By Govert Schuller.
Introduction.
Ever since obtaining the Encyclopedia of Central Banking the idea was dawning on me that, besides the researchers in the field of monetary history and theory familiar to us in the monetary reform movement, there is a research programme which looked into bank credit creation and that is the Post-Keynesian one and its theory of endogenous money, i.e. the idea that money is generated from within the economic system by commercial banks, and is not coming from an outside source (exogenous) like a central bank or other kind of monetary authority, as many economists, bankers and educated laypersons actually believe is the case.
The central document addressed in this article by Canadian economist, Louis-Philippe Rochon, is clear evidence how much Post-Keynesians were ahead in their thinking about bank credit money. This Post-Keynesian angle is very important, because the Monetary Reform Community is behind the bend somewhat in processing its theoretical contributions. Starkly put, most of us overlooked it, though many of our expert friends are knowledgeable about, or even are part of, that school.
As the compiler of an on-line bibliography dedicated to monetary history, theory and reform, I did find many Post-Keynesian papers and books addressing the bank credit creation theory and put them therefore in the bibliography. But only recently I started getting a sense of its history and its important researchers.[2]
Rochon’s 2001 Paper
Louis-Philippe Rochon is a macroeconomist at the Laurentian University, Ontario, Canada. He has an incredible output and he works closely with the Swiss economist Prof. Sergio Rossi, who was interviewed by AMI last year for its yearly conference. Together they edited the aforementioned Encyclopedia of Central Banking.
In this 2001 paper Dr. Rochon addresses the idea that–besides some American economists like Nicholas Kaldor and Hyman Minksy–there were some economists in the UK, at Cambridge University, like Joan Robinson and Richard Kahn, who also had done breakthrough work on endogenous money. Rochon’s article is very useful because he distills the theory of endogenous money into five propositions, which I like to share in the next section.
Rochon’s propositions were picked up by Malaysian economist Prof. Sabri Nayal et al in a 2013 paper, adding some formulas to the propositions to make clear how much these were outright inversions of mainstream economic thinking, but also, and more importantly, to test the hypothesis of endogenous money. This paper was authored by four Malaysians all working at the same Faculty of Business and Management at the Universiti Teknologi MARA in the state of Perlis.
Endogenous Money in Five Propositions
Below are, according to Rochon (2001: 294), the five propositions of the theory of endogenous money, followed by their formalizations according to Naya et al (2013: 49). I added some comments for clarification.
Proposition 1. Money & Income
“The causality between money and income in the Quantity Theory is reversed. Specifically, causality runs from the expected (or desired) income of firms, to the demand for credit, and then to money and effective income”. (Rochon)
PE → DC → MC → ED (Nayal)
So, the causal chain goes from first Expected Profit (PE) by a firm based on economic projections. This leads to a Demand for Credit (DC) from a bank in order to fund necessary investments. When the bank evaluates the loan application as feasible, then Money Creation (MC) takes into effect by booking the loan amount and the corresponding bank deposit of the payee. This triggers a chain of Effective Demand (ED) of purchasing capital goods, half-finished products, raw materials and labor.
This sequence can also be applied to consumer credit, which starts with 1) an assessment of one’s consumption desires and one’s income, to 2) application for a loan, to 3) possible approval resulting in a credit ex nihilo in one’s account, to 4) purchasing one’s desired goods.
Proposition 2. Reserves, Deposits & Loans
“The causality between reserves, deposits and loans is reversed. Reserves are endogenous and have no causal influence on loans. This implies that the money multiplier model must also be rejected”. (Rochon)
L → D → R (Nayan)
Loans (L) create deposits (D) when credit is extended ex nihilo by a commercial bank and deposited in the borrower’s account. Then the loans have to be backed up by a fractional reserve (R), which is almost automatically obtained from (or accommodated by) other banks or one’s central bank.
The mainstream understanding seems to be that a bank first obtains reserves, after which it can make loans and subsequent deposit. The equation for that would look like:
R → L → D
The money multiplier theory, which Rochon rejects, is based on the idea that, when a loan is made based on passing on a large fraction of a bank’s deposits, this loan will be deposited eventually in the account of a merchant, and that a large fraction of this deposit itself then can be used to create another loan. For example, a bank under the requirement of holding a 10% reserve, can loan out $9,000 after it receives a $10,000 deposit. Of the $9,000 deposited in the next bank 90% can again be loaned out, i.e. $8,100. And so on and on.
