paper by Marc Lavoie is an excellent source for open market operations and looking at central banking from an endogenous money viewpoint.

I mentioned in the previous post that the open market operations are defensive. In my analysis in this post till now, I ignored the factors which cause settlement balances of the banking sector as a whole to change. Let us bring in this complication.

Apart from banks, the Treasury – the domestic government’s fiscal arm – and other institutions such as foreign central banks, governments and international official institutions (such as the IMF) also keep an account at the (domestic) central bank. When these institutions transact, there is an addition/subtraction of banks’ settlement balances at the central banks.

Here’s one example. Suppose the Treasury transfers funds of $1m to a contractor for settlement of a project done by the latter. When the funds are transferred, the contractor’s bank account increases by $1m and the bank in which he banks sees its deposits and settlement balances rise by $1m while the central bank will reduce the Treasury’s deposits by $1m.

This may lead to a deviation of banks’ lending rate to each other and the central bank needs to drain reserves. The central bank can achieve this by shifting government funds at a bank into the central bank account. If the central bank transfers $1m of funds, banks’ deposits and settlement balances reduce by $1m and the Treasury’s account at the central bank will increase by $1m.

This is not an “open market operation” but another way of adding/draining reserves. In general, depending on institutional setups, the central bank may also do purchase/sale of government securities and/or repurchase agreements.

But this has nothing to do with policy itself – rather it is to maintain status quo. (Of course “large scale asset purchases” is a slightly different matter – first one needs to understand the corridor system).

In other words, this is a defensive behaviour on part of the central bank.

Alfred Eichner

In the previous post and in Alfred Eichner And Federal Reserve Operating Procedures, I mentioned about the contribution of Eichner. In an essay in honour, Alfred Eichner, Post Keynesians, And Money’s Endogeneity – Filling In The Horizontalist Black Box, (from the book Money And Macrodynamics – Alfred Eichner And Post-Keynesian Economics) Louis-Philippe Rochon says:

For Eichner, the overall or “primary objective [of the central bank], in conducting its open market operations, is to ensure the liquidity of the banking system,” which applies to either the accommodating or defensive roles. In either case, Eichner argues that “the Fed’s open market operations are largely an endogenous response to . . . the need both to offset the flows into and out of the domestic monetary-financial system and to provide banks with the reserves they require”; that is, resulting from the demand for money and the demand for credit respectively (1987, 847, 851).

And while the accommodating argument has been debated at length by post-Keynesians, the defensive role has been virtually ignored and only recently rediscovered (see Rochon 1999). Yet it is certainly Eichner’s greatest contribution to the post-Keynesian theory of endogenous money. . .

. . . The “defensive” behavior is defined by Eichner as the “component of the Fed’s open market operations [consisting] of buying or selling government securities so that, on net balance, it offsets these flows into or out of the monetary-financial system,” leaving the overall amount of reserves unchanged. This is the result of changes in portfolio decisions and increases or decreases in bank (demand) deposits. As a result of an increase in the nonbank’s desire to hold currency, for instance, “in order to maintain bank reserves at the same level, the Fed will need to purchase in the open market government securities equal in value to whatever additional currency the nonbank public has decided to hold” (Eichner 1987, 847).

In making the distinction between temporary and permanent open market operations, Rochon also quotes Scott Fullwiler:

Outright or permanent open market operations are primarily undertaken to offset the drain to Fed balances due to currency withdrawals by bank depositors. . . . Temporary open market operations are aimed at keeping the federal funds rate at its target on average through temporary additions to or subtractions from the quantity of Fed balances. Temporary operations attempt to offset changes in Fed balances due to daily or otherwise temporary fluctuations in the Treasury’s account, float, currency, and other parts of the Fed’s balance sheet, in as much as is necessary to meet bank’s demand for Fed balances. (2003, 857)

Paul Krugman

All this is completely opposite of Paul Krugman’s position that

. . . And currency is in limited supply — with the limit set by Fed decisions.

And Krugman’s mistake is not minor – it seems he is completely unaware of the huge difference money endogeneity makes.

So what is the difference between Krugman’s diagram and the one from FRBNY blog – even though they look similar? The difference is that the latter is descriptive of behaviour when policy is unchanged and is useful for describing open market operations etc while Krugman uses the same to describe policy changes – which in reality happen via open mouth operations. Paul Krugman confuses open market operations and open mouth operations. So much for a “teachable money moment”.

