Money, Credit and FinanceEndogenous Money

Marc Lavoie

University of Ottawa

Outline

• 1. The main claims of the post-Keynesian views on money, credit and finance

• 2. New developments in monetary policy implementation• 3. Implications for public finance theory and for open-

economy monetary economics• 4. The integration of PK monetary economics into PK

macroeconomics: the stock-flow coherent approach (SFC)

Part I

The main claims

M

i

Horizontalists(+ New Consensus)

MonetaristsIS/LMVerticalists

Structuralists(+ New Paradigm)

Ms

Ms Ms

A simplified overviewof endogenous money

Endogenous money supply: A PK claim now accepted by many schools

• Post-Keynesians• Neo-Austrians• New Keynesians

– (New consensus authors), Woodford, Taylor, Roemer, Meyer

– (New Paradigm Keynesians, focus on credit) Stiglitz, Greenwald, Bernanke

• Real business cycle theorists– Barro, McCallum

• Goodhart

Main features in monetary economicsFeatures PK school Neoclassical

Money Has counterpart entries

Falls from an helicopter

Money is tied to Production Exchange

The supply of money is

Endogenous Exogenous

Main concern with Debts, credits Assets, money

Causality Reversed: credits make deposits

Free reserves lead to money creation

Credit rationing due to Lack of confidence Asymetric information

Main features, interest rates

Features PK School Neoclassical

Interest rates Are distribution variables

Arise from market laws

Liquidity preference Determines the differential relative to base rate

Determines the interest rate

Base rates Are set by the central bank

Are influenced by market forces

The natural rate Takes multiple values or does not exist

Is unique, based on thrift and productivity

Main features, macro implications

Features PK School Neoclassical

A restrictive monetary policy

Has negative effects in short and long run

Has negative effects only in the short run

Schumpeter’s distinction

Monetary analysis

(monetized production economy)

Real analysis

(money neutrality,

inessential veil)

Macro causality Investment determines saving

Saving determines investment

Inflation The growth in money stock aggregates is caused by the growth in output and prices

Price inflation is caused by an excess supply of money

Two kinds of financial systems, according to Hicks 1974

• The overdraft financial system

• Firms are in debt towards commercial banks

• Commercial banks are in debt towards the central bank

• The auto or asset-based financial system

• Firms finance investment with retained earnings

• Commercial banks have large amounts of T-bills in assets

Overdraft vs Asset-based systems

• Overdraft systems• 90% or more of the world

financial systems (including the pre-euro Bundesbank)

• Ignored by textbooks• No control on HPM, except

through credit control• Clarifies how the monetary

system functions• In a sense, all systems are of

the overdraft type: no central bank controls directly the supply of money

• Asset-based systems• Only in some anglo-saxon

countries• Described by mainstream

textbooks• Based on open-market

operations; is said to be efficient in controlling the money stock

• Puts a veil on the operating procedures of monetary systems

Simplified neoclassical view

Central bank balance sheet

Assets Liabilities

Foreign reserves Banknotes

Domestic T-bills Reserves of commercial banks

Simplified PK view

Central bank balance sheet

Assets Liabilities

Foreign reserves Banknotes

Domestic T-bills

(and repos)

Reserves of commercial banks (deposit facilities)

Loans to domestic banks (lending facilities)

Government deposits

(Central bank bills)

Loans

Interest rate

Notional demandCredit-

worthy demandi2

A B i1

Credit rationing when there is a reduction in bank confidence(Credit-worthy demand: demand with appropriate collateral:Cf. De Soto, and Heinsohn and Steiger)

Part II

Historical perspective

And new developments

Cambridge proverbs

• The Cambridgian hare: « Economic ideas move in circles: stand in one place long enough, and you will see discarded ideas come round again. » (A.B. Cramp 1970)

• Most of modern monetary controversies can be brought back to the 1844 Currency school (Ricardo) and Banking school (Thomas Tooke) debates.

• The Radcliffe commission view (1959), endorsed by Kaldor and Kahn, which was considered dépassé in the 1970s and 1980s, is now back into fashion.– « There still do exist in England men whose minds were formed in 1939,

and who haven’t changed a thought since that time, and who … say money doesn’t matter. They have embalmed their views in the Radcliffe Committee, one of the most sterile operations of all time» Samuelson 1969

New operationg procedures and horizontalism

• Central banks have new operating procedures, although they are not that much different from what they used to be. They bring central banks closer to the « overdraft economy», and further away from the «asset-based econonomy» as defined by Hicks.