Proposition 3. Savings & Investments
“The causality between savings and investment is reversed. Firms must finance production before any saving is generated”. (Rochon)
I → S
This formula was not provided by Naya, but is the obvious reversal of the mainstream understanding that savings have to be made first before they can be passed on to borrowers as investments:
S → I
Proposition 4. Interest Rate
“The rate of interest is exogenous; it is not determined by any market mechanism where demand and supply schedules interact”. (Rochon)
Staying with the theme of catching some of these propositions and their erroneous counterparts in formulas, the interest rate (i), as a function of central bank decisions (CB) can be formalized as follows:
i = f(CB)
Both mainstream and folk economics assume that a price finding mechanism is in effect which determines the price of money expressed in an interest rate. This price, assumedly like any other market mechanism, would be the equilibrium result of, on one side, the demand for credit by consumers and producers (Cd) and, on the other side, its supply by savers and investors (Cs). This can be formalized as:
i = f(Cd;Cs)
This apparently is not the case.
Proposition 5. Money Creation & Destruction
“The money supply is ‘demand-determined and credit-driven.’ Money is created ex nihilo; it is not a result of portfolio decisions. In this sense, money exists in a continuous circular flow and is a result of the demand for credit that allows firms to fulfill their expenditure plans. The supply of credit is endogenous, based on the decisions of commercial banks. Money is primarily a flow, created by credit, and it is extinguished through the repayment of loans”. (Rochon)
This feature of ‘money creation & destruction’ in the money circuit is for most people the most counter-intuitive aspect and needs to be hammered home. Rochon’s Proposition #1 already referred to money creation (MC), but it has to be explicated in more detail. It is really now widely accepted that commercial banks, when you take out a loan, merely book the borrowed amount in your account and receive the loan contract as an asset (McLeay et al, 214; Werner, 2014; Titus, 2019). This operation is represented below in figure 1 of a bank’s balance before and after extending a loan.
Figure 1. Bank balance before and after extending a loan (McLeay et al, 2014: 3)
In this figure, generated by the research department of the Bank of England, it is clear that the bank’s balance sheet has increased by the amount of the loan and that a new deposit was created for the borrower ex nihlo, which increased the money supply by the same amount. When a loan is paid off the process goes in reverse. The bank’s balance sheet shrinks by the amount paid off and the money supply shrinks by the same amount.
Though there is empirical evidence for the specific procedures and accounting steps taken when originating a loan (Werner, 2014), the reverse process of money destruction has not been accorded a similar detailed investigation.
Meanwhile, the interest on the loan is booked as income for and by the bank. That is their compensation, disproportionate according to many, for evaluating the borrower, originating the loan, monitoring its pay-back, and taking a certain risk in doing so.
So, even if we are relatively ignorant about the procedural and accounting specifics of money destruction within a commercial bank when it receives a paid-off principle, we do have a few sets of verification for the credit creation and destruction theory.
- The most convincing set consists of research and admissions coming from the banking sector itself, including central banks.
- The second set consists of the series of papers and books in the last thirty years by the German economist Richard Werner.
- The third set are the macroeconomists working within the Post-Keynesian framework doing empirical work.
- The fourth set is comprised of all the modelers who incorporated the credit creation theory and produced interesting results.
- And fifth, all the non-economist social scientists and independent researchers who picked up the theory and worked it out within their own field of specialization, especially historians and sociologists.
The Nayan Paper
I will be short about this possibly important paper. Even though it initially got me on the trail of Rochon’s paper, I liked it also for adding some formulas to Rochon’s propositions, to which I tried to add some more. It presented some calculations based on ‘System GMM’ I cannot follow, but can be appreciative of, if correctly represented in the abstract. It is a short, powerful paper, the abstract of which reads:
“Post Keynesian economics is actually macroeconomics in a world of uncertainty and endogenous money. Post Keynesians posit that money supply in a market oriented production economy is endogenous or endogenously determined (rather than exogenous as claimed by Monetarists). Money supply is said to be endogenous if it is determined within the economic system itself. The present paper investigates this theory using a panel dataset of 177 countries from year 1970-2011 utilising dynamic panel data analysis and has found that money supply is endogenous as proposed by Post Keynesian theorists.”