Krugman also shows his Monetarist intuition by claiming:

And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.

implying that the central bank in reality controls the monetary base and thence the money stock.

Some Post Keynesians argued since long ago that the central bank cannot control the money stock:

Here’s on Wynne Godley from from The Times, 16 June 1978:

(click to enlarge)

Is Paul Krugman A Verticalist?

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24 years back, Basil Moore wrote a book Horizontalists And Verticalists: The Macroeconomics Of Credit Money (Cambridge University Press, 1988) which begins like this:

The central message of this book is that members of the economics profession, all the way from professors to students, are currently operating with a basically incorrect paradigm of the way modern banking systems operate and of the causal connection between wages, prices, on the one hand, and monetary developments, on the other. Currently, the standard paradigm, especially among economists in the United States, treats the central bank as determining the money base and thence the money stock. The growth of the money supply is held to be the main force determining the rate of growth of money income, wages, and prices.

… This book argues that the above order of causation should be reversed. Changes in wages and employment largely determine the demand for bank loans, which in turn determine the rate of growth of the money stock. Central banks have no alternative but to accept this course of events, their only option being to vary the short-term rate of interest at which they supply liquidity to the banking system on demand. Commercial banks are now in a position to supply whatever volume of credit to the economy their borrowers demand.

The book built on his own work and that of Nicholas Kaldor and Marc Lavoie among others goes on to describe the banking system, horizontalism and endogenous money. Money is credit-led and demand-determined was his message. Economists believing in the “incorrect paradigm” are Verticalists in Moore’s terminology.

Paul Krugman whom Post Keynesian have more respect than other mainstream economists probably disappointed them when he was arguing with Steve Keen in a 3-post blog series. Arguing like a Verticalist, Krugman claims (among other Verticalist claims) in his post Banking Mysticism, Continued:

… And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

The Defensive Nature Of Open Market Operations

The reason there is widespread misunderstanding of what the central bank does is because it carries out open market operations where it buys or sells government securities or does repurchase agreements. The orthodox view is that the central bank is acting the way it is to increase or decrease the amount of banks’ settlement balances and this affects the money supply – allowing banks to expand lending or leading them to contract – and thence the whole economy. The view is that the central bank has a direct control these operations and are purely volitional.

This is an incorrect view because no central bank claims to be “controlling” the money stock.

If money is truly endogenous, the question is why the central bank does these operations often. The reason is that operations of the central bank are defensive. 

In his article Endogenous Money: Accomodationist, Marc Lavoie argues:

Some post-Keynesians have pointed out long ago that open market operations had little or nothing to do with monetary policy.

For instance, It is usually assumed that a change in the Fed’s holdings of government securities will lead to a change, with the same sign attached, in the reserves of the commercial banking system. It was the failure to observe this relationship empirically which led us, in constructing the monetary financial block of our model, to try to find some other way of representing the effect of the Fed’s open market operations on the banking system. (Eichner, 1986, p. 100)

That other way is that ‘the Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system’ (Eichner, 1987, p. 849).

So the central bank purchases government bonds and/or does repos to neutralize the effects of transactions which change the settlement balances. One example is the flow of funds into and out of the government’s account at the central bank. Another is the demand for currency notes by banks to satisfy their customers’ needs. The central bank has no choice but to provide these notes.

Here’s a preview via Google Books:

click to view on Google Books

Also see this post Alfred Eichner And The Federal Reserve Operating Procedures.

Krugman is partly right when he says, “Banks are important, but they don’t take us into an alternative economic universe.” However he fails to see that money is endogenous and the way the banking system works show this endogeneity.

Of course, Steve Keen has issues with his models and accounting with which Krugman has troubles. Keen defines aggregate demand to be gdp plus “change in debt”. As much weird this definition is, it is double counting when investment expenditure is financed by borrowing rather than internal sources of funds. Also, if a person sells a home to another person who has financed this purchase by borrowing and the former does not make expenditure from this income, this does not increase aggregate demand – a point raised by Marc Lavoie here (h/t “Circuit” from Fictional Reserve Barking). But as per Keen’s definition it does. In his first post, Krugman seems to say the same thing as Lavoie – but in a roundabout way.

