Bubbles, Panics and Crashes: An Introduction to Alternative Theories of Economic Crisis

Dr. Sakir Devrim Yilmaz

Economics

University of Manchester

Endogenous Money, Credit Bubbles and Central Bank Policy

• “Talk about centralisation! The credit system, which has its focus in the so-called national banks and the big money-lenders and usurers surrounding them, constitutes enormous centralisation, and gives this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner— and this gang knows nothing about production and has nothing to do with it.”

Karl Marx

Capital Volume III, Chapter 33

Money: Endogenous vs. Exogenous • Starts with the critique of the exogenous

money view endorsed by mainstream economics for a very long time, and still present in textbooks.

• Exogenous money supply implies that base money supply is determined by the Central Bank, and credit money follows base money through the process of the money multiplier.

• Further, according to exogenous money, savings are the source of lending, therefore a shortage of savings leads to a decrease in lending.

Basics: Base Money, Money Multiplier and Broader Measures of Money

• High-powered money (monetary base, base money, M0) The monetary base consists of currency in circulation (cash and coins) and bank reserves at the Central Bank (both required and excess reserves)

• Broader Measures of Money: M1

a. currency and coins,

b. traveller's checks, and

c. checking accounts (demand deposits)

• Broader Measures of Money: M2

M1 +

a. savings and time deposits of less than $100,000,

b. money market mutual funds held by individuals, and

c. Eurodollars (U.S. dollars that are deposited in European banks)

• Money Multiplier:

• Assumes that banks lend the deposits minus required reserves, and create money against already available resources

Sloman (2010)

Money Multiplier = 1/RRR

• With a Reserve Requirement Ratio of 10%, the the Money Multiplier is 1/rrr = 1/0.1 = 10

• So an increase of 10£ in deposits (base money) leads to an increase of 100£ in the money supply, as banks continuously lend the additional deposits minus required reserves.

• Assuming that this is indeed how banks operate in reality, let us see the implications of exogenous money

Implications of Exogenous Money

i. Broader measures of money (M1, M2) must follow developments in high-powered money (M0).

ii. The money multiplier must be greater than one by definition. Or in other words, base money cannot be greater than M1/M2.

iii. Central Bank must be able to control the volume of high powered money. Further, an increase in high powered money (through an increase in bank reserves for example) should increase lending and credit creation

iv. Only the distribution, not the volume of debt will matter, since lending is financed through savings, and one’s debt is someone else’s asset.

Reality: i. Several empirical studies have shown that

broader measures of money do not follow the monetary base, rather the exact opposite holds: The increase in high powered money occurs after the increase in broad money supply, and lags the business cycle (See Kydland & Prescott 1990 for instance)

ii. Following the expansionary monetary policies by Central Banks all over the world in the Post-Credit Crunch period, money multiplier has been below one since 2009 and still falling! So monetary base is higher than the broad money supply.

iii. The attempt by Central Banks to control the money supply (in accordance with monetarist policy recommendations) had disastrous consequences during 1980s so central banks now implement inflation targeting through interest rate setting policy.

Further, banks have accumulated significant amounts of reserves following the excessive money printing after the credit crunch, but lending remains very limited.

iv. The most critical implication, however, is the claim that the volume, or the change in debt does not matter in analyzing business cycles. This follows from treating money as any other commodity, assuming that to create loans, savings (or base money) should exist a priori, and finance lending.

• That is exactly why in all presentations of the money multiplier, the analysis starts with “an initial deposit” in a bank account, which are funds the household already had but had preferred to hold as cash until then.

Bernanke (2002)

• “The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost... What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet.

...Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

• ...”By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation”

• This is treating a fiat-money system like a metallic monetary system prevalent in the Bretton-Woods era, and it is blatantly wrong!

• Since the volume of debt or the change in debt does not affect the business cycle, they are absent from the analysis of crisis in mainstream models.

Endogenous Money:

• In essence, the sequence of credit creation works completely the opposite way.

