By Philip Pilkington, an Irish writer and journalist living in London. You can follow him on Twitter at @pilkingtonphil
There’s been a bit of confusion of late in blogland about whether endogenous money really matters all that much. Endogenous money is, of course, the theory that, contrary to what mainstream economics would have you believe, private banks in modern capitalist economies actually create money out of thin air. In my experience, theoretical economists grasp very quickly how much of an impact such a theory would have if it were accepted as true. Less theoretically inclined commentators who are generally more interested in policy and practical matters, however, often express confusion over what exactly all the fuss is about. “Does endogenous money really matter?” they ask.
In what follows I will lay out the three leading reasons why endogenous money does, in fact, matter. While I will try not to go too much into theory I will briefly mention the ISLM, but as we move from point three to point one our discussion will become less and less abstract. Hopefully such an endeavour will play a part in lifting the fog surrounding the relevancy of endogenous money. Then it will simply be up to commentators themselves to decide what approach they want to accept.
Reason One: Death of the ISLM
The ISLM model has been called “the workhorse of mainstream macroeconomics”. It is generally taught at both a graduate and undergraduate level and as such it generally becomes lodged in the minds of economics students, thus informing many aspects of contemporary policy debate. Because of this it also tends to haunt the discussions we have about macroeconomic policy more generally – even if you couldn’t care less what an IS-curve is all about, it is likely that you are familiar with many arguments and policy prescriptions based on the ISLM framework.
The ISLM model assumes that there is a mechanical relationship between the amount of money central banks release into the banking system and the level of economic activity. The model represents this as an upward-sloping LM-curve – representing, broadly, money – and this is set against a downward-sloping IS-curve – representing, broadly, investment and hence incomes. While I have dealt with the workings (and flaws) of this model in detail elsewhere, I will here only point to one aspect of the model.
The model assumes that if you increase the amount of money in the system, the rate of investment will change. This is envisaged in a wholly mechanical fashion. Thus, more money = more investment. The channel through which this increase in the amount of money affects the rate of investment is the interest rate. More money = lower interest rate = higher investment. However, in the circumstances of a so-called “liquidity trap” no matter how much money is pumped into the system the rate of investment does not respond. This is represented on the ISLM model as the tail-end of the LM-curve flattening off. The extra money pumped into the banks then just sits there as would be investors hoard it out of fear. This, according to many, is where we are today.
Endogenous money theorists would have a different view of all this. They would say that there is never any mechanical relationship between the amount of money in the system and the rate of investment. Yes, they would say, if the interest rate is lowered this may have effects on investment, but these effects are highly indeterminate and always reliant on other variables (like confidence and the outstanding level of effective demand). Thus, endogenous money adherents are far more sceptical about the effects monetary policy alone can have on the economy in general. For them a “liquidity trap” means very little in that the effects of interest rate changes are always highly contingent.
Related to this is the idea that having a negative real rate of interest might kick-start an economy operating in a so-called “liquidity trap”. If inflation outpaces the rate of interest by a sufficient amount, an ISLM adherent would argue, then because the LM-curve falls below the zero-bound level, the ISLM framework begins to work once more. Because the ISLM theorist assumes that there is a mechanical relationship between the amount of money, the interest rate and the level of investment then economic recovery from a liquidity trap can always be overcome by simply lowering the interest rate below the zero-bound level.
Endogenous money theorists would be far more sceptical of this presentation. Again, part of the reason for this is that they do not believe in a mechanical relationship between the amount of money in the system and the rate of investment. For them economic relationships are not like those between snooker balls. They are complex, interrelated and overdetermined – and certainly in no way mechanical. With regards to the ISLM framework an endogenous money theorist would accuse an exogenous money theorist of simplifying the workings of the macroeconomy to the point of intellectual and policy irrelevance.
Reason Two: Institutional Versus Distributional Instability
Adherents of the exogenous money view have recently begun to recognise the important role played by debt in modern capitalist economies. Some might say that the reason that these theorists ignored the impact of debt prior to the crisis and thus were unable to predict the crisis was because they adhered to the view that money is exogenous. While I believe there is a lot of truth to this, we will not engage here in what sorts of myopias result from adhering to incorrect theoretical assumptions.
The main issue for our present discussion is that they view debt in terms of distribution. The exogenous money view holds that for every borrower there is a saver. Thus, when too many people are saving at the top and too many borrowing at the bottom, major imbalances may occur that result in financial crises. This may appear an intuitively appealing way to view the crisis of 2008 – especially from a left-of-centre perspective. After all, didn’t wealth inequality grow enormously prior to 2008? And isn’t it likely that this was one of the root causes?
