Saturday, April 20, 2013

Endogenous Money 101

Money is at the centre of all modern capitalist economies. Understanding its nature and origins is therefore of great importance. At the heart of Post Keynesian monetary theory is the idea of endogenous money.

This is opposed to the mainstream exogenous money supply theory: the idea that the central bank has direct control over the money supply and its growth. The latter theory is wrong, and I review that major points of endogenous money below.

I. History and Development of the Endogenous Money Theory
Endogenous money theory can be traced back to the 19th-century Banking school (Wray 1998: 32–33), and to Knut Wicksell and Schumpeter (Howells 2006: 53). The Continental European monetary circuit theorists also supported the idea of endogenous money.

Keynes in the General Theory of Employment, Interest, and Money (1936) treated the money supply as exogenous, but in A Treatise on Money (1930) and his article “Alternative Theories of the Rate of Interest” (Keynes 1937), he had recognised the concept (Arestis 1992: 180). In the latter work, Keynes had stressed the finance motive as a basis of endogenous money (Keynes 1937).

King (2002: 161) contends that Richard Kahn and Joan Robinson were the first to develop the Post Keynesian theory of endogenous money, even if in a somewhat limited and incomplete manner.

Nicholas Kaldor continued to develop the theory in his polemics against monetarism (King 2002: 166–167), and particularly in his now classic book The Scourge of Monetarism (Oxford and New York, 1982).

The fierce debate with monetarists actually inspired Post Keynesians to clarify and formulate a more rigorous endogenous money theory (King 2002: 172). The result was a better theory, but also a debate between so-called “horizontalists” and “verticalists” (see section III below).

II. Endogenous Money
Money in the modern world is mostly credit money. To understand this, we must understand how money is measured.

To take the US as an example, there are two main ways to measure money supply, as follows:
(1) High-powered money (= monetary base, base money, M0)
The “money base” consists of currency in circulation and bank reserves (both required and excess reserves). The monetary base includes all cash and coins, even vault cash at banks, as well as deposits that banks hold at the Fed (which are reserves).

(2) Broad Money (M1, M2, M3)
M1 includes:
(1) currency in circulation outside bank vaults (and also excluding bank reserves),
(2) checking/transactions accounts (or demand deposits) and other checkable accounts, and
(3) travellers checks.
M1 excludes vault cash and bank reserves at the central bank. The largest component in M1 consists of the demand deposits of banks. This used to be called “book money” or “bank money,” and is a form of “credit money.” The demand deposit is simply the debt owed to the bank client by the bank in a mutuum contract (or loan for consumption). The “demand deposit” is the “monetised” debt of the bank: a debt that functions as money. (On M2 and M3, see note below.*)
When cheques, debit cards, electronic funds transfer at point of sale cards, or UK “chip and PIN” cards are used in purchases, this is an example of a sale made by means of bank money. Although final clearing between banks is effected by transfers of high powered money (which these days happens much faster than in the past, because of information technology), nevertheless the “bank money” or “demand deposit” money is used extensively in everyday transactions.

This “demand deposit” money is, as noted above, a major component of the money supply, and it is created by banks in response to the demand for it.

The major factors in money creation are
(1) the new creation of demand deposits by banks when a client “deposits” base money in the bank. The money deposited becomes the property of the bank and then in return the client gets a debt instrument or “demand deposit,” which can also be understood as “bank money”;

(2) the creation of demand deposit accounts for those obtaining credit from banks.
In conventional theory, base money creation caused by the central bank, via the money multiplier, is seen as the causal mechanism in the movement of the price level.

The reverse is true:
changes in prices of factor inputs → more demand for credit money from businesses → money supply growth.
That this happens before final output is produced misleads economists who think the direction of causation is as follows:
money supply growth → more demand for credit money from businesses → price changes
But Moore’s empirical work showed that changes in the money supply are induced by changes in economic activity (King 2002: 175). If demand for further credit is not met, then economic activity and investment are stifled.

