The only truly exogenous factor is whatever exists at a given moment of time, as a heritage of the past.
– Nicholas Kaldor, 1985
That’s my favourite all time quote.
I got myself Kaldor’s lecture series Raffaele Mattioli Lectures in a book titled Causes Of Growth And Stagnation In The World Economy today.
Cover picture taken from my iPhone:
It has Kaldor’s biography by the one and only one Anthony Thirlwall (which is also available separately as a book but reproduced in this book) and a bibliography of Nicholas Kaldor compiled by Ferdinando Targetti.
Another biography is by John E. King, titled Nicholas Kaldor. It also has a lot of articles by Kaldor in the references section and is an excellent book.
Targetti has also written a biography – published in 1992 [which I just ordered on amazon.com!]
Luigi Pasinetti has a small biography of Kaldor in Keynes And The Cambridge Keynesians: A Revolution In Economics To Be Accomplished.
Of course – if you are highly interested in Monetary Economics – you simply shouldn’t miss The Scourge Of Monetarism.
The crisis has a lot of connections with the way Macroeconomics was done in the 1970s and this interests me a lot. Of course the equally important reason was that Nicholas Kaldor and Wynne Godley were highly involved in the public discussions. Here are some books I collected which have special importance to the Cambridge Economic Policy Group (CEPG):
I could manage to only get used copies of the first two books.
The book has the paper New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, by Martin Fetherston and Wynne Godley and comments by others such as Alan Blinder – which I mentioned in the post Debt Monetization. The book is also available from Wiley but you have to pay $500+ for it!
This one got the title right – it wasn’t Keynesianism versus Monetarism. It was New Cambridge versus Keynesianism versus Monetarism.
The following book by Peter Kenway was first published in 1994 but was republished recently because the crisis has deep roots with debates in the 1970s!
It has nice discussions about the various types of income/expenditure models of the 1970s in the UK with a lot on the CEPG. It gives nice lists of all models – some of them here (via amazon.com preview):
Here’s a short autobiography by Wynne Godley (written around 1999) on how he dissented from the profession. Here’s a Google Books preview from the book A Biographical Dictionary of Dissenting Economists edited by Philip Arestis and Malcolm C. Sawyer
click to view on Google Books
I like this:
… I had extraordinary difficulty in understanding, not the sentences, but what real life state of affairs mainstream ‘neoclassical’ macroeconomics could possibly be held to be describing. I went through the standard textbooks on macroeconomics and then back to the underlying professional literature (the locus classicus being, as I now see it, Modigliani. 1944 and 1963). I taught myself how to draw the diagrams and solve the equation systems, but for years could not make any connection between these and the real world as I knew it…
One of the things which made Godley dissenting was the proposal to control imports as the paper title suggests:
(click for link to the journal)
This was met with huge hostility as a Times article (from the late 70s) shows. Economists confused it as “selective protectionism”:
Good read on the Keynesian principle of effective demand and the practice of Keynesianism till it was abandoned using faulty reasoning in the 70s and 80s. Nicholas Kaldor from 1983:
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
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)
Kaldor N. and Trevithick J. 1981. A Keynesian Perspective On Money, Lloyd’s Bank Review.
In one of my recent posts, Saving Net Of Investment, I went into gross saving versus saving net of consumption of fixed capital. I showed how depreciation – or more appropriately, consumption of fixed capital – is treated in the flow of funds accounts.
Since the transactions flow matrix is a powerful tool for visualizing flow of funds, the question is where depreciation makes an appearance. The following table created by me using shows how for a simple economy.
FIGURE 1. Transactions Flow Matrix (click to enlarge)
Here “Firms” is a shorthand for all production firms as a sector and I took the consumption of fixed capital of firms only for illustration purposes. (Else I would have needed to break the households’ accounts into current and capital accounts – eating up space).