• The procedures of some central banks are more transparent (than they were and than those of other central banks), so the horizontalist story is more obvious: Canada, Australia, Sweden

• The procedures of other central banks are less transparent; but when interpreted in light of horizontalism, we can see that their operational logic is identical to that of the more transparent central banks (like the Fed).

The new operating procedures put in place in Canada and other such countries are fully compatible with the

PK monetary theory

• Central banks set a target overnight rate, and a band around it

• Commercial banks can borrow as much as they can at the discount rate

• There are no compulsory reserves and no free reserves (zero net settlement balances)

• The target rate is (nearly) achieved every day• Central banks only pursue defensive operations, trying to

achieve zero net balances.• When there are tensions, as during the recent subprime

financial crisis, they try their best to supply the extra amount of balances demanded by direct clearers (mainly banks)

Settlementbalances

Overnight rate

0 + (surplus)- (overdraft)

Target rate TR

Bank rate = TR+25pts

Rate on positive balances = TR-25pts

The Bank of Canada channel system

Two different justifications for the current interest rate procedures ?

• Post-Keynesians• Based on a

microeconomic justification

• Tied to the inner functioning of the clearing and settlement system

• Linked to the day-by-day, hour-per-hour, operations of central banks

• New Consensus• Based on the 1970 Poole

article• A macroeconomic

justification• If the IS curve is the most

unstable, use monetary targeting

• If the LM curve is unstable (money demand is unstable), use interest rate targets

The microeconomic justification for interest rate targeting

• Central bank interventions are essentially « defensive ». Their purpose is to compensate the flows of payments between the central bank and the banking sector.

• These flows arise from: a) collected taxes and government expenditures; b) interventions on foreign exchange markets; c) purchases or sales of government securities, or repurchase of securities arrriving at maturity; d) provision of banknotes to private banks by the central bank.

• Without these defensive interventions, bank reserves or clearing balances would fluctuate enormously from day to day, or even within an hour. The overnight rate would fluctuate wildly.

Authors who support the microeconomic explanation

• Several central bank economists – Bindseil 2004 ECB, Clinton 1991 BofC,

Lombra 1974 and Whitesell 2003 Fed

• Some post-Keynesian authors– Eichner 1985, Mosler 1997-98, Wray 1998

and neo-chartalists in general

• Institutionalists – Fullwiler 2003 et 2006

The Fed never tried to constaint reserves !

• “The primary objective of the Desk’s open market operations has never been to ‘increase/decrease reserves to provide for expansion/contraction of the money supply’ but rather to maintain the integrity of the payments system through provision of sufficient quantities of Fed balances such that the targeted funds rate is achieved”. Fullwiler (2003)

This was understood a long time ago by some PK economists

• “The Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system” (Eichner, 1987, p. 849).

• “Fed actions with regards to quantities of reserves are necessarily defensive. The only discretion the Fed has is in interest rate determination” Wray (1998, p. 115).

There is no relationship between open market operations and bank reserves

• “No matter what additional variables were included in the estimated equation, or how the equation was specified (e.g., first differences, growth rates, etc.), it proved impossible to obtain an R2 greater than zero when regressing the change in the commercial banking system’s nonborrowed reserves against the change in the Federal Reserve System’s holdings of government securities ....”(Eichner, 1985, pp. 100, 111).

Part III

Implications for:

Public finance theory and

Open-economy monetary economics

Government deficits lead to lower overnight interest rates !

• This is a consequence of the payment and clearing system.

• When the government pays for its expenditure through its account at the central bank, settlement balances (reserves) are added to the clearing system.

• This tends to reduce the overnight rate (the fed funds rate) (cf. Mosler 1994)

• Keeping the rate at its target level requires a defensive intervention of the central bank

• Might as well let the overnight rate fall to zero, its “natural” level, say some neo-chartalists !

Open economies: Are interest rates exogenous?

• My position and that of Godley (The PK horizontalist position ?) is that interest rates are exogenous both in flexible and in fixed exchange rate regimes.

• Any increase in foreign reserves will be compensated by a decrease in another asset of the central bank, or will be compensated by an increase in some liability of the central bank.

