The State, the central bank and the monetary circuit

1. The State, the central bank and the monetary circuit Marc Lavoie and Louis-Philippe Rochon

2. First meeting with Alain Parguez • Jogging with Alain Parguez and Frédéric Poulon. • Replacement of professor Bernard Ducros in 1976-1977. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

3. Parguez main fields • A critique of Keynesian disequilibrium theory • Circuit theory • The rentier economy • A critique of post-keynesian theories • Economic policies Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

4. A critique of PK monetary theory • Parguez was always closer to the horizontalist view in the debate of structuralist vs horizontalist views. • He always argued that money was logically endogenous, while interest rates were exogenous. • He disliked the idea that money was endogenous thanks to liability management and financial innovation, and he rejected the structuralist notion that central banks could impose constraints on banks’ reserves, arguing that these claims reinstated the scarcity theory of money. • However, he tought that horizontalist post-Keynesians were conceding too much to structuralists by accepting to debate in terms of supply of and demand for money, or by discussing the possibility of a dynamic upward-sloping supply curve of money. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

5. Two major critiques of PKE • For Parguez(2001, 2002), the theory of the monetary production circuit provided an extension of PK monetary theory, which relied too much on Keynes (1936) who assumed that outlays by firms and the government had no impact on the money supply, thus ignoring the temporal dimension of outlays and purchases. • Parguez (2001) argued that a weakness of PK monetary theory was the absence of the State; only the central bank was present in discussions of PKE, with an emphasis on the relation between the central bank and the commercial banks. • Parguez (2001) made a distinction between weak exogeneity and strong exogeneity of interest rates, claiming that PK economists only rely on weak exogeneity. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

6. Strong vs weak exogeneity of interest rates • Weak exogeneity in Parguez (2003) means that central banks are able to control only short-term interest rates, such as the overnight rate or three-month Treasury bill rates. • Strong exogeneity means that central banks can determine long-term interest rates as well. • This he relates to Keynes (1936): when Keynes talks of the rate of interest he means the long-term rate, not the short-term rate on bills, which is nearly considered as liquid as money, and hence should earn an interest rate close to the interest rate on money deposits (cf Parguez 1975). • « An exogenous long-run rate would be deemed the ultimate break-up of all established theories of interest rates, because both Hayek and Keynes had the long-term rate and not the short-term rate in mind » (Parguez 2001, p. 92) Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

7. Strong exogeneity of interest rates • « According to the strong exogeneity theory, the State may impose the desired level of all interest rates to achieve its policy ». (p. 93) • « The rate of interest on state bonds is the anchor of the long-term rate of interest. The rate of interest on bonds is exogenously determined by the State through the treasury department and the central bank ». (p. 93) • The theory of the monetary circuit brings about proof that the generalized endogeneity of money (applied to both firms and the State) and a strong exogeneity of interest rates are the twin aspects of a total break between neoclassical economics and the portion of Keynes’s legacy ensconced in the scarcity of money » (p. 95) Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

8. A SFC proof of strong exogeneity • In Godley and Lavoie (2007, ch.5), we have a simple SFC model with bills and bonds, where interest rates on bills and bonds can both be made exogenous. • Households have a Tobinesque portfolio behaviour. • It is assumed that the Treasury only supplies the amount of bonds that the public wishes to hold (demands) at the existing price (or a the pre-determined yield rate). • Thus the Treasury buy backs outstanding bonds that are not desired, issuing new bills as a replacement. • The central bank holds all the bills that households don’t wish to hold at the existing interest rate. • As a result both interest rates are made exogenous. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

9. Strong exogeneity and modern monetary theory • To justify the strong exogeneity of interest rates, Parguez relies on arguments similar to those advanced by the so-called modern monetary theory or neo-chartalism (Mosler, Bell, Forstater, Mitchell, Wray). • When the government spends, this creates bank reserves, and unless something is done, interest rates will fall as banks hold reserves with a zero rate of interest and search in vain for an alternative. • Hence, if the central bank offers to conduct open-market operations, selling bonds to banks, the banks will eagerly accept the offer, at whatever price is being proposed by the central bank. • Today, Fullwiler and Wray (2010) also argue that it is possible for the central bank to set long-term rates on government securities. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