The cause of credit money growth can be related to the various motives for holding money when that money is derived from bank credit:
(1) transactions motive – money is created from credit demand for money for capital goods or consumption goods purchases, or to pay off debt and other obligations (e.g., taxes);
(2) precautionary motive – money can be created to meet demand for money to hold as a hedge against future uncertainty;
(3) speculative motive – money is created to meet the demand for money to speculate on asset prices; and
(4) finance motive – money is created from the demand for factor inputs for investment, either capital goods or the wage bill for labour.
Since both default of borrowers and the negative effects of speculation are two major elements that destabilise market economies, it follows that regulating the quality of loans and cutting off the flow of credit to speculators are two main aims of any successful financial regulation.

III. Horizontalists versus Structuralists
Basil Moore’s Horizontalists and Verticalists: The Macroeconomics of Credit Money (Cambridge and New York, 1988) was an important statement of the “horizontalist” viewpoint, which contends that banks passively supply the quantity of credit demanded, and the central bank accommodates the banks’ demand for high-powered money.

Opponents of this view were called “Structuralists,” and they argued that central banks are not as passive as the “Horizontalists” maintained, and that greater emphasis needs to be put on financial innovation and liquidity preference.

The resulting debate that emerged focussed on the question whether the money supply curve is horizontal or slopes upwards (Keen 2011: 359). I will not go into the details of this issue, but note how Steve Keen concludes that the debate actually
“ … put the empirically accurate findings of Post Keynesian researchers into the same methodological straightjacket that neoclassical economics itself employed: the equilibrium analysis of intersecting supply and demand curves. Though this was hardly the intention of the originators of endogenous money analysis, it effectively made monetary analysis an extension of supply and demand analysis.

Participants in this debate were aware of the limitations of this approach – as Sheila Dow observed, ‘[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’ (Dow 1997, p. 74). But one of the great ironies of economics is that, because critics of neoclassical economics were themselves trained by neoclassical economists, most critics weren’t trained in suitable alternative modeling methods, like differential equations or multi-agent simulation.” (Keen 2011: 359).
Keen sees the solution in models of money creation that capture feedback effects (Keen 2011: 360), and has provided his own developed money model derived from the Monetary Circuit School and Minsky’s Financial Instability Hypothesis (Keen 2011: 360–368).

IV. Conclusion
This is the key point:
Normally money creation is credit-driven. This means that most money is created by private banks and its quantity is determined by the private demand for it. This is the essence of endogenous money.
Of course, none of this denies that money can also be created in other ways.

Let us summarise the ways money can be created:
(1) creation of credit money by the banking and financial institutions;

(2) creation of other credit money by means of negotiable debt instruments by private sector agents;

(3) creation of high powered money by the central bank through open market operations or discount window lending, and occasionally by unconventional means such as monetising a budget deficit.
But the crucial point is that the fundamental impetus, drive and cause of most money creation is demand from the private sector. The broad money stock of any capitalist nation is fundamentally driven by demand from bank clients for credit or demand deposits.

Some would say that even the money base is largely endogenous too, given that the central bank must accommodate the banks’ demand for high-powered money to avoid financial crises and banking panics.

But even in abnormal times, such as we have seen from 2008 onwards, when highly unconventional and radical open market operations have been performed by central banks in the form of Quantitative Easing (QE), the creation of vast excess reserves has not induced a sufficient level of private investment or economic activity to create full employment. The reason is that most businesses and consumers do not wish to hold any greater levels of money in the form of debt, since they are over-indebted, engaged in deleveraging, or affected by pessimistic expectations about the future.

This failure of the QE in the UK and the US (and before them in Japan) is explained precisely by endogenous money theory.

But governments can, and do, have influence on the monetary and credit systems of an economy. Central banks control the interest rate, which is, above all, the price of credit money.

From the 1930s to the 1980s, many countries had policies of financial regulation that included many of the following:
(1) Interest rate ceilings;
(2) Liquidity ratio requirements;
(3) Higher bank reserve requirements;
(4) Capital Controls (that is, restrictions on capital account transactions);
(5) Restrictions on market entry into the financial sector;
(6) Credit ceilings or restrictions on the directions of credit allocation;
(7) Separation of commercial from investment (“speculative”) banks;
(8) Government ownership or domination of the banks. (Ito 2009: 431–433).
Many of these controls were abolished as financial liberalization and capital account liberalization became widely adopted in the 1980s and 1990s.