Investment here is gross investment and consumption of fixed capital makes its appearance in the line 3. It is a negative item in the current account and a positive item in the capital account. So it more of a book-keeping device but an important one because depreciation is not unimportant. The definition of profits is that of Wynne Godley and is slightly different from National Accounts. Also, while undistributed profits is a source of funds, CFC is also!
So undistributed profits (FU) and consumption of fixed capital (CFC) are both sources of funds. (Positive signs denote sources of funds and negative – uses of funds). This can be confusing because depreciation is a negative for net worth. The reason is that, as I have mentioned before, revaluations need to be done before end of period stocks are calculated. And it is where consumption of fixed capital will make a reappearance – subtracting from net worth due to a reduction in the value of nonfinancial assets.
It is important to keep in mind that equities are also sources of funds as the last line (above Σ) shows. So net saving (undistributed profits for firms) and consumption of fixed capital add to changes in net worth. (Note: Net is net of consumption of fixed capital here and not net of investment!).
This can be seen from the UK Blue Book 2011.
FIGURE 2. UK Blue Book 2011 Accumulation Accounts (click to enlarge)
A Digression
What is the origin of the confusing phrase “net saving” – saving net of investment? I believe it came from Nicholas Kaldor himself who originated the sectoral balances approach. Here’s from The Scourge Of Monetarism, 1982, pp 48-50:
The PSBR in any year can be defined as the public sector’s net de-cumulation of financial assets (net dissaving) which by accounting identity must be equal to the net acquisition of financial assets (net saving) of the private sector, home and overseas; which in turn can be broken down to the net acquisition of financial assets of the personal sector, of the company sector, and the overseas sector (the latter is the negative of the balance of payments on current account).
Nicholas Kaldor’ resembled Keynes more than any other twentieth-century economist because of the breadth of his interests, his wide-ranging contributions to theory, his insistence that theory must serve policy, his periods as an adviser to governments, his fellowship at King’s and, of course, his membership of the House of Lords.
I was reading this article (for the 3rd time!) Kaldor And The Kaldorians by John E. King. It appears as a chapter in the book Handbook Of Alternative Theories Of Economic Growth edited by Mark Setterfield.
I came across this strong Kaldorian view (which I share):
How, exactly, does the constraint [balance-of-payments constraint] operate? Three mechanisms can be distinguished. First, in extreme cases like Cuba in the 1990s and Zimbabwe in the 2000s, a shortage of foreign exchange makes it impossible fully to operate the existing capital stock (since spare parts can no longer be imported), and growth declines or becomes negative. Second, during the fixed exchange rate regime imposed by the Bretton Woods system (1945–73), governments were forced to implement deflationary monetary and fiscal policies to protect the currency in face of often quite small payments deficits. This generated the “stop–go” cycle that Kaldor regarded as the principal cause of Britain’s poor growth performance in this period. Third, in a floating exchange rate regime, the principal constraint on output growth is the rate of growth of export demand. Kaldor himself came to believe that exports were the only source of autonomous aggregate demand, since all other categories of expenditure were fully determined by income: consumption directly, investment indirectly through the accelerator coefficient, and government spending indirectly through taxation receipts, themselves a function of income. This is a characteristically extreme position, which is difficult to justify. But it is not necessary to deny the existence of some autonomous consumption, investment and government spending in order to recognise the importance of export demand as a factor in economic growth. For most small countries, and for all regions within countries, exports are indeed the most important factor.
I am not sure if King’s description of Kaldor and the Kaldorians is the best but a decent one. So, as King hints, Kaldor fully understood the injection to demand due to government expenditure and private sector borrowing. In fact, one whose views closely resembled that of Kaldor was Wynne Godley.
How are exports determined?
