Friday, 19 July 2013

Endogenous Monetarism

When I studied economics in the 1980s, the concept of endogenous money was very much a post-Keynesian weapon in the war against the monetarist orthodoxy of the time (see for example N. Kaldor - The Scourge of Monetarism).  Reading some accounts of endogenous money today however, I wonder if the monetarists didn't win the argument without the post-Keynesians noticing.

We start off OK with a recognition of two important features of a monetary economy.   The first is the role of the demand for and supply of loans in determining the money supply.  The second is that this process is related to the level of aggregate demand.  When new loans and new money are being created, spending goes up; when the banks stop lending and the money supply contracts, spending falls.

This is all fairly straightforward, but the problem comes when trying to explain the link.  It is at this point that there appears to be a tendency to fall back onto the quantity theory of money as an explanation.   The story seems to go: 1) banks expand lending, increasing the money supply; 2) an increase in the money supply leads to higher nominal GDP.

I don't like this story.  I've called it Endogenous Monetarism, but really it's just monetarism.  It completely ignores the wider picture of what is going on with financial balances.  I'm not intending to get into the arguments for rejecting the idea that money determines spending.  If you think of yourself as a monetarist, this post will do nothing to convince you otherwise.  Instead, I just want to look at why we don't need to rely on the quantity theory of money to understand the importance of banks and lending. 

To get a better understanding we need to see that the creation of money is simply a by-product of a different process, and it is that process which is driving demand.  The process in question relates to the credit constraints of borrowers.

The budget constraint of all agents requires that their expenditure (including asset purchase) in any period is limited to their income plus their assets plus their available credit - the amount they can borrow.  In general, there are always agents that would like to borrow more, but who are unable to.  If a change in credit conditions now allows them to borrow, their spending or asset purchase will increase.  

This has nothing to do with the money created.  In fact, it doesn't even require money to be created, because the same applies for non-bank lending, which does not create money.  The reason bank lending is of particular importance is simply because it accounts for the majority of lending to credit-constrained borrowers.  Decisions on bank lending therefore critically affect the overall level of credit constraint and hence the net savings ratio of the private sector.

The fact that non-bank lending does not increase the supply of bank deposits, and therefore simply transfers it from one party to another is not important.  Non-bank lending still increases gross financial assets, just not in deposit form, and it is wealth measures that matter, not exclusively money (unless of course you are a monetarist.)

Understanding that it is not the money creation aspect that matters is important because it affects how we think about policy.  Although banks demand special attention, we cannot afford to lose sight of the wider aspects of debt levels (see Bank Lending Compared To Total Credit).  If we focus on money, we're missing the thing that really matters.

This post is not intended to convert those who believe in the quantity theory of money anyway.  This is an appeal to those who think of themselves as post-Keynesians to please try and avoid the trap of accepting the most important principle of monetarism without even realising it.


  1. Your emphasis seems to be on borrowers, who having borrowed, can now increase demand and national wealth. Is the money to be used to increase naked consumption alone or is the money to be used to increase production by the borrower?

    If the goal is a naked consumption increase, then we should look more carefully at the motives of the lender. First, the lender has money to lend, and second, the lender is likely a seller of product to the borrower. How else could the lender get initial seed money for loans?

    Borrowing as a method of wealth distribution is an illusion heavily biased in the favor of the lender. Borrowers who are encouraged to in-debt themselves past their ability to cash flow the resulting declining balance payments have been setup for a very unpleasant hard landing.

    1. You've raised a number of interesting points, Roger, most of which I'm going to duck I'm afraid, because I wanted to look at them in later posts.

      With regard to whether the spending is on consumption or investment, I haven't distinguished. The difference is important to many aspects of what is going on in the economy, but less so to the particular point I was looking at.

  2. I agree that many post-Keynesians have a tendency to get caught up in debates about technical or semantic details , and often find that they've painted themselves into a corner.

    In this particular case the problem is not so much one of insisting on the idea of endogenous money as it is on refuting the idea of loanable funds. When you have guys like Krugman out there saying stuff like this :

    " Well , if I loan you $1000 dollars , sure , you can spend it into the economy , but I now have $1000 less that I can spend , so debt makes no difference ! ".

    ..... then you simply must respond. The trick is to respond effectively without getting bogged down , and to maintain the pursuit of bigger prizes.

    1. I totally agree.

      The issue here is loanable funds. The problem I was griping about is PK economists who understand endogenous money and therefore can see why loanable funds doesn't apply in the bank market, but who still seem to think loanable funds applies to all other forms of debt.

