Financial Economics Lecture Eight

1. Financial Economics Lecture Eight Theory of endogenous money

2. Last Week • The conventional “deposits cause loans” view • Statistics tell the opposite story • Basic mechanics of “loans cause deposits” creation of credit money • This week: • Early theorists of “loans cause deposits”, endogenous money • Development of theory over time

3. The progenitor: Basil Moore • Debate in literature over whether Keynes believed money endogenous or exogenous • No argument that strongest proponent of endogenous money was Basil Moore • US Post Keynesian economist • Criticised IS-LM model of money • Argued that Central Bank had to “accommodate” demands for liquidity of commercial banking system • Focused on mechanics of loans for large corporations • “Lines of credit” • Negotiated guaranteed access to credit for major companies with major banks • Mainly used to finance rapid changes in input costs without needing to go “cap in hand” to the bank…

4. Moore on endogeneity • “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 that their borrowers demand.” (Moore [1] : 3-4) • In a nutshell • The supply of money & credit is determined by the demand for money & credit. There is no independent supply curve as in standard micro theory • All the state can do is affect the price of credit (the interest rate).

5. Moore on endogeneity • Conventional economic theory springs from the facts that • Once, money was gold and silver coin • Today, bank notes are state-issued legal tender • Conventional theory treats the latter as just a variant of the former • Endogenous money theorists look instead at the invention of credit, when negotiable notes were first issued by private banks: • “The crucial innovation was the finding that a banking house of sufficient repute could dispense with the issue of [gold and silver] coin and instead issue its own instruments of indebtedness. The payability of bank IOUs to the bearer rather than to a named individual made them widely usable as a means of payment.” (4)

6. Moore on endogeneity • Thus there is an essential difference between commodity or fiat money and credit money, but this is missed by conventional theory: • “modern monetary theory has inherited an approach to money that was more appropriate in a world where money was a commodity … without fully recognising the fundamental differences between commodity and credit money.” (5) • The supply of commodity money is clearly limited by • new output of gold and silver • Plus accumulated saleable or hoardable stocks • Monetarist/neoclassical views ascribe the same to modern credit money:

7. Moore on endogeneity • In the quantity theory relation MV=PT, there is an assumption that • “is something so elementary that it is almost never discussed, reflectively considered, or even noticed: the assumption that there exists an independent supply function of money.” (7) • This is feasible in a solely commodity or fiat money system. With a system in which money is “commodities … or … fiat debt of the government, it is easy to envision an independent supply of money function, conceptually distinct from the demand for money function.” (7-8) • But in a credit money system, the supply of credit adjusts to the demands of the financial and productive systems.

8. Moore on endogeneity • One essential difference between commodity [gold/silver] or fiat [coins and notes] money and credit money is • “Because commodity money is a material thing rather than a financial claim, it is an asset to its holder but a liability to no-one. Thus, the quantity of commodity money in existence denotes nothing about the outstanding volume of credit.” (13) • On the other hand, “Since the supply of credit money is furnished by the extension of credit [and hence debt], the supply schedule is no longer independent of demand… the stock of bank money is completely determined by borrowers’ demands for credit.” (13-14) • So what’s wrong with the quantity theory equation?

9. Endogenous money: Macro • Quantity Equation a truism But... These 3 are givens: Price level This is just a ratio derived from the other three numbers Output Stock of money • Exogenous money (Friedman) argues V stable • Endogenous money argues V variable • Statistics support Endogenous money • V highly volatile, and rises during booms/deregulation, falls during slumps/reregulation

10. Endogenous money: Macro • Quantity Equation • is flexible • “works backwards” Changes in P & T (e.g., increase in wages) force changes in money supply Causation runs from P&T to M: If M inflexible during a boom, V can rise via financial innovations where “money multiplier” “Base money” Bank loans (M3)