The result has been a return to the pre-1940s type of business cycle in which asset bubbles and the wealth effect from speculative activity have driven capitalist boom phases, and financial crises and debt deflation have driven busts.

* M2 and M3 merely include increasingly less liquid forms of money, such as time deposits, money market deposits, and savings deposits. Thus M2 is as follows:
M1 supply + money held in money market funds + savings accounts + small certificates of deposit (CDs).
M3 is simply M2 plus large CDs. The M3 measure was discontinued by the Federal Reserve in 2006.


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  1. Nice post and references.

    I'd also add Wynne Godley's work in this list because it ties together various pieces and provides deep insights on its own into the endogeneity of money.


    Marc Lavoie: "Endogenous Money in a Coherent Stock-Flow Framework"

    (published in some book which I can't find!).

  2. Kaldor claimed that he first theorised endogenous money in his 1939 paper "Speculation and Economic Stability".

    His first thorough discussion of it, so far as I know, is the be found here:

    I'm dubious about letting Wicksell get the credit for endogenous money. I think he quite consciously reintroduced the quantity theory by the back door. I also think that the first actual THEORIST of endogenous money was Marx. Here's an unpublished paper on the topic:

    1. Thanks for these links. I'll read them both as soon as time permits.

    2. All great and rewarding links -- thanks for these.

    3. Philip.I think you can trace even more than endogenous money back to old "Charlie Marx",he seem to in to so much long before his time it sometimes stunning, even the Keynes-Kalecki´s "effective demand"
      was written about by old Karl,if not fully advanced
      but check:
      Marx, Kalecki, and Socialist Strategy
      John Bellamy Foster
      Crisis Theory, the Law of the Tendency of the Profit Rate to Fall, and Marx’s Studies in the 1870s
      Michael Heinrich more on Economics, Marxism & Socialism
      and about the roots to Monetarist-Post Keynsian controversy on money ,rates etc and how it goes back to Wicksell i guess you maybee allready read this one
      but just incase:
      Axel Leijonhufvud-Wicksell Connection
      Variations on a Theme

  3. Good explanation, especially regarding the persistent failure of QE. My one carp: I don't see how Post Keynesians do their theory any favors by always using the term "endogenous." A translation into everyday English ("self-creating"? "inwardly generated"?) might win this perspective more currency both among economists and the lay public.

  4. I like these posts that attempt to explain how a modern economy works and I'm sure economists from various economics schools of thought would agree with the majority of what you wrote.

    Would you have the government completely focus on instating a much larger fiscal policy if you don't find QE valid? I also like how you don't support military Keynesianism, something that was popular during the heyday of the Iraq and Afghanistan Wars. I also want to know more about how a jobs guarantee program would work and how that would differ from a guaranteed minimum income program as a social safety net.

    1. I am not sure any academic Post Keynesian or neoclassical one was ever a "military Keynesian", but, anyway, the solution to the current mess for a country like the US is:

      (1) reducing the level of private debt, by writing off and restructuring a great deal of it.

      (2) reform of banking, and purging banks of non performing loans and bad assets. (1) and (2) are strongly related.

      (3) breaking up large banks and reintroducing effective financial regulation.

      (4) a very strong fiscal stimulus to bring unemployment right down to below 4%.

      (5) return to an economy where real wages rise in line with productivity growth, and preventing people from being driven into high levels of debt in the first place. In the US, that would mean universal health care and a university education system that is either subsidised or free at the point of delivery for those qualified and wanting to get it, as in various Western European nations.

  5. I hope you won't mind publishing this comment. It's off-topic, but I've noticed that race realism seems to be something that I'm seeing more common on YouTube and there have been people who claimed that James Flynn let ideology cloud his judgement and that Stephen J. Gould did a lousy job at measuring the skulls. The so-called racialists try to make their finding seem legitimate with what they claim to be science and say that one does not need to know the exact gene in order to determine heritability. These racialists are also focus a lot on IQ scores, ACT tests, SATs, and all of these findings to claim that there' some 15 point IQ gap between Blacks and Whites and that because IQ is mainly genetic and heritable that there isn't much that can be done to close the gap between the two groups.