    2. Krugman is notoriously bad on this, but the irony is that people like Steve Keen (see comments at the bottom) take him to task on loanable funds in relation to bank debt, and then make exactly the same mistake themselves in relation to non-bank debt.

    3. To Anonymous.

      Am I correct that "endogenous money" is increased money supply that results from bank lending? A sudden jump in money supply anticipates an increased number of transactions and an increase in GDP.

      While a single bank loan results in a sharp increase in spending power for the borrower, a sequence of loans can be looked at in at least two ways:

      1. Repeated loans over a long period of time results in a one time increase of activity with money supply becoming stable at a level higher than pre-loan conditions. New borrowers increase the money supply at the same rate as loan repayment lowers the money supply.

      2. Repeated loans, with each loan proceeds becoming a deposit available for further loan, has the character of start-stop. The act of loaning starts a process but the act of saving to acquire funds to loan stops the process. Each stop results in a PERCEIVED money supply increased by the amount of the original loan. The total PERCEIVED money supply can be found by adding the original money supply to the loan-value multiplied by the number of times the loan-value is reissued.

      Sequence two is not a health way to save for the future. The "future" is probably a long term future but PERCEIVED money supply is based on term limited loans with a short term payout.

      Sequence one is a health way to manage an economy. It does not provide future savings except to the extent that borrowed resources are used to build durable improvements.

    4. Nick,

      I agree. Whichever way one defines "money creation" , it seems to me that virtually all forms of credit creation exhibit some degree of a "money from thin air" characteristic.


      I think the acid test of "healthy" lending on an aggregate basis is in the behavior of the credit aggregates in relation to economic growth. If debt/gdp is ever-rising , that's not healthy.

      Mayers and Biggs found that the credit impulse , i.e. the second derivative of debt/gdp , correlates very well with movements in economic output. Keen uses the same measure and calls it the "credit accelerator".

      This FRED graph of total nonfinancial (private and public) debt/gdp illustrates the case of a jump to a higher level during the 1980s , of the sort you describe in your point 1 :

      The steady rise of debt/gdp during the 80s means that a positive credit impulse would be more likely during that time than , for example , during the 90s , when debt/gdp was more stable. During the stable period of the 90s , the credit impulse would have cycled back and forth from positive to negative , averaging to zero. This is sustainable and healthy , unlike the continuous rise scenario.

      A separate issue is what stable level of debt/gdp is best for an advanced economy like the U.S. A very low level might indicate poor access to and/or functioning of financial markets. My own thoughts are that we'd be better off if we had debt ratios more like what we had back in the 60s or 70s.

    5. The issue of what level of debt/gdp is suitable is indeed a tricky one and makes it hard to distinguish unsustainable borrowing from what is merely an adjustment to a new equilibrium.

    6. Anonymous,

      Your reply left me thinking, the same as Nick's work usually does for me. I appreciate the stimulus.

      I had not seen the total private liability chart previously. Thanks for pointing it out. I notice that the total liability is about four to five times total bank deposits, FWTW.

      Without success, I have been trying to concoct a persuasive way to relate bank debt, federal government debt, and money supply. My paper, "Fiat Money Begins", downplays the role of banks in money supply creation. Having interacted for a short time on these blogs, I am persuaded that a much deeper role for banks must be integrated into my version of fiat monetary framework.

      Thanks to both Nick and Anonymous for your comments.

  3. Nick, I wouldn't despair too much, Steve Keen is not representative of the Post Keynesian community. Sadly, he seems to be trying to reinvent the work of Moore and Godley without actually understanding any of it. By the way, your posts are excellent, but very subtle - they take a few reads to fully understand.

    1. I should say that this is a different 'Anonymous' from that further above.

    2. Thanks for your comments. Part of the reason the posts may seem subtle is that it is often the subtle things that interest me - the things that can be quite hard to grasp. Even if you follow what I'm saying, please let me know if you think I'm being opaque, so I know how to structure future posts.

    3. If I follow you correctly, you are saying that spending can be from existing (i.e. previously saved) deposits or new deposits (from new loans) and it doesn't matter which in determining NGDP. But is there a hot potato effect from there potentially being too many deposits?

    4. I'm not saying that spending is "out of" anything specifically. But I am saying that spending by any agent in any period is limited to his income plus his assets (including existing deposits) plus the amount he can borrow. For many agents, this limit never matters because they are spending less than that anyway. For some it does and those are the ones that are credit constrained. But everyone's spending counts the same in NGDP.

