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Alfred Eichner And Federal Reserve Operating Procedures

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Alfred Eichner was a Post-Keynesian economist known for his text Macrodynamics of Advanced Market Economies published 3 years after his death in 1988. He died at the age of 50 in an accident and at the time he was preparing to include an analysis of open economy macroeconomics in his story of how economies work.

This post is about an article/chapter he wrote (with Leonard Forman and Miles Groves)* in 1984 in a book titled Money And Macro Policy edited by Marc Jarsulic. It is a fantastic book with chapters written by Basil Moore and Marc Lavoie as well on the endogeneity of money. I discussed this previously in my post More On Horizontalism.

Google Books allows a preview of the chapter and embedding it on a webpage and I have done so at the end of this post. If it doesn’t appear properly in your browser, please let me know. Else, like me, you can buy the book 🙂 Of course G-books won’t allow a preview of all pages due to copyright restrictions.

Eichner’s chapter (#2) is titled The Demand Curve For Money Further Considered. 

The authors start off the description with

First, the amount of bank reserves, and thus the monetary base, is not the exogenously determined variable assumed in both orthodox Keynesian and monetarist models but instead depends on the level of nominal income. This is because the central bank, in order to maintain the liquidity of the financial system, is forced to purchase government securities in the open market so as to accommodate, at least in part, the need for additional credit as the pace of economic activity quickens. With the amount of unborrowed bank reserves, and thus the monetary base, to a significant extent endogenously determined, it follows that the money supply is, to no less an extent endogenously determined as well. It is therefore a misspecification to assume that the money stock, or any of its components, is entirely exogenous, subject to the control of the monetary authorities, and then to derive a demand curve for money based on that assumption. In reality, the demand for and supply of “money” are interdependent, with no possibility in practice of being able to distinguish between the two.

Second, it is the demand for credit rather than the demand for money which is the necessary starting point for analyzing the role played by monetary factors in determining the level of real economic activity…

The authors then point out the neutralizing nature of open-market operations of the Fed. Usually this – open market operations – is presented in textbooks and in some old Federal Reserve publications as causing the amount of reserves to rise and allowing banks to increase the supply of reserves. Eichner had earlier worked with data and failed to see open market operations increasing the amount of reserves in practice. He realized that the open market operations neutralize flows:

… Thus, in the face of a fluctuating public demand for currency, flows of gold into and out of the country, variations in the amount of deposits held at the Fed by foreigners and others, changes in the amount of float and fluctuations in the Treasury’s cash holdings, the Fed must engage in open-market operations just to maintain bank reserves at a given level. This is the neutralizing component of a fully accommodating policy, and it is one reason why it is difficult in practice to relate change in bank reserves to open market operations …

What is so nice about the quote above is that Eichner knew exactly what factors affect reserve balances. At the time, “float” may have been more important than it is today. Eichner not only knew that the Treasury’s account at the Fed affects reserve balances but also holdings of other institutions such as foreign central banks – i.e., as a result of “flows of funds into or out of the Federal Reserve System” in his own words. (In the same paragraph from which the quote is taken).

Further the article goes:

An increase in the demand for credit will, to the extent it is satisfied, lead to an increase in bank deposits (especially demand deposits). This is because banks make loans by simply crediting the borrower’s account at the bank with the funds advanced. The increase in deposits will, however, require that banks maintain larger reserves at the Fed. Thus required reserves, ResR, will increase and, unless the Fed acts through the purchase of government securities in the open market to provide banks with the necessary additional reserves, banks will find themselves with insufficient reserves to meet their legal requirements… the Fed is forced to accommodate, at least in part,  whatever demand for credit may manifest itself.

The terminology “accommodating” was later made clear later by Eichner in his book Macrodynamics as operations aimed at pegging the short term interest rate whatever the economic or credit conditions. So when the Fed is not accommodating – in this terminology – it means it is pursuing a policy of raising rates at frequent intervals with an aim to impact credit and aggregate demand.

The Google Books link is embedded below.

click to view on Google Books

Endnote

*Chief Economist and Economic Analyst, respectively at The New York Times at the time of writing.

More On Horizontalism

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Horizontalism, Endogenous Money and ideas such as that were brought into Macroeconomics by Nicholas Kaldor. In [1] he wrote

Diagrammatically, the difference in the presentation of the supply and demand for money, is that in the original version, (with M exogenous) the supply of money is represented by a vertical line, in the new version by a horizontal line, or a set of horizontal lines, representing different stances of monetary policy.  