The resulting debate has however highlighted the Verticalist intuition of Krugman!

Income And Expenditure Flows And Financing Flows

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In the previous two posts, I went into a description of the transactions flow matrix and the balance sheet matrix as tools for an analytic study of a dynamical study of an economy.

During an accounting period, sectors in an economy are making all kinds of transactions. These can be divided into two kinds:

  1. Income and Expenditure Flows
  2. Financing Flows

Let’s have the transactions flow matrix as ready reference for the discussion below.

(Click for a nicer view in a new tab)

The matrix can easily be split into two – on top we have rows such as consumption, government expenditure and so on and in the bottom, we have items which have a “Δ” such as “Δ Loans” or “change in loans”. We shall call the former income and expenditure flows and the latter financing flows.

To get a better grip on the concept, let us describe household behaviour in an economy. Households receive wages (+WB) and dividends from production firms (called “firms” in the table) and banks (+FD_{f} and +FD_{b}) respectively) on their holdings of stock market equities. They also receive interest income from their bank deposits and government bills. These are sources of households’ income. While receiving income, they are paying taxes and consuming a part of their income (and wealth). They may also make other expenditure such as buying a house or a car. We call these income and expenditure flows.

Due to these decisions, they are either left with a surplus of funds or a deficit. Since we have clubbed all households into one sector, it is possible that some households are left with a surplus of funds and others are in deficit. Those who are in surplus, will allocate their funds into deposits, government bills and equities of production firms and banks. Those who are in deficit, will need funds and finance this by borrowing from the banking system. In addition, they may finance it by selling their existing holding of deposits, bills and equities. The rows with a “Δ” in the bottom part of transactions flow matrix capture these transactions. These flows will be called financing flows.

How do banks provide credit to households? Remember “loans make deposits”. See this thread Horizontalism for more on this.

This can be seen easily with the help of the transactions flow matrix!

The two tables are some modified version of tables from the book Monetary Economics by Wynne Godley and Marc Lavoie.

It is useful to define the flows NAFA, NIL and NL – Net Accumulation of Financial Assets, Net Incurrence of Liabilities and Net Lending, respectively.

If households’ income is higher than expenditure, they are net lenders to the rest of the world. The difference between income and expenditure is called Net Lending. If it is the other way around, they are net borrowers. We can use net borrowing or simply say that net lending is negative. Now, it’s possible and typically the case that if households are acquiring financial assets and incurring liabilities. So if their net lending is $10, it is possible they acquire financial assets worth $15 and borrow $5.

So the the identity relating the three flows is:

NL = NAFA – NIL

I have an example on this toward the end of this post.

I have kept the phrase “net” loosely defined, because it can be used in two senses. Also, some authors use NAFA when they actually mean NL – because previous system of accounts used this terminology as clarified by Claudio Dos Santos. I prefer old NAFA over NL, because it is suggestive of a dynamic, though the example at the end uses the 2008 SNA terminology.

While households acquire financial assets and incur liabilities, their balance sheets are changing. At the same time, they also see holding gains or losses in their portfolio of assets. What was still missing was a full integration matrix but that will be a topic for a post later. Since, it is important however, let me write a brief mnemonic:

Closing Stocks = Opening Stocks + Flows + Revaluations

where revaluations denotes holding gains or losses.

This is needed for all assets and liabilities and for all sectors and hence we need a full matrix.

We will discuss more on the behaviour of banks (and the financial system) and production firms some other time but let us briefly look at the government’s finances.

As we saw in the post Sources And Uses Of Funds, government’s expenditure is use of funds and the sources for funds is taxes, the central bank’s profits, and issue of bills (and bonds). Unlike households, however, the government is in a supreme position in the process of “money creation”. Except with notable exceptions such as in the Euro Area, the government has the power to make a draft at the central bank under extreme emergency, though ordinarily it is restricted. Wynne Godley and Francis Cripps described it as follows in their 1983 book Macroeconomics:

Our closed economy has a ‘central bank’ with two principle functions – to manage the government’s debt and to administer monetary policy. [Footnote: The central bank has to fund the government’s operations but this in itself presents no problems. Government cheques are universally accepted. When deposited with commercial banks the cheque become ‘reserve assets’ in the first instance; banks may immediately get rid of excess reserve assets by buying bonds.]. The only instrument of monetary policy available to the central bank in our simple system is the buying and selling of government bonds in the bond market. These operations are called open market operations. We assume that the central bank does not have the right to directly intervene directly in the affairs of commercial banks (e.g., to prescribe interest rates or quantitative lending limits) or to change the 10% minimum reserve requirement. But the central bank is in a very strong position in the bond market since it can sell or buy back bonds virtually without limit. This gives it the power, if it chooses, to fix bond prices and yields unilaterally at any level [Footnote: But speculation based on expectations of future yields may oblige the central bank to deal on a very large scale to achieve this objective.] and thereby (as we shall soon see) determine the general level of interest rates in the commercial banking system.