Nicholas Kaldor, Geneva, 1948
Picture source: Economica
Kaldor had the following to say:
The growth of a country’s exports should itself be considered as the outcome of the efforts of its producers to seek out potential markets and to adapt their product structure accordingly. Basically in a growing world economy the growth of exports is mainly to be explained by the income elasticity of foreign countries for a country’s products; but it is a matter of the innovative ability and adaptative capacity of its manufacturers whether this income elasticity will tend to be relatively large or small.
in “The role of Increasing Returns, Technical Progress and Cumulative Causation in the Theory of International Trade and Economic Growth”, Economie Appliquée, 1981
This is oft-quoted by economists who are inspired by Kaldor’s work. This may look straightforward but in my opinion, it is not so in practice. There are just too many different kinds of stories one hears about the external sector from economists. In stock-flow-consistent Post Keynesian macro modelling literature, one sees equations such as
The algebra is involved and there are many more equations than the above two. To get exports and imports, one has to multiply the x£ and im£ by prices. Refer Godley&Lavoie’s text Monetary Economics, oft referred in this blog.
The above equation assumes important causalities. Exports of a nation depends on prices of exported products relative to domestic prices of products in the foreign country, for example. In addition, exports also depend on demand and income in the foreign country(y$). The parameter ε2 (and μ2 from foreigners’ viewpoint) is what Kaldor is talking of in the quote above. The more competitive producers in the £-country are, the higher ε2 will be. Of course, this is not the only important thing, and prices are also important. (For example, if the GBP starts appreciating, UK exporters will face pressures in selling their products in the US).
The above equation also shows that if there are injections to demand, such as from government expenditure or tax cuts or due to higher private expenditure (either by higher borrowing or an increased propensity to consume etc), imports will increase. Similarly, if there is a contraction, imports will decrease as was evident by the collapse of world trade due to recessions in many parts of the world during the “Great Recession”.
The purpose of my post was to highlight what importance economists give to price-elasticity and income-elasticity of exports/imports. Most economists worry too much about ε1 (and μ1) and Kaldorians pay much more attention to ε2 (and μ2) and what sorts of policies governments should follow based on this. For example, a nation’s government may be concentrating too much in promoting exports of goods and services where price-competitiveness plays a role. It may be beneficial if it switches to promoting exporting goods and services in which it has unique capabilities which if successful will greatly improve its external situation.
In fact, according to the work of Kaldorians such as Anthony Thirwall and John McCombie, growths of nations can be explained by the ratio of the rate of growth of exports to the income elasticity of its imports. In the stronger form, exports themselves depend on the income-elasticity of imports in the foreign nation – i.e., the “non-price competitiveness” of exporters.
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.
In a recent post, I quoted Kaldor and got a lot of response on what I quoted. So a post on more from the book The Scourge Of Monetarism from the early 80s.
In the following PSBR is Public Sector Borrowing Requirement – the term used often in the UK for net market borrowing of the UK Treasury for a given period such as a month/quarter/year.
The following appears in the Part II of the book. The Select Committee of the House of Commons on the Treasury and the Civil Service ordered an enquiry into monetary policy and Kaldor was invited to write on this in 1980. The whole text appears in the book and the following appears on pages 48-50:
In the Green Paper on Monetary Control of March 1980 it is asserted that ‘it is sometimes helpful to examine how a particular control will affect items on the asset side of the banking system’. The Paper then proceeds to state an accounting identity which shows the change in the money stock (£M3) in a given period as the sum of five separately identified items, of which PSBR is one (though it is not claimed that the five items are mutually invariant).
In my view it may be more helpful to view the effects of the PSBR on the asset side of the non-banking private sector, both at home and overseas. The PSBR in any year can be defined as the public sector’s net de-cumulation of financial assets (net dissaving) which by accounting identity must be equal to the net acquisition of financial assets (net saving) of the private sector, home and overseas; which in turn can be broken down to the net acquisition of financial assets of the personal sector, of the company sector, and the overseas sector (the latter is the negative of the balance of payments on current account). Ignoring capital flows of existing wealth to and from the country, the change in liabilities of the banking system is thus equal to that part of the net saving (or the net increment of financial assets) of the home and overseas private sector which persons and companies wish to hold in the form of sterling bank deposits as against other financial assets (such as ‘bonds’ or ‘gilts’) and which in turn is equal to that part of the PSBR which is financed by the addition of the banking system’s holding of the public sector debt.