And if you look at the list of publications citing this paper on Google Scholar you will find many studies geared towards testing the theory in single countries (like Chai et al, 2018).
The paper poses also a good question in the form of an observation:
“It is curious why the seemingly erroneous conception implied by the money multiplier model prevailed so long among academic economists”(Nayan: 218).
The more so because the credit creation theory was already formulated a hundred years ago (Werner, 2016). More importantly it concludes that it is “legitimate to assert that endogeneity of the money supply is a universal phenomenon in the modern economy”(Nayan: 236).
Conclusion
Rochon’s paper, presenting five propositions regarding the credit creation theory of banking as seen from a Post-Keynesian framework, is a welcome contribution to our evolving understanding of the current monetary system. It also brings into play many other economic variables we have to keep in mind like savings, investments and the dynamics of the demand and supply of credit.
It overall confirms what the monetary reform movement knew to be the case, i.e. banks create almost the whole of the nation’s supply of money, which comes with the awesome power of credit allocation, which is far from prudently handled, creating inequality and destructive financial crises.
On this last point we have to see if the Post-Keynesians agree and, if so, if they would also agree if sovereign monetary reform is the wise policy to promote to redirect the system towards the economic well-being of society in general and not a small elite. We know some of them do agree. Maybe it is time to find more.
Sources
Chai, Hee-Yul, and Sang B. Hahn. 2018. “Does Monetary Policy Regime Determine the Nature of the Money Supply?: Evidence from Seven Countries in the Asia-Pacific Region“. East Asian Economic Review, 22/2: 217-239.
McLeay, Michael & Radia, Amar & Thomas, Ryland. 2014. “Money Creation in the Modern Economy”. Monetary Analysis Directorate. Bank of England Quarterly Bulletin (Q1, 2014): 1 – 13.
Nayan, S., Kadir, N., Abdullah, M. S., & Ahmad, M. 2013. “Post Keynesian Endogeneity of Money Supply: Panel Evidence”. Procedia: Post Keynesian Endogeneity of Money Supply: Panel Evidence Economics and Finance, 7: 48-54.
Rochon, Louis-Philippe. 2001. “Cambridge’s Contribution to Endogenous Money: Robinson and Kahn on Credit and Money”. Review of Political Economy, 13/3: 287-307.
Rochon, Louis-Philippe & Rossi, Sergio (Eds.). 2015. The Encyclopedia of Central Banking. Cheltenham, UK & Northampton, MA: Edward Elgar Publishing.
Titus, John. 2019. “Mommy, Where Does Money Come From?“. BestEvidence on YouTube. 15 April 2019.
Werner, Richard A. 2014. “Can banks individually create money out of nothing? The theories and the empirical evidence”. International Review of Financial Analysis, 36 (2014): 1–19.
Werner, Richard A. 2016. “A lost century in economics: Three theories of banking and the conclusive evidence”. International Review of Financial Analysis, 46 (July 2016): 361-379.
Footnotes
[1]. I did write about some of these researchers in a small unposted article criticizing Stephen Zarlenga for adhering to the deposit multiplier theory and only belatedly catching on to the credit creation theory with the 2014 Bank of England paper by McLeay.
[2]. The Quantity Theory of Money is the monetarist formula to express their understanding of the correlation between the money supply, money velocity, production and prices. It is formalized as:
MV = PT.
The money supply x yearly velocity = the average prices x the total amount of goods produced.
Thx Govert,
The last paragraph you wrote “ if sovereign monetary reform is the wise policy to promote to redirect the system towards the economic well-being of society in general and not a small elite.”
How new money is distributed is one of the central issues of every monetary reform proposal. The current system is at least in theory a meritocracy, providing new money to ‘we the people’ in a federated decentralized fashion based on professional skills and capacities. In theory the production of new economic goods and services always has access to new money, which is also retired when productive members of society are fine with it.
How can centralized Sovereign money in practice distribute money more effectively? How does it distribute it at all? Does is deliver bottom up debt-free through government spending? That is very sound economically up to the current year budget of $1.7T, Treasury Coin, but what happens after that? Does the government refinance the $30T in debt, causing QE on steroids? Not sound, as this will drive asset prices through the roof and transfer wealth through higher housing and rents. This is a serious real world problem if you de-link new money from capitalizing the creation of new goods and services.