    How would you go about debunking these potentially pseudoscientific claims, especially from an economic standpoint? In response, these same people would try to brand you as some cultural Marxist egalitarian that thinks that "evolution stopped at the neck." They would try to use Black on Black and Black on White crime rates and FBI statistics to also claim that Blacks are more inherently violent and have a lot more testosterone and then claim that many of the inventions that Blacks invented were myths. I would also imagine they would try to pull the argument that corrupt countries in Africa are corrupt because the leaders are Black.

    It's something that's been bothering me for a long while and I was hoping someone knowledgeable like you would be able to provide some proper insight.

    1. There are a lot of issues here:

      (1) It is known that Stephen Jay Gould’s The Mismeasure of Man seems to have various mistakes in it, but admitting this isn't a big deal, frankly.

      Even Flynn found Gould’s book flawed. See:

      Flynn, James R. 1999. “Evidence against Rushton: The Genetic Loading of the Wisc-R Subtests and the Causes of Between-Group IQ Differences,” Personality and Individual Differences 26: 373–393.

      (2) On Lynn and Vanhanen's IQ and the Wealth of Nations (2002), which tries to explain the IQ gap between developing and developed nations in terms of genetics, see my post here:

      (3) On the American race debate, Flynn, as far as I can see, has been an effective critic of the "racialists" (or whatever they call themselves) for years now, and more recently with his use of data from Eyferth's work on the IQs of the offspring of African American soldiers in post-WWII Germany. Although the sample might be small, it is nevertheless very suggestive.

      See this debate between Flynn himself and Charles Murray:

      It is a multi-video debate, so you have to keep clicking on the next video.

  6. Could there be endogenous money creation under a gold standard?

    1. Yes, there was, but the extent of credit money creation was in theory constrained by inelastic base money (gold), though in practice for nations like, say, the UK the banknotes of the Bank of England could function as somewhat elastic base:

  7. Nice post, LK!

    John Helstone: It's quite likely that the (inherently) deflationary bias of the gold standard was actually avoided (for as long as it did) as a result of the endogenous growth of deposits as medium of exchange.

  8. From a history of economic thought perspective, endogenous money theory appeared before 19th century, and therefore before the banking school. It was called the real bills doctrine, and you can find it in Adam Smith. On this topic (and probably ONLY on this topic) Schumpeter is the best reference in his History of Economic Analysis. He may well qualify as a Chartalist.

  9. Under the kind of monetary regime that exists in the US and most other advanced economies at any given moment private banks and other institutions can create credit money much as you describe. To that extent the money supply is endogenous. However the CB , by controlling base money, always has the power to bring the money supply to whatever level it wants. If the CB thinks the money supply is expanding too fast it can increase the overnight rate and slow down or stop the rate of growth by slowing down or reversing changes in base money

    When you say
    "This failure of the QE in the UK and the US (and before them in Japan) is explained precisely by endogenous money theory."

    You seem to be claiming that beyond a certain point any increase in the money supply has no effect (QE is really just a way of increasing the money supply by the CB swapping assets for new money). I don't understand how this is a tenable theory. if the fed increased the money supply by 10-time tomorrow (via
    "helicopter drops") are you saying that this would not be hugely inflationary? If yes, then doesn't that "disprove" endogenous money ? If no, then what will happen to all that newly created money ?

    1. "However the CB , by controlling base money, always has the power to bring the money supply to whatever level it wants. "

      It does not directly control the quantity of money at all, but is mostly forced to accommodate private bank demand for reserves to avoid financial crises.

      What it controls is the price of credit money. But even here this control can have variable effects.

      " if the fed increased the money supply by 10-time tomorrow (via"helicopter drops") are you saying that this would not be hugely inflationary?"

      You are saying: what if the Fed just printed a lot of money and directly gave it to people to spend?

      Such a policy would be functionally equivalent to fiscal policy, not monetary policy -- precisely as if the government cut people's taxes by the same amount or simply ran a deficit and mailed a cheque to everyone.

