...against fictions and other tall tales

Sunday, 30 September 2012

Thoughts on endogenous money

The author of Unlearning Economics has written two good posts on the endogenous nature of money (i.e., the notion that the money supply adjusts to the demand for money). I agree with the author's assertion that recognizing the endogenous nature of money is important in order for policymakers to properly address issues relating to financial instability.

Just to add to this discussion, the key aspect about the endogenous nature of money is its ambivalent effects on the working of the economic system. On the one hand, as stressed by many post-Keynesian monetary economists (especially circuitistes and modern monetary theorists), the endogeneity of money enables both the level of investment and growth to surpass what it would otherwise be in a context of self-financing.

According to this view, a recognition of the endogeneity of money frees us from the "fictitious" constraint of a fixed money stock and, as such, opens up new possibilities (from a economic policy standpoint) for achieving full employment and improved living standards (e.g., via public investment financed by government deficit financing and money creation). Also, it forces us to look for a better explanation in regard to the causes of inflation and to reconsider the popular view that inflation occurs solely as the result of an excessive rate of growth in the money supply or as a consequence of government deficit spending. In a context of endogenous money, the causality between increases in prices and the money supply can also be considered as flowing from prices and output to money rather than uniquely the other way around, as is most often believed.

On the other hand, as recently emphasized by the staff economist of the Bank for International Settlements (BIS), the endogenous nature of money, by allowing investment to surpass the capacity of self-financing, also acts to intensify the inherent risks and instability of the modern economy (in which finance plays a critical role) by creating the conditions that lead to unsustainable booms in credit and asset prices that "can eventually lead to serious financial strains and derail the world economy" (Borio and Disyatat, 2011:27).

Now, let me be clear: I'm not saying that these approaches are irreconcilable, or that they exclude each other's views on the issue. On the contrary, one has to look very closely to uncover the difference between the views on the monetary system of post-Keynesian monetary economists and those of BIS economists. They are quite similar in many respects, as recently highlighted by economist Bill Mitchell. For instance, recall that the late Hy Minsky, a post-Keynesian economist, emphasized long ago the destabilizing effect of the modern financial system, a notion that is closely aligned with the views of the BIS economists today. So, in this sense, all I mean to suggest is that the focus of these two groups of economists tends to be different, not that both views are necessarily different in scope.* (For instance, modern monetary economists have been doing some excellent work to address the financial stability issue. See, for instance, Randall Wray and Eric Tymoigne.)

Finally, I will just conclude by saying that, in Canada (where I reside), empirical evidence pointing to the endogeneity of money (i.e., that money supplied by the central bank is demand-led) has been around for a while. Consider this excerpt from Bank of Canada Technical Report 16: Monetary Base and Money Stock in Canada by economists Kevin Clinton and Kevin Lynch arguing against the notion of an exogenous money supply:
...the findings contrary to the monetarist position are strongly enhanced by evidence that emphatically demonstrates causality running from money to the base. The historical association observed between the two arises primarily from the influence of deposits on bank reserves, not vice versa, so that the existing correlation, weak though it may be, could give an exaggerated impression of how well the money supply could be controlled via the base. [...] The empirical tests reject the notion that there is "direct" link between bank reserves and bank deposits and that changes in bank reserves cause changes in bank deposits. (4,40)
This technical report was published in 1979. I know of no convincing evidence that refutes these findings (keeping in mind that Canada no longer requires banks to hold reserves).

* The difference between the two approaches lies mainly in their views regarding the existence of the Wicksellian notion of natural rate of interest. Although this is not an insignificant issue, for the purpose of this post there is no need to elaborate further on this point.


Borio, C., and P. Disyatat, Global imbalances and the financial crisis: Link or no link? Bank for International Settlements Working Paper No. 346, May 2011.

