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)
(1) currency in circulation outside bank vaults (and also excluding bank reserves),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.*)
(2) checking/transactions accounts (or demand deposits) and other checkable accounts, and
(3) travellers checks.
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).
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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