    2. "What it controls is the price of credit money. But even here this control can have variable effects"

      If you mean by this that is sets interest rates then the way it maintains the chosen interest rates is by adjusting the money supply to match the rate. It is not forced to accommodate the demands of private banks beyond the short term. For example if it targeting inflation and inflation expectations increase it will raise interest rates by reducing the money supply irrespective of what private banks want.

      On "Such a policy would be functionally equivalent to fiscal policy, not monetary policy"

      You can call it what you want - the point is that an "exogenous" increase in the money supply will induce changes to the economy including inflation. To me this is contra to exogenous money theory as explained in your post.

    3. The central bank's relevant behavior is not acommodative, but defensive. Defensive behavior aims to keep zero excess reserves, because if it is non-zero the interbank rate may go to zero or infinity. Acommodative behavior is a (non necessary) implication of defensive behavior: if banks, in the agreggate, face deficit reserves because of having made a lot of loans, the central bank must provide the reserves to keep excess reserves equal to zero. If only some banks face deficit reserves, but they can borrow them in the interbank market, they will do it without the central bank having to provide the reserves, but this does not change the causality loans-deposits-reserves, nor the fact that the central bank cannot control reserves, because this does not follow from reserve requirements. "No reserve requirements" can be thought as a requirement of 0%; the point is that an amount of reserves beyond the legal requirement (0% or otherwise) is not profitable for banks, because they do not get interest revenue from it. Because of this, they will try to lend their excess reserves in the interbank market, but if there is excess in the aggregate, they will not be able to get rid of it, and they will drive the overnight rate to zero. The only one who can accept the excess reserves of banks is the central bank; it only has to set the interest rate. That's why what it controls is the price of reserves. It does not maintain the chosen rate by varying the supply of money; it maintains it by draining the excess reserves from the banking system, which is a result of the banks' behavior, not of the central bank's.

      Because of that, the QE policy is not an increase in money supply, it is just an increase in liquidity (a stock); banks' balances are not being expanded, they are just giving up junk assets to Fed in exchange of liquidity. Fiscal policy actually can increase exogenously the money supply by spending (a flow), and it DOES induce changes to the economy (that's the idea), but it does not necessarily generate inflation.

    4. Rob,

      How is paying interest on reserves adjusting the money supply?

      Even neo-classicals accept that paying interest on reserves is the same as playing 'open market operations'. There is no magic in bonds.

      Both do nothing other that alter the amount of income injected into the private sector as interest - there is no change in the amount of financial assets in the hands of the private sector.

      That is altering the interest rate.

  10. BTW, LK, totally off topic. But you might like this...

  11. Yes, the Reinhart and Rogoff affair is just outrageous, isn't it. Will these people formally declare their policy advice was wrong? I doubt it.

    And I see you get a name mention in the Guardian, next to Warren Mosler! Congratulations on that!

  12. 'Some would say that even the money base is largely endogenous too, given that the central bank must accommodate the banks’ demand for high-powered money to avoid financial crises and banking panics.'

    Ive heard it said that this theory contradicts Austrian accounts. What I am confused about is: If the Central Bank refuses to provide extra reserves, this will lead to crises? Does it not follow that the Central Bank creates moral hazard and therefore is ultimately responsible for credit bubbles?

    1. There is no reason for "credit bubbles" in the first place if the financial sector is properly regulated in what type of loans it can provide and the flow of credit to asset price speculators is cut off.

      In any case, the Austrian business cycle theory (ABCT) says that the central bank or FR banks drive the market interest rate below the Wicksellian natural rate, and then induce unsustainable capital goods investments: the classic ABCT does not invoke asset bubbles as an explanation for business cycles at all.

    2. Yes u are quite right about ABCT. But the more populist anti-Fed movement does blame the Central Bank. I do not think u have addressed my question about moral hazard though. U say there is no reason for credit bubbles if properly regulated but would it also be true that there would be no credit bubbles if Central Banks did not provide reserves on demand??

    3. (1) If the central bank did not provide reserves on demand, it would cripple the financial system, probably inducing a financial crisis or panic.