11. Endogenous money: Macro • Reserve Bank controls B; but • Primary role “lender of last resort”: guarantees depositors funds • If bank gets into trouble, Reserve will: • Relax (increase) m • Expand B to suit • “The need for an elastic currency to offset weekly, monthly and seasonal shocks, and avert the resulting chaotic interest rate fluctuations and financial crises, was … the major determining factor in the formation of the Federal Reserve System” (Moore [2]: 540) So causation runs backwards in the money multiplier too:

12. Endogenous money: the main mechanisms • Moore argues • Primary short term role of banks is to provide firms with working capital • Primary need for additional working capital is new wage demands (remember Kydland & Prescott on procyclical wages?) or material costs • (Also later research by Fama and French) • “Debt seems to be the residual variable in financing decisions. Investment increases debt, and higher earnings tend to reduce debt.” (1997) • “The source of financing most correlated with investment is long-term debt… These correlations confirm the impression that debt plays a key role in accommodating year-by-year variation in investment.” (1998) • Credit expands & contracts w.r.t. needs of firms

13. Endogenous money: the main mechanisms • Firms face new wage/material cost/investment demand • Firms extend lines of credit with banks for working capital/investment finance shortfalls • Increased loans lead to increased deposits by recipients of expenditure • New deposits are created after the loans, but balance the new indebtedness • Central bank need to underwrite liquidity ensures changes to base/money multiplier (itself no longer monitored) accommodate additional loans • Causation thus works • From P and T to M (with volatile “V”) • From M to m and B

14. Endogenous money: initial consequences • The money supply is determined by the demands of the commercial sector, not by the government • It can therefore expand and contract regardless of government policy • Credit money carries with it debt obligations (whereas fiat or commodity money does not), therefore debt dynamics are an important part of the monetary system • Financial behaviour of commercial sector is thus a crucial part of the economic system. • “Endogenous money” prima facie persuasive… • But some controversies in endogenous money…

15. Not a homogeneous field… • Many disputes within endogenous money camp • Definition of money (also problem for exogenous case) • Origin of money (was state necessary for its creation, or irrelevant?) • “Degree of Horizontality”: is credit system completely flexible to desires of borrowers, or are their limits? • Relation between money and credit • How credit system works to expand during booms/contract during slumps • Measurement of money… • And… do these disputes matter anyway? Or are they just semantics?

16. Vicki Chick, circa 1971 • Consider early (1971) article by Vicki Chick, modern Post Keynesian proponent of endogenous money • Article somewhat “agnostic” on exogenous v. endogenous debate • Ideas have developed significantly since • Many neoclassical concepts used in paper • Article encapsulates shared debate (between exo & endo schools) over nature of money • How do you define it? • How is it created?… • Article indicates how endogenous money is a recent concept, how fluid economic views on money still are

17. Vicki Chick, circa 1971 • 5 main points to article: • Definition: What is money? • Origin: How did money come about? • Reason: Why does money exist? • Impact: How does money affect the real economy? (covered more in later lectures) • Fragility: How robust is money? (covered more in later lectures)

18. What is money? • Many attempted definitions • By function: “money is as money does”—means of payment, store of value, unit of account, standard of deferred payment; but • First two sides of same coin (“nothing could serve as a means of payment that was not also a store of value, for things which had no value would not be acceptable in exchange” (144) • “Store of value” not seen as unique attribute of money; “Unit of account” and “standard of deferred payment” seen as same thing with different time horizons; “Unit of account” had occasionally been separate from money • So all collapses to “means of payment” • BUT belief that “means of payment” and “store of value” identical not shared by Marx…

19. What is money? • Means of payment & store of value… • Neoclassical economics sees purpose of economic system as consumption (Chick still influenced by this view in 1971) • Marx sees market economy as dominated by desire of capitalists to accumulate wealth: • “Accumulate! Accumulate! That is Moses and the prophets!” (Capital I, Ch 24.3: p. 558 [Progress Press]) • Store of value and unit of account crucial here: what matters to capitalists is not consumption per se, but accumulation. Abstract unit by which to measure accumulation therefore vital • Main point of Marx’s analysis of money:

20. What is money? • “It must never be forgotten, that in capitalist production what matters is not the immediate use-value but the exchange-value, and, in particular, the expansion of surplus-value. This is the driving motive of capitalist production, and it is a pretty conception that—in order to reason away the contradictions of capitalist production—abstracts from its very basis and depicts it as a production aiming at the direct satisfaction of the consumption of the producers.” (Theories of Surplus Value II, s 17.6) • “Store of value” an essential aspect of accumulation, therefore cannot be collapsed to consumption-oriented “means of payment” function • Back to Chick…

21. What is money? • Problem with using “medium of exchange” & “means of payment” interchangeably as definition of money raises distinction between money and credit • “Trade credit” a common means of payment • But “trade credit” does not settle an account—merely changes who is in debt to whom • Money as payment does settle an account… • “Payment is effected when the transaction is finally closed, the debt discharged, and no further contact between the parties required or expected. If money is proffered for goods, payment and exchange coincide. But if trade credit is offered, there must be another exchange later on in which the credit is extinguished by a transfer of money or by a reverse flow of funds. Only then is payment affected.” (145)

22. What is money? • So money and credit must be distinguished when… • “The problem is not to discover the essence of money but to decide on criteria for useful aggregation of the economy’s assets. Aggregation must be determined by what we are trying to explain: if we wish to understand the phenomenon of exchange, something which takes place at a point of time, trade credit shares the property of money that within its established sphere it is accepted as a matter of routine, even if it is not ‘demanded to hold’, that is, even if it causes temporary balance-sheet disequilibrium.” • Making the distinction, think of implications of this for quantity theory approach MV=PT…

23. What is money? • Identity V=PT/M presumes only M used for transactions; but • Credit (e.g., trade credit) a common means of payment; • Credit expands and contracts dramatically over trade cycle: willing extension of credit during boom, severe contraction during slump • From quantity equation point of view, given measured money stock, effect will be strong pro-cyclical volatility in value calculated for V • This is result found by Kydland & Prescott • Volatility of V undermines monetarist/exogenous money approach… • Back to Chick…

24. What is money? • “Means of payment” definition raises issue of what in practice is the means of payment? • General acceptability becomes important, a pragmatic issue • But raises dilemma: how to explain something going from non-money to money or v.v.? • “We can only describe what is: whatever is used as money is defined as money. We cannot predict the limits to which a given monetary system can be pushed before the monetary asset becomes unacceptable. Hence it is impossible to analyse the breakdowns associated with hyperinflation, the future of a new instrument such as credit cards… We need to know why assets become and remain ‘generally acceptable’” (146)

25. What is money? • General acceptability has two elements • Basic characteristics of money (durability, maintenance of value, ease of transportation, etc.) • Confidence. (This issue better handled by Dow, so discussed later; but an essential issue) • Summing up • Need to distinguish money from credit • No appreciation yet of causal chain: does money control credit creation or does credit creation control money? • Importance of purpose of inquiry for definition of money: credit plays obvious role when measuring transactions but does not when measuring final payment. • Next issue considered by Chick: origin of money…

26. Origin • (Does it matter?; reasonable argument that not important issue; • But beliefs re origins affect how people define/interpret money today) • Two extreme positions • Money originated in commercial exchange • Money invented by non-market (State) instrumentalities • Latter approach emphasises role of levying of State taxes in creation of money (“Chartalism”) • Former approach emphasises importance of credit in commercial system • Next argument: Reason: Why does money exist?