Can a CBDC improve upon this distribution? There is no evidence it can, not even theoretically, so TreasuryCoin > CBDC, but can either of them distribute money effectively while still remaining anchored to real economy goods snd services?
Is there a federated solution as you explained above, better than we have today but the most effective at giving everyone access based on ability to use new money to create new goods and services? One that avoids politics like the debt ceiling, and avoids centralization of central bank digital currency? If we concentrate money creation power, ‘we the people’ know power corrupts, and money power corrupts absolutely.
The US will create $60b in new goods and services today, just like we did yesterday, just like we will tomorrow. We can’t just create goods and services with no new money or it will be deflationary. Where does that new money come from each day? How under every proposal will new money get out into the market? Practically speaking, this us the fundamental issue every proposed solution needs to answer.
Dear Jon, thanks for the response and questions. Much to think about because the subject is inherently very complex.
First of all, my intention with this article is to highlight the school of Post-Keynesian (PK) economics and their own investigations of the bank money creation process. Though AMI has hosted prominent PK economists like Steve Keen, overall the organization was not engaging the PK community in general, nor its best thinkers in particular. Unfortunately this resulted in some theoretical weaknesses in its pre-2014 publications. Because we have to give credit where it’s due, AMI has some theoretical catching up to do.
Nevertheless, Zarlenga’s work on monetary history, his work on the NEED Act, and the subsequent modeling of the NEEd Act by Yamaguchi and later the 1930s Chicago Plan by Kumhof, strongly indicate the very benign effects of these bank reform proposals (no bank runs, less volatility, less debt, less inequality). If ever a bill might be considered in congress, I’m sure there will be debates about the allocation of new money. For now, as it stands in the NEED Act, 25% goes to the states and 75% to congress, which can allocate it as it wants, either to alleviate the federal budget or fund a national investment bank.
One of the overlooked powers in the NEED Act is how much and where the Federal Revolving Fund (FRF) will re-allocate incoming payments of principal, which will be substantial. The idea is that commercial banks will have access to this fund, and necessarily so, to keep the economy going with credit. Here I think there might be some wiggle room to impose some ‘credit guidance’ criteria you might like, for example, a necessary pivot towards productive investments, and within that frame a more equitable spread of credit towards smaller businesses. And it could be mandated that a substantial amount will be allocated through an extended network of local, non-profit banks, which can better evaluate the credit-worthiness of smaller applicants.
As far as CBDC is concerned I would first refer to the very recent modeling done by Kumhof for the BoE and highlight its a) expected beneficial effects, b) the design requirements to prevent abuse, and c) its future potential towards an increased sovereign system, which I expect to happen after every monetary crisis and the way CBDC will play in solving them.
Overall I’m in accord with you to bust the Too Big To Fail banks and get a more decentralized credit system in place, but I think we’ll get there incrementally.
It seems to me (as a retired bank officer) that the essential banking reform needed is to require banks to actually have monetary assets on their books before such assets are loaned out to borrowers. Those individuals who desire to establish a new bank need to invest their own cash savings, raise additional cash by the sale of stock and the issuance of bonds. And, of course, a bank can attract cash by offering services to depositors and by paying interest on those deposits. The bank needs to generate revenue and does so by lending its cash assets to others at interest. All lending requires sound underwriting of and pricing for the risk. Sound underwriting requires the use of historical performance statistics. Moreover, a bank needs to diversify risk geographically and by market segment.
Any bank executive with a brain realizes the risk of borrowing short and lending long. There are sound way to mitigate the risk. One is to offer loans at interest rates that adjust periodically to coincide with changes in the cost of funds. Another is to pool loans together a collateral for a special purpose bond (e.g., a mortgage-backed security), creating a liquid asset that can be sold to investors while charging a fee to continue to service the payments on the underlying loans.
You know all this, of course.
One more way to protect the public (i.e., us taxpayers) from having to bail out failing banks and protect the bankers from a serious systemic risk was advanced some years ago by University of California economics professor Mason Gaffney. Nothing the volatility of land markets in our economic system, Gaffney argued that any financial institution that accepts government-insured deposits should be prohibited from extending loans for the purchase of land or accepting land value as collateral for borrowing. Such institutions would then finance only actual tangible capital goods, leaving the high risk lending on land to other investors not protected by any expectation of government intervention should they experience heavy losses when land markets crash (as they do every 18-20 years).