Given such powers, we can assume in many descriptions that the government’s expenditure and the tax rate is exogenous. However, many times, there are many constraints such as price and wage rises, high capacity utilization and low production capacity and also constraints brought about from the external sector due to which fiscal policy has to give in and become endogenous.

While I haven’t introduced open economy macroeconomics in this blog in a stock-flow coherent framework, we can make some general observations:

For a closed economy as a whole, income = expenditure. While it is true for the whole economy (worth stressing again: closed), it is not true for individual sectors. The household sector, for example, typically has its income higher than expenditure. In the last 15-20 years, even this has not been the case. If one sector has it’s income higher than expenditure, some sectors in the rest of the world will have its income lower than its expenditure. Many times, the government has its income lower than expenditure and we see misleading public debates on why the government should aim to achieve a balanced budget. When a sector has its income lesser than expenditure, it’s net lending is negative and hence is a net borrower from the rest of the world. It can finance this by borrowing or sale of assets. A region or a whole nation can have its expenditure higher than income and this is financed by borrowing from the rest of the world. A negative flow of net lending implies a net incurrence of liabilities – thus adding to the stock of net indebtedness which can run into an unsustainable territory. Stock-flow coherent Keynesian models have the power to go beyond short-run Keynesian analysis and study sustainable and unsustainable processes.

In an article Peering Over The Edge Of The Short Period – The Keynesian Roots Of Stock-Flow Consistent Macroeconomic Models, the authors Antonio C. Macedo e Silva and Claudio H. Dos Santos say:

… it is important to have in mind that it is possible to get three kinds of trajectories with SFC models:

  • trajectories toward a sustainable steady state;
  • trajectories toward a steady state over certain limits;
  • explosive trajectories.

The analysis of SFC models’ dynamic trajectories and steady states is useful, first because it makes clear to the analyst whether the regime described in the model is sustainable or whether it leads to some kind of rupture—either because the trajectory is explosive or because it leads to politically unacceptable configurations. In these cases, as Keynes would say in the Tract, the analyst can conclude that something will have to change and even get clues about (i) what will probably change (since the sensitivity of the system dynamics to changes in different behavioural parameters is not the same); and (ii) when this change will occur (since the system may converge or diverge more or less rapidly).

Example

Note that Net Lending is different from “saving”. Say, a household earns $100 in a year (including interest payments and dividends), pays taxes of $20 and consumes $75 and takes a loan of to finance a house purchase near the end of the year whose price is $500. Assume that the Loan-To-Value (LTV) of the loan is 90% – which means he gets a loan of $450 and has to pay the remaining $50 from his pocket to buy the house. (i.e., he is financing the house mainly by borrowing and partly by sale of assets). How does the bank lending – simply by expanding it’s balance sheet (“loans make deposits”). Ignoring, interest and principal payments (which we assume to fall in the next accounting period),

His saving is +$100 – $20 – $75 = +$5.

His Investment is +$500.

His Net Incurrence of Liabilities is +$450.

His Net Accumulation of Financial Assets is +$5 – $50 = – $45.

His Net Lending is = -$45 – (+$450) = -$495 which is Saving net of Investment ($5 minus $500).

This means even though the person has “saved” $5, he has incurred an additional liability of $450 and due to sale of assets worth $45, he is a net borrower of $495 from other sectors (i.e., his net lending is -$495).

Assume he started with a net worth of $200.

Opening Stocks: 2010

$

Assets

200

Nonfinancial Assets
Deposits
Equities

0
30
170

Liabilities and Net Worth

200

Loans
Net Worth

0
200

 

Now as per our description above, the person has a saving of $5 and he purchases a house worth $500 by taking a loan of $450 and selling assets worth $50. We saw that the person’s Net Accumulation of financial assets is minus $45. How does he allocate this? (Or unallocate $45)? We assume a withdrawal of $10 of deposits and equities worth $35. At the same time, during the period, assume he had a holding gain of $20 in his equities due to a rise in stock markets.