• As prices of factor inputs increase (or households cannot finance their current spending with their income), demand for credit increases.

• Banks supply the credit demanded at the interest rate they choose to offer on loans. This interest rate is determined by a mark-up over the central bank lending rate (base rate) and costs of other sources of financing. In this sense, banks are price-makers and quantity-takers.

• Deposits are one way (in most cases the cheapest one) of obtaining these funds. Alternatively, banks can borrow from the Central Bank at the policy rate, or borrow from money markets (interbank borrowing)

• The Central Bank, as the lender of last resort, accommodates to the borrowing demands of banks, setting the cost of borrowing rather than its quantity. If the Central Bank refuses to lend to banks, money markets will collapse and a credit crunch will occur.

• Therefore, the Central Bank cannot control the money supply, but can effect the cost of credit through interest rate policy.

Credit Creation, Deposits and Reserves: How It Works in Reality

• So, rather than deposits leading to new lending as in the money multiplier model, it is the loans that create bank deposits, as newly created money is used for purchasing of goods.

• In other words, banks first lend, and then look for reserves. So credit-creation is independent of savings, and debt matters! In essence, new credit will subsequently create the observed savings, not vice versa.

• The process starts with a bank making a new loan rather than a deposit. The new loans is shown as an asset in the bank’s balance sheet, and the amount in the borrower’s account (deposits) is shown as the bank’s liability.

• On the other hand, for the borrower, the loan is a liability, and the deposits in his/her bank account is his/her asset.

• Assuming that there are reserve requirements and the bank starts from an initial excess reserves of zero, the new deposits require additional reserves at the Central Bank, which the bank borrows from money markets.

Fullwiler (2012)

• Now let us assume that the borrower uses the deposits to purchase a good, and that the seller of the good (the recipient) uses another bank.

• In this case, the deposits will be withdrawn from the borrower’s bank. Therefore, the reserve balances borrower’s bank keeps at the central bank are not required any more. However, the bank now needs to borrow the total amount of the withdrawal, most commonly from money markets (borrowings withdrawal below)

• As a result of this, the bank now incurs a larger cost, which is the cost of borrowing the total sum of the loan from money markets. So the bank would like to attract more deposits now in order to reduce this cost, or would charge higher interest rates on loans.

• As we can see, the initial loan creates the deposit of the recipient, the associated moves in the reserve. The initial lending decision does not depend on the availability of the reserves, but the profitability of the initial loan for the bank.

• Borrowing from the central bank or money markets can always be made at some interest rate, the question is whether or not the spread between the borrowing and lending rates is profitable enough for the bank.

• Banks want deposits because they are the least expensive sources of funding and encouraged by regulators, the lending decision is not deposit-constrained.

• The Central Bank accommodates to the borrowing demands of banks but sets the price. In other words, the Central Bank is a price maker and a quantity-taker in the market for reserves.

• So reserve balances have no effect on the ability to lend. Further, inter-bank lending does not affect the total Reserves of the banking sector, since these reserves are a liability on the Central Bank balance sheet. For the total reserves to change, assets of the central bank must also change.

Interest-Rate Targeting

• Modern central banks use interest rate targeting rather than targeting the money supply.

• In order to do so, in a corridor system, the Central Banks sets two rates: Remuneration rate and lending rate.

• The remuneration rate is the interest the CB pays on bank reserves at the central Bank, whereas lending rate is the interest rate the Central Bank charges on bank borrowings.

• Further, rather than requiring banks to settle their reserve balances daily, most Central Banks use a reserve averaging system.

• In U.S for instance, banks can average over a period of fifteen days, and maintain a positive reserve balance on some days which will be offset by a negative balance on others.

• This policy gives the Central Bank more room to achieve the interbank borrowing rate target (called federal funds rate in the U.S), as demand for reserves by banks on every day (apart from the last day of the period) is more flexible. Therefore, the Central Bank does not have to estimate the demand for reserves as precisely when there is a reserve averaging mechanism

Lavioe (2010)

• Let’s first assume that the Central Bank does not pay any interest on reserves (pre-Lehman case in the U.S)

• The demand for reserves has two flat parts. At the lending rate of the central bank, the curve is flat because the interbank borrowing rate (federal funds rate) cannot exceed the lending rate. If it did, banks in need of liquidity would borrow from the central bank instead of money markets.