The answer to both those question is undoubtedly “Yes”. However, such observations do not excuse us for sloppy and unempirical thinking. The idea that for every saver in the economy there is a borrower is simply not true. Endogenous money theorists make the case that banks create loans out of nowhere – ex nihilo, if you will. If a bank wants to create a loan they need not wait for a saver to deposit cash that they then hold in reserves while they make their loans. Instead they simply enter the loan as an asset on their balance sheet and give the borrower cash. The reserves are sorted out later and are usually advanced by the central bank when the situation warrants.
Thus, we can imagine that even in an economy with fairly equitable distribution of income a debt crisis might arise. In fact, we have an empirical example of just this: namely, the case of the Swedish housing bubble that deflated in 1991-92 and resulted in a series of bank bailouts. Sweden, of course, is a country recognised for its equitable income distribution and yet its banks lent out in a manner similar to those of the US prior to 2008 crisis. When viewed from the point-of-view of the exogenous, distribution theory of debt this may appear confusing; but when viewed from the endogenous, institutional theory of debt this does not appear remotely unusual. Such is simply the nature of the modern capitalist game.
What endogenous money theory tells us is that banking in a capitalist economy is inherently and structurally unstable. It is not distribution that matters so much as it is the institutional arrangements of banks themselves. If banks are able to issue credit whenever bubbles begin to inflate in the economy, thus accommodating their expansion, it simply does not matter whether savers are saving – the credits are simply entries on computer balance sheets. This has enormously important implications for how we envisage the functioning of a modern capitalist economy.
Reason Three: There is No Such Thing as “Crowding Out”
These days we hear a lot about the supposed phenomenon of “crowding out”. The story goes something like this: there is a fixed supply of funds available in any economy at any given time and if the government borrows those funds to pay for its deficits, the private sector will not be able to borrow them. Thus, any expansion of government spending will restrain private sector spending. And since most people assume that government spending is inefficient this is usually seen as a bad thing.
The manner in which this crowding out is supposed to effect the private sector is through interest rates. Since there is a fixed quantity of money in the system, the more of this money is demanded the higher its price (interest rate) will be. Even though we see no effects on interest rates as government borrow in large amounts today, adherents of the “crowding out” view claim that we eventually will and hence the government should be cutting down on its expenditure by engaging in austerity.
Neo-Keynesians and sympathetic media pundits who, implicitly or otherwise, believe in exogenous money largely agree with this view. They claim, however, that during times when the economy is in a “liquidity trap” – that is, when people are essentially hoarding money and not investing it (see Reason One above) – there will be no crowding out effects because this money would be sitting idle anyway. However, these same authors and commentators do recognise that eventually when the economy recovers and the liquidity trap comes to an end government borrowing will indeed lead to crowding out.
Endogenous money theorists, on the other hand, argue that this is not the case. They argue that central banks set a target interest rate and then inject reserves into the system to maintain this interest rate regardless of what the government is spending or taxing. Thus, even in a boom, if the government borrowed lots of money this money would, in a roundabout way, be replaced by the central bank. (This, the astute reader will note, is where endogenous money theory meets MMT).
Crowding out, then, can never ever be a problem in an economy where the central bank sets a target rate of interest. Interest rates will always be set by the central bank and private sector actors will get access to funds at this price regardless of how big the government deficit is. In this way the quantity of money in the system is never fixed, but fluctuating with regard to how much private sector demand for that money there is at any given point in time. And so, the endogenous money theorist would argue, crowding out will never be a problem – ever. Not even in a boom. The only restraint upon government spending is that it might lead to inflation or devaluation of the currency.
This is a powerful argument when it comes to considering policy. No longer can we justify policy decisions based on the idea of crowding out or a limited pool of loanable funds. Instead we must take a more nuanced look at inflation, unemployment and other economic variables when making policy choices. Needless to say, greater public awareness of these issues could change the framing of political debates significantly. Exogenous money theory, many endogenous theorists would argue, places a massive taboo on discussing economic policy in a reasonable manner.
There are a number of other important aspects of the endogenous money theory. Most notably, that it largely demolishes marginalist or neoclassical conceptions of how the economy functions and renders many textbooks used by undergraduates and graduates irrelevant. However, this is beyond the ambit of this article which merely seeks to lay out some of the more practical differences endogenous money theory makes to how we understand the economies in which we live and consider policy decisions that might improve them.
Between the endogenous and exogenous views of money there lies a gulf of difference. And while those that adhere to the latter may try to integrate elements of the former, they will, in the view of those that adhere to the former, always come up short. For they are, as the great French psychoanalyst Jacques Lacan said in a rather different context, “two countries towards which each of their souls strive on divergent wings, and between which a truce will be the more impossible since they are in truth the same country and neither can compromise on its own superiority without detracting from the glory of the other.” If we renege on their absolute difference we render both banal and meaningless.