Hence his deposits reduce by $10 from $30 to $20. His holding of equities decreases by $15 (-$35 + $20 = -$15)

How does his end of period balance sheet look like? (We assume as mentioned before that the purchase of the house occurred near the end of the accounting period, so that principal and interest payments complications appear in the next quarter.)

Closing Stocks: 2010

$

Assets

675

Nonfinancial Assets
Deposits
Equities

500
20
155

Liabilities and Net Worth

675

Loans
Net Worth

450
225

 

Just to check: Saving and capital gains added $5 and $20 to his net worth and hence his net worth increased to $225 from $200.

Of course, from the analysis which was mainly to establish the connections between stocks and flows seems insufficient to address what can go wrong if anything can go wrong. In the above example, the household’s net worth gained even though he was incurring a huge liability. What role does fiscal policy have? The above is not sufficient to answer this. Hence a more behavioural analysis for the whole economy is needed which is what stock-flow consistent modeling is about.

One immediate answer that may satisfy the reader now is that the households’ financial assets versus liabilities has somewhat deteriorated and hence increased his financial fragility. By running a deficit of $495 i.e., 495% of his income, the person and his lender has contributed to risk. Of course, this is just one time for the person – he may be highly creditworthy and his deficit spending is an injection of demand which is good for the whole economy. After all, economies run on credit. While this person is a huge deficit spender, there are other households who are in surplus and this can cancel out. In the last 15 years or so, however (before the financial crisis hit), households (as a sector) in many advanced economies ran deficits of the order of a few percentage of GDP. If the whole household sector continues to be a net borrower for many periods, then this process can turn unsustainable as the financial crisis in the US proved.

Now to the title of the post. Flows such as consumption, taxes, investment are income/expenditure flows. Flows such as “Δ Loans”, “Δ Deposits”, “Δ Equities” are financing flows. Income/expenditure flows affect financing flows which then affect balance sheets, as we see in the example.

The (Almost) Irrelevance Of Reserve Requirements

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Earlier this week, the Reserve Bank of India reduced banks’ reserve requirements by 50bps. It’s called Cash Reserve Ratio and the RBI reduced it from 6.00% to 5.50% with effect from the following week.

The Reserve Bank of India is one of the most backward central bank in liquidity management and sometimes panics and changes the reserve requirements. Typically this happens when taxes flow into the government of India’s account at the RBI and since this is not smooth, the RBI simply doesn’t know what to do.

To me this confusion was good, because three years back when someone asked me to read about this in office, I came across this Reuters article and after reading it (and slightly before when I became interested in macroeconomics after the Federal Reserve announced a Large Scale Asset Purchase Program, popularly known as “QE”) I started having suspicions on the way economists seem to describe banking and economics. This ultimately led me to some Neochartalists’ blogs and finally to Post-Keynesian Economics.

In many countries central banks have a zero-reserve requirement, such as in the UK, Canada, Sweden, Australia and New Zealand. In the United States, the Federal Reserve imposes a requirement of 10% with additional complications.

Basil Moore in his 1988 book Horizontalists and Verticalists goes into the details of central banking operating procedures and provides a fantastic account of central banking. See pages 63-65 and 95-97 for reserve requirements.

From page 63-65:

… Fed non-interest earning reserve requirements put member banks at a disadvantage relative to non-members, who were generally allowed to hold interest-earning assets as reserves and who in addition typically had lower reserve requirements. Because membership in the Federal Reserve system is voluntary under the dual banking system tradition, as interest rates rose an increasing number of banks withdrew from the system. In desperation the Federal Reserve finally proposed to pay interest on required reserve balances. Congressional reaction to this potential erosion of seigniorage from reserve earnings was loud and swift and led rapidly to the Monetary Control Act of 1980. Its solution, to make reserve requirements universal and uniform for all depository institutions, whether members of the Federal Reserve or not, was, as revealed in the 1979 hearings before the Senate Banking Committee, a compromise clearly designed to safeguard the volume of Fed-Treasury transfers and at the same time reduce membership attrition for the Fed.