      (2) As I said above, credit "bubbles" and asset price inflation can exist under just about any monetary system:

      (1) tulip mania -- silver standard
      (2) Australian property bubble 1880s -- gold standard
      (3) 1920s US stock market bubble -- gold exchange standard

    4. //If the central bank did not provide reserves on demand, it would cripple the financial system, probably inducing a financial crisis or panic.//

      Yes i agree but i do not think this contradicts the claim of moral hazard in the boom years.

      //As I said above, credit "bubbles" and asset price inflation can exist under just about any monetary system://

      I think what confuses me is in the absence of Central Banks essentially bailing out these banks through provision of reserves, by what mechanism would banks be able to create these bubbles? And if they were still able to, would not the fact that the Central Bank would refuse to provide extra reserves be a disincentive to behave this way??

    5. The central bank can refuse the extra reserves now. In which case the interest rate on clearing will rise and transactions will fail until bankruptcy clears the market.

      The result would be utter chaos.

      The only solution is to remove the transaction system from the lending banks so that it can't be held to ransom.

      Then you are into the pure price of loans and the concentration of wealth issues.

      Without central bank direct involvement the price of loans would be very much higher - as you have to pay twice. Once to the lender and once to the funder.

      That is damaging to the correct capital development of the economy - point two of Lerner's functional finance approach.

      Moral hazard would be curtailed completely, yet the price of loans remain reasonable if the lending banks were 'in the bank'. In other words if the funding is all central bank funding at whatever rate the central bank determines.

      Then there is no cost of funding to the lending banks, yet the lending criteria is strictly controlled by the controlling investor - the central bank.

      Lending banks really need to be agents for the central bank - doing the sole thing that they are required for - underwriting capital development projects in the private sector.

      Everybody else in the finance sector needs to be equity funded and maturity matched.

  13. LK, the verticalists of Moore are monetarists; and they are not equivalent to structuralists post-Keynesians. I think the debate between Horizontalists (though they rather being called "Acommodationists") and Structuralists is a really important one because it has prevented the post-Keynesian endogenous money theory from becoming a fully coherent theory.

    There is actually, IMHO, a (tacit) consensus between Structuralists and Acommodationists in that the money supply curve may have any form. So I think that to say (by quoting Keen) that this debate is just a reminiscence of neoclassical equilibrium analysis since it deals only with the slope of a curve is not valid to completely dismiss it, because IT IS NOT TRUE. The dabte is not about the slope of a hypothetical money supply curve, as the participants have recognized.

    The core of the Acommodationsts-Structuralists debate (and note that the use of the right words by which they denominate themselves helps to clarify that the debate is not just some kind of neoclassical-geometrical issue) lies with the role of the interest rate; in short: Structuralists think that the interest rate (because of liquiditiy preference, Minsky's financial instability hypothesis, etc.) can be somehow related to the business-credit cycle, while Acommodationists think instead that such a claim is a revival of loanable funds or Wicksellian theory because, by stating a stable relationship between the interest rate and the level of economic activity, the interest rate can be made somehow a "real" variable, instead of "nominal".

    I think this interest rate issues is the biggest problem of heterodox theory. The Acommodationists-Structuralists debate is a demonstration of this, just like the role of liquidity preference in Keynes' General Theory but not in the Treatise, or the debate around "finance motive", or the claim by Philip Pilkington in a paper above that Marx's theory is indeterminate because of the lack of a definitive theory of interest rate.

    I really think that you should pay more attention to this debate.

    1. Thanks for this comment -- I will take a proper and more detailed look at the Accommodationist versus Structuralist debate soon.

  14. Hey LK,
    I'm not sure if you are interested in doing a post on this. But I'm a bit confused here and this guy posted about Endogenous Money not being a real thing, and that in real-world actuality Money Multiplier is the real deal.
    If you have any input on this I'd be interested in hearing, as I'm confused. It's from a while ago, and they mentioned you super briefly on one of their debunking Endogenous Money posts.
    If you have any thoughts?, much appreciated. The guy that runs the website is a major Mises kind of guy, seems like he's redefining some stuff, I saw Pilkington had commented even on one of the posts.