Clinton, K. and K. Lynch, Bank of Canada Technical Report 16: Monetary Base and Money Stock in Canada, Bank of Canada, 1979

Tuesday, 25 September 2012

Marvin Goodfriend on QE3: "This is a game changer for the Fed"

From a Bloomberg interview on QE3 with Marvin Goodfriend (click on "OK"):
I think this is a game changer for the Fed. I think it's a return to what we called a few decades ago "go and stop" monetary policy, which is to say, go all-in on a low unemployment target until the actual inflation rate rises enough to alarm the public.
As previously mentioned, I'm not sold on the idea that a new round of quantitative easing (QE) by the Fed will have much impact on the US economy. So, in a way, I don't reject Goodfriend's view that QE could involve diminishing returns down the road. However, I disagree with Goodfriend in regard to the inflationary risks that QE poses in future. Here, it may be worth highlighting an important point advanced by Oscar Jorda, Moritz Schularick and Alan Taylor in their paper "When Credit Bites Back: Leverage, Business Cycles and Crises" (2011), which discusses the after-effects of financial crises from a historical perspective:
...[O]ur results speak more directly to the question of whether policy-makers risk unleashing inflationary pressures by keeping interest rates low. Looking back at business cycles in the past 140 years, we show that policy-makers have little to worry about. In the aftermath of credit-fueled expansions that end in a systemic financial crisis, downward pressures on inflation are pronounced and long-lasting. If policy-makers are aware of this typical after-effect of leverage busts, they can set policy without worrying about a phantom inflationary menace. (2011:6)
That said, the interview nonetheless contains a lot of valuable insight on the policy implications of QE3 moving forward, as well as the reasons that may have prompted FOMC members to go ahead with another round of QE right now.

Finally, I also think Goodfriend makes a valid point when he suggests that the Fed is not providing sufficient information to the public about both the specific unemployment (or any other labor market indicator) target for QE3 and the evidence to justify additional QE at this time. That Goodfriend focuses on this last point is not surprising given that he's been a longtime advocate of central bank transparency, a principle that I too find important, although for different reasons. While Goodfriend views transparency as necessary for policy effectiveness, I believe it is a commendable principle for government organizations to follow for reasons of public accountability.


Jorda, O., M. Schularick and A. Taylor, When Credit Bites Back: Leverage, Business Cycles and Crises, Federal Reserve Bank of San Francisco, Working Paper, November 2011.

Sunday, 16 September 2012

Another round of QE: More of the same?

I once had a boss who always asked for briefing material of "no more than 100 words". He'd also say "Give me charts, please. Charts!" Here's a snapshot of what he would get if I was asked to update him on the effect of the Fed's quantitative easing (QE) strategy.

Recall that the Fed implements QE by buying financial assets from banks and other private institutions in the aim of putting downward pressure on yields and thus reducing interest rates. QE as a policy measure is easily identifiable in charts since it increases massively the amount of excess reserves in the banking system.

Given that Chairman Bernanke announced a new round of QE last week, I thought these charts might be of interest.* Not all of these indicators are related to QE's stated objectives. Still, given the centrality of QE in the Fed's overall strategy, I think it's useful to include them.

So, to summarize, since the start of QE, bank lending standards have returned to normal...

...business loans have rebounded, though not at pre-QE levels...

...the rate of increase in manufacturers' new orders has normalized...

...corporate profits have continued to rise well beyond pre-QE levels...

...the cost of borrowing for businesses (as reflected in the rate of 10-year inflation protected securities) has come down...

...as did the 30-year conventional mortgage rate...

... and stocks have recovered.

On the other hand, home prices have remained depressed...

...the employment-population ratio has flattened...

...and, finally, the rate of unemployment is still stubbornly high.

In a speech earlier this year, the President of the San Francisco Fed, John Williams, called the level of unemployment in the US a "national calamity that demands our attention". From the charts above, it's clear that another round of QE is unlikely to do much to help create more jobs moving forward.

* All charts and data are from the St. Louis Fed, FRED.

Wednesday, 12 September 2012

Joseph Stiglitz on low interest rates as the cause of the crisis

Joseph Stiglitz takes on the argument that low interest rates caused the subprime crisis. It appears to be an old clip but I'm adding it to the file.

And, as I've noted previously, Robert Shiller agrees with Stiglitz on this.

Similarly, Barry Eichengreen also makes a great point when he argues that it's not only borrowers' frenzy for easy credit that's to blame for these types of problems. This is what Eichengreen has to say about who's at fault for the current European mess:
I’m not too big on the language of culpability. But it takes two to tango. For every reckless borrower there is a reckless lender. The Greeks may have borrowed too much, but someone lent them all that money. German banks and those who regulated them clearly played some role in the crisis.
See here for a more detailed analysis on the role of low interest rates during the lead up to the US subprime crisis.