Contrary to conventional wisdom, changes in reserve requirements imposed by the central bank do not directly affect the volume of bank intermediation. A change of required reserve ratios influences the volume of bank intermediation only indirectly, by affecting the required reserve markup or spread. A rise (reduction) in reserve requirements raises (lowers) the cost of obtaining funds to place in loans financed via  additional reservable deposits, in the manner of an indirect tax. The banks will therefore raise (lower) the markup of their lending rates over their borrowing rates. As a result, depending on the interest elasticity of demand for bank credit, the volume of bank intermediation will be indirectly reduced (increased).

From pages 95-97:

… In practice the Federal Reserve fully compensates for any excess reserves created by a lowering of reserve requirements by open-market sales so as to maintain free reserves at some target level. This evidence is clearly consistent with the notion that nominal money stock is demand-determined …

There are other effects. The ECB governing council decided in December to reduce reserve requirements to 1% from 2%  January 18. This “freed up” a lot of collateral banks in the Euro Area needed to pledge to the Eurosystem, thereby providing some relief to the banking system in crisis.

Chart Source: ECB

On 18 January, reserve requirement was €103.33bn as compared to €207.03bn on the previous day.

By The Theory’s Originators, At Any Rate

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While most people – including most economists – treat money as a commodity, there are some who understand the endogeneity of money. However, there is a degree of endogeneity assigned to the nature of money with some thinking money was a commodity in some periods in history. So one sees claims that what is written in economics textbooks works only in “gold standard” or worse – fixed exchange rate regimes. Fixed or floating is not the focus of this post, but I’d like to quote James Tobin who once said:

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.

… The man and his wisdom 🙂

Nicholas Kaldor wrote a major article in 1985 titled How Monetarism Failed (Challenge, Vol. 28, No. 2, link). The article goes into the heart of confusions in economists’ minds on the nature of money.

Kaldor talks about the Monetarists’ false intuition:

Given the fact that the demand for money represents a stable function of incomes (or expenditures), Friedman and his associates conclude that any increase in the supply of money, however brought about (for ex- ample, through open-market operations that lead to the substitution of cash for short-term government debt in the hands of discount houses or other financial institutions), will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will “find themselves” with more money than they wish to hold). This defect, in their view, will be remedied, and can only be remedied, by an increase in expenditures that will raise incomes sufficiently to eliminate the excess of supply over the demand for money.

As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of “credit money” brought about by the creation of public or private debt, this is a fallacious piece of reasoning. It is an illegitimate application of the original propositions of the quantity theory of money, which (by the theory’s originators at any rate) were applied to situations in which money consisted of commodities, such as gold or silver, where the total quantity in existence could be regarded as exogenously given at any one time as a heritage of the past; and where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities. Until that happened, someone was always holding more gold (or silver) than he desired, and since all the gold (and silver) that is anywhere must be somewhere, the total quantity of precious metals to be held by all money-users was independent of the demand for it. The only way supply could be brought into conformity, and kept in conformity, with demand was through changes in the value of the commodity used as money.

[boldening: mine]

Notice the wording “by the theory’s originators at any rate”.

And what about mining or the lack of mining?

… the value of the money commodity depended, in the longer run at least, on its costs of production, in the same way as the demand for other commodities. With the expansion of the general level of production, the value of monetary transactions through the purchases and sales of goods and services expanded pari passu, which made it profitable to expand the production of the money commodity in line with commodities in general. From the very beginning, therefore, the increase in the supply of money in circulation was a response to increased demand and not an autonomous event, though occasionally the supply of the money commodity ran ahead of the increase in the supply of other commodities, as with the gold and silver discovered in the new Spanish colonies of the sixteenth century; at such times, money could be said to have exerted an autonomous influence on the demand for goods and services. It did so because those who first came into the possession of the new gold or silver were thereby personally enriched, and thus became the source of additional demand for goods and services. But the converse of this proposition was equally true: where the increase in the supply of the money commodity lagged behind, this placed obstacles on economic expansion that historically were gradually overcome with the successive introduction of money substitutes.