27. Reason • Chick’s analysis focuses entirely on exchange issue • Does not even contemplate accumulation perspective used by Marx • Basic issue in transaction analysis is elimination of need for “double coincidence of wants” • Useful observations on convertibility between different currencies • But most useful comments here continue of money/credit relation—beginning of endogenous money appreciation:

28. Reason • “The expansion of credit is, of course, the usual way of transcending a shortage of money in the short run. Money is probably only important as a budget restraint for small, recurring purchases: the money in one’s wage packet may determine one’s beer consumption but it is unlikely to be the operative restraint in the purchase of a car; a firm may pay its wage bill out of the cash flow from sales, but is hardly expected to finance a new plant that way.” (156) • Overall impression of 1971 article • Endogenous approach still nascent • Many neoclassical (and therefore exogenous) concepts interspersed with analysis • By way of comparison, Dow’s 1998 paper focuses on nuances within definite endogenous money perspective…

29. Sheila Dow, circa 1998 • Chapter a contribution to Geoff Harcourt’s “Second edition of the General Theory” • Overall theme “how would Keynes had revised the GT, had he the chance?” • Dow’s paper now much more on nuances within endogenous money camp, rather than overall issue of whether money endogenous or exogenous • Main themes • What did Keynes believe? • Role for liquidity preference • How “horizontal” is the money supply? • Passive or active role for banks?

30. Keynes on money • GT a fascinating but difficult book • Difficulty caused by • Extent to which Keynes had not fully escaped his previous neoclassical training • Developmental nature of ideas • Debating approach often taken by Keynes—accept premise used by opponent and still show that opponent is wrong • All these cloud question of whether GT/Keynes assumed exogenous or endogenous money…

31. Keynes on money • Conventional Hicksian IS-LM: money supply exogenous • “The schedule of the marginal efficiency of capital depends, however, partly on the given factors and partly on the prospective yield of capital-assets of different kinds; whilst the rate of interest depends partly on the state of liquidity-preference (i.e. on the liquidity function) and partly on the quantity of money measured in terms of wage-units. • Thus we can sometimes regard our ultimate independent variables as consisting of (i) the three fundamental psychological factors, namely, the psychological propensity to consume, the psychological attitude to liquidity and the psychological expectation of future yield from capital-assets, (2) the wage-unit as determined by the bargains reached between employers and employed, and (3) the quantity of money as determined by the action of the central bank” (GT 246-247)

32. Keynes on money • But contrary propositions to this also given: “The amount of cash that the banking system has created” (GT: 84); • “In Chapter 15 … Keynes explicitly raises the issue of how a change in money supply comes about … either as a counterpart to increased income … or ‘by a relaxation of the conditions of credit by the banking system’ [GT: 200]…” (63) • “It will, therefore, be safe for us to take the latter case as typical. A change in M can be assumed to operate by changing r, and a change in r will lead to a new equilibrium partly by changing M2 and partly by changing Y and therefore M1. The division of the increment of cash between M1 and M2 in the new position of equilibrium will depend on the responses of investment to a reduction in the rate of interest and of income to an increase in investment.” (GT 200-201)

33. Keynes on money • So Keynes of the General Theory (1936) appears midway between the argument that the State controls the creation of money, and that the banking system does • Keynes 1937 rather different—next lecture • Dow argues significant structural changes to banking since Keynes’s time that amplify endogenous position: • “Progression through the stages [of banking evolution] can be characterised by the increasing capacity of the banking system to create credit.” (68) • (1) Commodity Money; (2) Fiat Money; (3) Fractional banking • Before stage four (circa Keynes): “banks have been able to increase the bank multiplier, and the speed with which the multiplier operates; but the multiple is still constrained by a given volume of bank reserves” (68)

34. Evolution of Banking • Stage 4: “the central bank accepts the role of lender-of-last-resort in order to maintain confidence in the banking system. Now the banks are no longer constrained by a given stock of reserves. They are still subject to reserve requirements, and the central bank can influence the demand for reserves by manipulating [short term] interest rates. But if the banks are prepared to pay the required interest rate to borrow reserves, then there is no limit on their credit creation.” (68) • “Limit on their credit creation” the essential point of the endogenous money case: there is no limit if some part of the banking system keeps zero reserves. • Stage 5: Liability management…