The main monetarist thesis is that the net dissaving of the public sector is ‘inflationary’ in so far as it is ‘financed’ by the banking system and not by the sale of debt (bonds or gilts) to the public. But this view ignores the fact that the net saving, or net acquisition of financial assets of the private sector will be the same irrespective of whether it is held in the form of bank deposits or of bonds. The part of the current borrowing of the public sector which is directly financed by net purchases of public debt by the banking system – and which has its counterpart in a corresponding increase in bank deposits held by the non-banking private sector – is as much part of the net saving of the private sector as the part which is financed by the sale of gilts to the private sector. When the public sector’s de-cumulation of financial assets increases (i.e. the PSBR increases) there must be an equivalent increase in the net savings of the non-bank private sector (home and overseas) as compared with what net savings would have been with an unchanged PSBR which will be the same irrespective of how much that saving takes the form of purchases of gilts and how much takes the form of an increase in deposits with the banking system. The decision of how much of the increment in private wealth is held in one form or another is a portfolio decision depending on relative yields, the expectation of future changes in interest rates (long and short), and the premium which the owners are willing to pay for ‘liquidity’ – i.e. the possession of command over resources in a form that can be directly applied to extinguish debts or to meet financial commitments.
But it is a mistake to think that an individual’s spending plans (whether in a business or in a personal capacity) are significantly affected by the decision of how much of his wealth he decides to keep in the form of ‘money’ (broadly or narrowly defined) as against other financial assets that are readily convertible into money (including available overdraft facilities). It is equally mistaken (in my view) to assume that the part of current private saving which is held in the form of additional bank deposits gives rise to additional lending by the banks to the private sector, whereas the part which is held in the form of bonds does not. In the former case, the increase in the bank’s liabilities to depositors is matched by a corresponding increase in the banks’ holding of public sector debt.
I have been reading this article/blog post The Curse of Tina by Adam Curtis of the BBC – it’s a long article and there are several videos in the post, making it a long read. What led me into the article was the discussion of policies put forward by Monetarists which led to a damage of the British economy in the 70s and the 80s. The IEA – Institute of Economic Affairs – called Monetarism “scientific” (!) and persuaded the government in adopting its policies. Overall, the article gives a good glimpse of failed policies over so many years. (Nevermind the author’s mistaken belief that there is no alternative)
Of course, the best source for this is Nicky Kaldor’s The Scourge Of Monetarism (Oxford University Press, 1982). Kaldor had a supreme understanding of banking and the endogenous nature of money. In the book, he wrote:
As it is, a highly developed banking system already provides such facilities on an ample scale, since it is prepared to accommodate the public’s changing demand between different types or financial assets by altering the composition of the banks’ assets or liabilities in a reverse direction. If the non-banking public wishes to switch its holding of gilts for interest-bearing bank deposits, the banks are ready to supply such deposits at the minimum of inconvenience, and at the same time to place their surplus funds into the gilts which were previously held by the public. Similarly the banks provide easy facilities to their customers for switching balances on current accounts into interest-bearing deposit accounts, or vice versa. Hence, while the annual increment in the total holding of financial assets of the private sector (considered as a whole) is nothing more than the mirror-image of the borrowing requirement of the public sector (in a closed economy at any rate), neither the Government nor the banks can determine how much of this increment will be held in the form of cash (meaning notes and current deposits) and how much in the near-equivalents to cash (such as interest-bearing demand deposits) or in various forms of public sector debt. Thus neither the Government nor the central bank can control how much or the total financial assets the public prefers to hold in the form of ‘money’ on one particular definition or another.
*I initially thought Adam Curtis as saying that there is no alternative which he was not – he probably just meant that according to politicians there is no alternative. I thank Philip Pilkington in pointing this out).
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
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.
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)