• The curve is also flat at the expected interbank rate due to reserve averaging.

• The lower bound for the interbank rate is zero in this case, at which banks are indifferent between lending in the money market or keeping their excess liquidity at the Central Bank, which pays nothing.

• If the Central Bank has been successful in achieving its target before, and can correctly estimate the reserve requirements of the banking sector, the expected interbank rate must be close to its target. The Central Bank supplies the demanded reserves at the announced lending rate, and the actual interbank rate hovers around its target.

• If on the other hand the Central Bank pays interest on reserves, then the demand curve for reserves becomes flat at this rate as well, and the interest on reserves becomes a floor for the interbank rate. Now, the interbank rate cannot fall below this rate, as otherwise banks would keep the excess liquidity at the central bank instead of lending in money markets.

• Fontana (2003) provides a simplified graphical presentation of Central Bank policy, credit creation and bank reserves.

• In the graph below, the Central Bank sets the interest rate on the upper left panel. In the upper right panel, demand for credit is a decreasing function of cost of credit, whereas the supply of credit is perfectly elastic (horizontal) at a rate equal to the Central Bank policy rate plus a fixed mark-up.

• Initially, the total credit is determined in the upper right panel where credit demand intersects credit supply at point A.

Fontana (2003)

• Moving to the lower right panel to the Loans-Deposits line, we can determine the deposits that correspond to the equilibrium level of credit.

• On the lower left panel, reserve requirement ratio (the slope of the HD line) then determines the amount of bank reserves held at the central bank (H0)

• If the credit demand increased and the credit demand curve shifted to Cl

D, then, equilibrium in the credit market would move to point B, with demand for reserves increasing to H1.

• The Central Bank could accommodate this increased demand at a higher interest rate, particularly if the increase in credit (and therefore demand) creates inflationary pressures. This would shift the credit supply curve up to C1

S, as cost of obtaining reserves from the central bank would be higher now. The economy would move from point B to point E, as banks call some loans back and reduce credit (This is never a preferred policy for a bank).

• However, keep in mind that this process of obtaining costly reserves would occur after the initial loans are made. So a more likely scenario is that banks will anticipate the behaviour of the central bank, and shift the credit supply curve up immediately as a response to the increase in credit demand. The economy would never move to point B but to point E straightaway if banks could correctly estimate central bank policy.

• Therefore, in a Post-Keynesian world, the volume and the rate of change of debt drives the credit cycle, and therefore the business cycle (Remember the Minsky cycle)

• Problem of wrong causality and the following absence of debt in mainstream economic analysis implies credit bubbles are not possible by definition, and do not need to be addressed in the theory.

• Fontana, G. (2003) “Post-Keynesian Approaches to Endogenous Money: A

Time-Framework Explanation”, Review of Political Economy, vol.15 (3), pp. 291-314, July 2003.

• Moore, B. (1991) “Money Supply Endogeneity: Reserve Price Setting or Reserve Quantity Setting?”, Journal of Post Keynesian Economics, vol. 13(3), 404-13

• Fullwiler, S. (2013) “An Endogenous Money Perspective on the Post-Crisis Monetary Policy Debate” Review of Keynesian Economics, Vol. 1 No. 2, Summer 2013, pp. 171–194.

• Lavoie, M. (2009) “Endogenous Money: Accomodationist” in P. Arestis and M. Sawyer eds., A Handbook of Alternative Monetary Economics, Edward Elgar, Cheltenham, 2009.

• Lavoie, M. (2010) “Changes in Central Bank Procedures During the Sub-

prime crisis and Their Repercussions on Monetary Theory”, Levy Economics Institute at Bard College, Working Papers, No:606.