35. Evolution of Banking • “… liability management. Banks now more actively sought out lending opportunities, taking care of deposit funding by competing over deposit rates and by making increased recourse to the wholesale market.” (68) • “This period can be seen as close to the modern endogenous-money account”, but Dow cautions that • “even then, banks could not be said to have been passive, in that they themselves were creating much of the credit demand by opening up speculative opportunities in the wholesale market. • Further, attempts by monetary authorities to curtail the growth of credit, if anything, further fuelled the process: the massive growth in the Eurodollar market can be seen to have resulted in large part from attempts to evade monetary control in Britain and the USA.” (68-69)

36. Evolution of Banking • Stage six: “securitization”—bundling loans to create marketable securities with income streams generated by the repayments. Also further disintermediation—”banks withdrew from lending in favour of the securities markets” (69) • Stage seven: “market diffusion”—“The divide between banks and non-banks has been eroded by deregulation, as well as by market forces.” (69) • “Thus, countering the disintermediation process of stage six, we now have the possibility of the liabilities of a wider range of institutions becoming so liquid as to be treated as money, so we need to consider their credit-creation process as well.” (69) • Next issue: how tenable is the extreme Post Keynesian horizontalist position that the banking system is completely passive and just supplies as much credit as the economy wants?

37. Passive Banking? • Moore’s position known as “Horizontalism” • Supply of credit by banks unlimited at going interest rates (short-term set by government, longer term partly market-affected) • Implies banks passively supply the credit desired by corporations/private borrowers • Dow argues for some role of banks in setting supply • Not complete independence of supply from demand, but some control over terms and some limits…

38. Passive Banking? • “[T]he supply of credit, and thereby of money, has become more endogenous over the last few decades. But the private sector is not homogeneous; there is no necessary reason for the banks (or credit-creators…) to accommodate all demand at the market interest rate.” (69-70) • Criticises Moore’s emphasis of role of “lines of credit” in making supply elastic with statistics: • “in the UK, for example, from 1984 … to 1992, the proportion [of overdrafts of total lending] had fallen from 22 per cent to 14 per cent… the evidence suggests that these, like the volume of credit as such, may also be rationed.” (70)

39. Passive Banking? • Essential qualification of Moore’s position • Banks may limit credit creation in some economic circumstances • Willingness to lend may collapse during a slump • Qualification doesn’t alter endogeneity per se; just gives banks role in determination of credit creation process. • Banks/financial institutions as active players in endogeneity, rather than passive • Implies further pro-cyclical, cycle-leading role for credit • Financial institutions may help acceleratie expansion of credit during a boom, accelerate its collapse during a slump.

40. Liquidity Preference and Endogenous Money • “Liquidity preference may be characterised as a preference for short-term over long-term assets.” (74) • Concept is feasible with completely demand-determined money supply; but Dow argues for banks to have a role in setting supply w.r.t. their own lending preferences • “[N]ot only are banks (and thereby the monetary authorities) given some control over the volume of credit … but the theory of liquidity preference has been extended in a way Keynes only hinted at in 1937.” (75) • Modelled clumsily by a series of diagrams…

41. Liquidity Preference and Endogenous Money • “[T]he limitations of a diagrammatic representation of a non-deterministic organic process become very clear. This framework is being offered here as an aid to thought, but it can only cope with one phase of the process, not with the feedbacks.” (74) • Dynamic models are needed to represent feedback effects; introduced in last 2-3 lectures in the subject • Basic impact of Dow’s framework is to reintroduce notion of a credit institutions having some active role in setting supply of credit and money • “The volume of credit is thus shown to be jointly determined by the central bank, the banks and the non-bank public.” (78)

42. Next lecture • Discussion of alternative but complementary perspective: the Circuitist School of France and Italy • There is economics outside the USA and England!