      With regard to the hot potato question, my view is that spending is driven by income and wealth, rather than deposit balances specifically. Therefore higher deposits will indeed imply higher spending, other things being equal, but so will higher non-deposit assets. If new lending does not involve banks at all, there must be some alternative asset that end investors are holding instead of deposits, and that asset will also count as part of wealth.

    5. The problem with spending being driven by wealth is that most forms of wealth need to be converted to money before it can actually be spent. Specifically I was wondering where you sat, say, in the old debate between Moore and Howells on the demand for deposits. Also in the case of non-bank lending, such as P2P, surely they are simply lending existing bank deposits to each other, so banks are still involved. Or have I misunderstood the 'alternative asset' comment?

    6. I'm not suggesting that people spend anywhere near their actual wealth, so I don't think it's a problem that most of it is illiquid. For a start, income will account for most of what people spend. In fact, spending will typically be less than income in a growing economy, so people are actually accumulating deposits and other wealth rather than running them down. So it's better to think of wealth as affecting how much of their income people spend, rather than that they are necessarily spending their wealth.

      You could characterise the idea that people are spending most of their income as being them treating deposits as hot potatoes, but I think that's problematic if you believe (as I do) that it's not money balances alone that determine how much is spent.

      I'm afraid I'll have to read up on Moore and Howells before I answer on that.

      Banks would still be involved for payments on P2P, but my point is that gross assets and gross debt have gone up, even if deposits haven't. The end borrower will spend the same regardless who he borrowed through. The end investor's portfolio will be different, he will have less in bank deposits and more in P2P loans, but I don't think that will mean his own consumer spending will be lower. I think it would be useful to illustrate all this with a little model, but I'll have to do that in a separate post.

    7. Yes, but although it's subtly different I like to think of wealth determining saving intentions rather than spending intentions. (I admit, a distinction without a difference.) But it's interesting given the negative saving rates before the GFC - i.e. spending greater than income in a growing economy.

      It's quite a monetarist view to think that deposits spend themselves but I'm interested in views opposed to this. Basil Moore's view was seen to be quite extreme, even in Post Keynesian circles.

      Yes, I see what you mean about P2P - more links in the chain between original bank loan and final holder of the deposit means more gross assets and debt. The media are filled with stories of banks being cut out of the lending loop. But what happens if no-one borrows from banks anymore? Where will the deposits come from?

    8. Actually I tend to think of wealth as driving savings too, although that obviously then determines spending, which is income less saving.

      I don't think P2P loans are really going to have a great impact on the size of bank loans, which will always be fairly substantial, I think. In theory, though, I think that bank loans and deposits could be much smaller. This would mean a large chunk of savings would have to be in a different form - maybe P2P loans. There would still need to be some amount of bank deposit to function as the medium of exchange, but I actually don't think that would need to be that great.

  4. Nick,

    I must be reading your post for the 4th or 5th time, seeking clues to the greater puzzle which is "understanding the works of the economy". Your post is more question than answer (I think), but we seem to be looking in a parallel fashion.

    Your comment to the effect that money supply is the end, not the driver, resonates with me. Using my words, "Loans or new money both increase the rate of transactions, which can be measured with GDP. New loans and new money (both) will also increase money supply measurements."

    I think it is important to recognize that money supply is a measure of future GDP. How do I explain that statement?! If all money supply is the result of loans, then when all loans are retired, the money supply will be zero. A second fact: The money supply is not held in the borrowers hands.

    As a result of those two facts, the minimum GDP that can be expected from complete retirement of the money supply is: GDP = value of Money Supply. This formula is the result of all the anticipated transactions as the money supply moves from hands of owners to hands of borrowers.

    The timing of loan retirement GDP would be highly speculative.

    Am I capturing the thrust of this posting?

  5. I don't think that is what I am saying.

    The money supply is really just a measure of those things defined as money. I know that sounds trite, but really that's all it is. Broad money is roughly defined as non-capital, bank liabilities held by the domestic private sector, which is principally deposits. So the money supply is just a measure of deposits. This bears some relationship to GDP. However, I do not think there is a strong and stable causal relationship running from money to GDP. Instead I think there is something else (bank lending) that is affecting both money and GDP.

  6. Nick,

    I think you will like these Steve Keen charts found at

    He charts loans and GDP, then relates to unemployment.

    1. Thanks.

      I am sympathetic to Steve Keen's attempts to draw attention to the importance of debt in understanding overall demand, even though I do have a number of issues with his theoretical analysis.