Kaldor then goes into the development of the banking system:

This latter development was closely associated with the development of banking. Originally, goldsmiths (who possessed strong rooms for holding gold and other valuables) developed the facility of accepting gold for safekeeping, and issued deposit certificates to the owners. The latter found it convenient to make payments by means of these certificates, thereby saving the time and trouble of taking gold coins out of the strong room only to have them re-deposited by the recipient of the payment, who was likely to have much the same incentive of keeping valuables deposited for safekeeping. The next step in the evolution toward a credit-money system was when the goldsmiths found it convenient to lend money as well as to accept it on deposit for safekeeping. For the purpose of lending they had to issue their own promissory notes to pay cash to the bearer (as distinct from a named depositor) on demand; with this latter development the goldsmiths became bankers, i.e., financial intermediaries between lenders and borrowers. Since real money (gold) was only required on specific occasions (when payments had to be made abroad or when the contract specifically provided for payment in cash), the banks found that the amount of such notes issued to borrowers came to exceed by many times the amount of gold deposited in their vaults by the lenders- though the total amount they owed to the lenders was always larger than the total amount lent to the borrowers. The apparent contradiction between the formal solvency of the banks when the volume of credits granted to borrowers was compared with their total obligation to their depositors, and their palpable insolvency when the value of the promissory notes issued was compared with the amount of gold held for their encashment, was not properly understood for a surprisingly long period. It gave rise to prolonged controversies between those (like Edwin Cannan) who firmly believed in “cloakroom banking” and those who believed that, by issuing pieces of paper that came to serve as a circulating medium, the banks were “creating credit,” which meant an effective enlargement of the money supply.

Did central banks “control” the money stock during gold exchange standards? Kaldor says:

Traditionally, the core of central-banking policy consisted of protecting the reserves (in gold or reserve currencies) through the instrument of changes in the bank rate. Ostensibly, such changes served the purpose of keeping the balance of payments with foreign countries on an even keel – a loss of reserves was taken as evidence of an unfavorable balance, and vice versa. The policy worked in the sense that even moderate changes in short-term interest rates (relative to other financial centers) sufficed to reverse the trend in the movement in reserves. But until the new monetarism came into fashion, stabilizing the quantity of money in circulation, as distinct from stabilizing the volume of international reserves, was not regarded as a primary objective.

One more thing. There is a very interesting point that Kaldor makes at the beginning of the article – the ending of the following is the point of the greatest interest to me.

In the light of the above, the main contention – and indeed, the sine qua non – of monetarism, that the money supply of each “economy” is exogenously determined by the monetary authority of the “economy” concerned, may be questioned from the start. Monetarists, following Milton Friedman, assume that the monetary authority determines the so-called “monetary base” (or “high-powered money,” to use Friedman’s expression), which is nothing else but the amount of bank notes issued which at any one time are partly in the hands of the public and partly in the hands of the banks, whether in the form of vault-cash or of deposits with the central bank; either legally enforceable rules or conventions determine an established ratio between this “base money” and all other forms of money. Hence the “monetary authority” ultimately determines the supply of money in all forms. It does so partly by active measures such as “open-market operations,” by which the central bank buys or sells government securities in exchange for its own notes, and partly by passive measures, the re-discounting of short-term paper consisting of public or private debt, in which it seeks to achieve its objective as regards the money supply by varying its own rate of re-discount. The further assumption that the (inverted) pyramid of bank money bears a stable relationship to the monetary base is supposed to be ensured by the banks’ rationing credit so as to prevent their liabilities from becoming larger (or rising faster) than the legal or prudential reserve ratio permitted. It is admitted, however, that each “economy” characterized by the possession of a separate currency must be wholly autonomous, which means that the central bank is not under any obligation to maintain its exchange rate at a predetermined relationship with other currencies (as was the case under the pre-1914 gold standard or the Bretton Woods system); rather, it allows its exchange rate to fluctuate freely so as to achieve a balance in the foreign-exchange market without central-bank intervention. (The possibility that payments, whether among the same nationals or between different nationals, are effected in other currencies or through transfers between extraterritorial bank accounts has not, to my knowledge, been explicitly considered.)

[last emphasis: mine]

I will have a post in the future on international flow of money, correspondent banking, foreign exchange market microstructure, fx settlements and balance of payments to argue Tobin’s wisecrack that the fixed versus floating debate obscures the problems facing the world today.

Hopefully my post (which was mainly quotes from Kaldor) may force the reader to think about the Horizontalist claim that money is endogenous and it cannot be otherwise.