Loans Make Deposits. Deposits Make Reserves

In 1985, Marc Lavoie [2] coined the phrase Loans Make Deposits and Deposits Make Reserves. In the article Credit And Money: Overdraft Economies, And Post-Keynesian Economics, he says:

Orthodox monetary economics is founded on the double entry hypothesis of free reserves and the credit multiplier Each individual bank may only increase its loans to the public when depositors increase their balances there, i.e., when free cash reserves augment for that one bank. In the aggregate, commercial banks are allowed to make supplementary loans when they dispose of free reserves. The latter can be obtained through modifications of the behaviour of the public, as a result of a surplus in the foreign account, as a consequence of the intervention of the central bank on the open market, or following a change in the reserve requirements. Although the credit multiplier functions on the basis of an expansion of credit, deposits make loans in the orthodox context. The usual sequence of events is as follows: the central bank buys some security from a member of the public; the deposits of this person are increased; the bank which benefits from these increased deposits now disposes of excess reserves and can make new loans …

… The credit-money view rejects this approach to money and inflation by reversing the sequence of events. According to the unorthodox view, loans make deposits. Banks do not wait for the appropriate amount of liquid resources to exists to provide new loans to the public (mainly firms). Credits are created ex nihilo. The recipient of the purchasing power is the initial recipient of the loan. When the bank makes a new loan, the borrower is being immediately credited with a deposit, the amount of which is exactly equal to the amount of the loan. Hence, the increase in the supply of money is a consequence of increased loan expenditure, not a cause of it. The loan is the causal factor …

… Once commercial banks have created credit money, how do they get hold of the reserves required by the newly created deposits or how do they obtain the currency cash requested by the public? In many European banking systems, France in particular, commercial banks simply borrow their requirements in high-powered money. Most banks are permanently indebted to the central bank. The money market in those circumstances does not play a fundamental role. When banks, overall, are in need of more high-powered money, they increase their borrowings with the central bank at the discount rate set by the latter. Legal reserve ratios, when they do exist, are not used to control the created quantity of money. They exist to increase the cost of the loans granted by the banks since reserves carry no interest revenue …

… It is often claimed that the North American and German banking systems function in quite a different way. This however is an illusion. Although institutional arrangements are quite dissimilar, the expansionary process of credit is the same… First… banks grant legally binding lines of credit which imply future access to reserves. Second, North American banks must respond to lagged required reserve-accounting conventions. Third, banks always have access, although limited, to the discount window of the central bank.

References

  1. Nicholas Kaldor, Keynesian Economics After Fifty Years, p22, Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983.
  2. Marc Lavoie, Credit And Money: Overdraft Economies, And Post-Keynesian Economics, pp 67-69, Money And Macro Policy, ed. Marc Jarsulic, 1985. (Available at UMKC’s course site)

Horizontalism

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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.

– Basil Moore, Horizontalists and Verticalists, 1988 [1]

Most economics books come nowhere close to starting like this. To be fair, when Moore wrote the book, many Post-Keynesians thought that this picture is too simplified. Only a few – such as Marc Lavoie – supported Moore’s view. He himself had been writing about the Post-Keynesian theory of money for some years, around that time. The supposed simplicity gave rise to the long debate Horizontalism versus Structuralism. There’s a lot of nice literature on this and its worth a read.

What do the terms horizontal and vertical refer to? Economists make supply-demand diagrams in which price is on the y-axis and quantity is on the x-axis. Moore called neoclassical economists Verticalists because according to them, the “money supply” is vertical in the diagram. “Money demand” is downward sloping. The interest rate at which the supply and demand curves meet is the market interest rate. Horizontalists, strongly believe that this is exactly wrong and the supply curve is horizontal at the rate determined by the central bank. The quantity of money, then, is the point at which the non-banking sector’s desire to hold money balances (as opposed to “demand”) determines the money stock (as opposed to “supply”). Of course, as explained by Louis-Philippe Rochon and Matias Vernengo [2], the idea of making supply-demand diagrams is only a second-best tool, the more important point being that money is endogenous.

Recommend Moore’s book. I had previewed the book at amazon.com but had to search the whole internet to get it. I tried a Greek and a French seller and ordered online, only to be told later I should expect a refund since that the book is out of stock and wrongly mentioned on the website as available. I finally found a seller at Amazon France selling a used copy for €175.38 but would deliver only to a few countries. I had to get it shipped to a friend in the US and ask him to ship it to me, which cost me an extra $94.

References

  1. Basil Moore, Horizontalists and Verticalists, The Macroeconomics Of Credit Money, Cambridge University Press, 1988.
  2. Louis-Philippe Rochon and Matias Vernengo, Introduction, p2, Credit, Interest Rates And The Open Economy: Essays On Horizontalism, ed. Louis-Philippe Rochon and Matias Vernengo, Edward Elgar Publishing, 2001.

Update: 4 Jan 2012: Fixed some errors in the quote.