• This is the compensation thesis, or the thesis of endogenous sterilization (Godley and Lavoie 2005-06), first emphasized by Banque of France officials (1960s).

The compensation thesis

Central bank balance sheet

Assets Liabilities

Foreign reserves Banknotes

Domestic T-bills Reserves of commercial banks

Loans to domestic banks

Government deposits

(Central bank bills)

Historical example of the compensation thesis: The Bundesbank 1992-1993

31 August 1992

30 Sept. 1992

15 July

1993

Foreign reserves

104 181 108

Domestic credit

237 144 236

Total assets

341 325 344

Part IV

The integration of PK monetary economics into PK macroeconomics

and the stock-flow coherent approach (SFC)

The stock-flow consistent approach• The Holy Grail of PKE has always been the full integration of

monetary and real macroeconomic analysis, i.e., provide a true “Monetary” analysis in the Schumpeter sense.

• Until recently, this seemed like a rather impossible task.• Godley (1996, 1999) has now done it, under the name of SFC.

[Other authors, around Willi Semmler and Peter Flaschel, also achieve something nearly similar]

• Portfolio and liquidity preference issues, along with banking and financial stocks of assets and liabilities, are now tied with flows of production, income, and expenditures. Deflated and monetary variables can also be carefully distinguished.

• The method is presented in the Godley and Lavoie book (2007).• In my view, the method is particularly appropriate to model the

interaction between (Minsky) financial crises and real crises, or to deal with financialisation issues.

• At an aggregate level, it makes use of the fundamental identity, underlined by Godley in the 1970s:(S – I) = (G – T) + (X – IM + NFY)

1.1 Keynesian and modern (Barro DGSE) macroeconomics

• Y = C+I+G = W+P• There is no room or no role for banks• What about the central bank, where does it fit?• Individuals and firms are often netted out (representative

agent)• Where does personal saving go?• What are the liability counterparts of this saving?• What sector provides the counterparty to the

transaction?• How are government deficits financed?• What role play financial stocks?

1.2 National accounting and flow of funds analysis 1940s-1950s

• Macroeconomics is based on the system of national accounts of the UN 1953 (Richard Stone) (flow national income and product accounts)

• This system left out flow-of-funds and balance sheets• French and Dutch national accountants bitterly complained

then (Denizet: irony) • “When total purchases of our national product increase,

where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?” (Copeland 1949)

• The 1968 new System of National Accounts (SNA) remedies to all this (and again in SNA 1993). But to no avail, despite the introduction of Social Accounting Matrices (SAM).

2.1 No black holes• “The fact that money stocks and flows must satisfy

accounting identities in individual budgets and in an economy as a whole provides a fundamental law of macroeconomics analogous to the principle of conservation of energy in physics”. (Godley and Cripps 1983)

• Everything must add up.• The simplest way to make sure that nothing has been

forgotten is to construct matrices.• This consistency requirement is particularly important

and useful in the case of portfolio choice with several assets, where any change in the demand for an asset, for a given amount of expected or end-of-period wealth, must be reflected in an overall change in the value of the remaining assets which is of equal size but opposite sign (cf. Tobin)

The balance sheet of Model INSOUT (Basic banks)

Hhholds Firms Govt Centralbank

Banks

Inventories +IN +IN

HPM +Hh H +Hb 0

Checkingdeposits

+M1h M1 0

Timedeposits

+M2h M2 0

Bills +Bh B +Bcb +Bb 0

Bonds +BLh.pbL BL.pBL 0

Loans L +L 0

Balance V 0 +GD 0 0 IN 0 0 0 0 0 0

The balance sheet of Model INSOUT (Basic banks)

Hhholds Firms Govt Central Banks

2.2 The quadruple entry principle

• This principle is attributed to Copeland (1949).• Any change in the sources of funds of a sector must be

compensated by at least one change in the uses of funds of the same sector.

• But any transaction must have a counterparty. Therefore the above two changes must be accompanied by at least two changes in the uses and sources of funds of another sector.

• « Because moneyflows transactions involve two transactors, the social accounting approach to moneyflows rests not on a double-entry system but on a quadruple-entry system » (Copeland, 1949)

2.2A The quadruple entry principle

Sources of funds: + sign; Uses of funds: minus sign

2.2B The quadruple entry principle