Financial Economics Lecture Eight

Theory of endogenous money

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
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…
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).
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)
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:
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.
 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],
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?
Endogenous money: Macro
• Quantity Equation a truism
But... These 3 are givens:
This is just a ratio Price level
derived from the Output
other three numbers
P T
V
M 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
Endogenous money: Macro
• Quantity Equation Changes in P & T (e.g.,
– is flexible increase in wages)
– “works backwards” force
changes in money
supply Causation runs
If M inflexible from P&T to M:
during a boom,
PT
V
V can rise via
financial innovations
M
where M  m B
“money
Bank loans (M3) “Base money”
multiplier”
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
M  m B
money multiplier too:
 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
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
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…
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?
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
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)
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…
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.
accumulation Abstract unit by which
to measure accumulation therefore vital
• Main point of Marx’s analysis of money:
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…
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)
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…
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…
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)
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…
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?
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:
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…
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?
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…
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”
bank (GT 246-247)
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
typical A change in M can be assumed to
case as typical.
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)
 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)
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…
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)
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?
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…
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)
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.
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…
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)
Next lecture
• Discussion of alternative but complementary perspective:
the Circuitist School of France and Italy
– There is economics outside the USA and England!