10. Circuit theory and neo-chartalism • For Parguez (1999, 2001, 2002), the theory of the monetary circuit and neo-chartalism go hand in hand. • The generalized monetary circuit theory says that expenditures by firms and the State generate an influx of money, thanks to credit creation by banks and the central bank (the bank of the State), which create bank deposits for the firms and central bank deposits for the State. • The reflux occurs when households consume, and then when their saving is collected by both the firms and the State, and when taxes are collected. One must thus distinguish initial finance (through credit creation) from final finance (saving, taxes). Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

11. The normal relationship between the State and the central bank • The State finances its expenditures by drawing on its account at the central bank. • The State is not subjected to credit-worthy rules. • The State is not limited by its tax revenues. • To some extent, these ideas can already be found in Parguez’s 1985 article in Économies and Sociétés (Monnaie and Production series) Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

12. The flawed structure of the eurozone • Parguez (EEJ, 1999) points out that the ECB is forbidden to create State money, directly or indirectly. • There is still endogenous money however, because banks can rediscount government securities through repos with the ECB. • However, banks (or rating agencies) are free to set creditworthy norms. The European governments have given up their power to create money (Parguez 2006). • The State has no checking account at the ECB (?) • The eurozone contradicts circuit theory (1999, p. 67). • The eurozone re-establishes the scarcity principle (p. 68). • This leads to the privatization of the State (p.69). Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

13. Consequences for the eurozone • « Member states will have to be granted credit by private banks. They will have to pay interest rates fixed by the Central Bank and their ability to borrow will depend on the ability and willingness of private banks to finance government expenditures…. A credit-worthy state should pledge to balance its budget, to get to a zero ex post deficit, so as to protect the banks against the risk of accumulating public debt. Government bonds will no longer be liquid assets » (Parguez 1999, p. 73). Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

14. Further consequences for the eurozone • « …The fate of the euro will depend upon the fiscal austerity rules. States could not be granted credits by private banks if they do not meet the constraint of running a balanced budget or a fiscal surplus. To comply with this constraint, states will have to slash their social expenditures because they are the most adverse to the brutal instincts of financial investors. » (p. 73) • « Contrary to the hopes of its architects, the Euro will increase financial instability in the world economy. By exporting its self-imposed deflation, Europe will, like in the early 1930s, accelerate the pace of the world crisis ». (p. 74) Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

15. A way out ? • In a 1982 paper, « Hayek et Keynes face à la crise », Parguez suggests that if private investment and public expenditures are too low to achieve full employment, in particular because of the doctrine of sound finance, a possible way out would be consumer credit! • Parguez argues that the banking system rations consumer credit, the demand of which exceeds by far its supply, thus forcing consumers only to rely on their current income when planning consumer expenditures (p. 731). Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

16. No way out! • However, in his IJPE 2002 paper, while Parguez points out that rising household debt has allowed firms to achieve high profits, despite « sound finance » policies from governments, he now claims that such a way-out is unsustainable in the longer term, as the burden of household debt is limited by future household income. • Households will not be bailed out when they will go bankrupt because of over-indebtedness. • There is an inconsistency: « Implementing the new fiscal orthodoxy is just substituting household net indebtedness for planned deficits, private deficits for public deficits » (2002, p. 96). • Here Parguez uses the fundamental identity of Godley, which is now so often mentioned by neo-chartalists. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

17. Conclusion • Parguez was quick to recognize the validity and usefulness of the propositions advanced by neo-chartalists about the creation and destruction of high powered money in a clearing and settlement system. • Parguez was also quick to identify the potential drawbacks of the eurozone architecture and of the constraints imposed on European governments and the ECB, predicting the crisis which is happening right now. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011

18. Contemporary capitalism: its financial circuit, its transformation and future prospects, Ottawa May-June 2011