James Galbraith: How Central Bank Myths and Practices Support Financiers and Dollar Hegemony

Yves here. Richard Murphy summarized an important paper by James Galbraith, which takes on two different, but actually somewhat related, central bank fixations. One is the loanable funds theory, which is the false and long-ago debunked notion that banks lend out pre-existing savings. In fact, banks create new deposits every time they lend; they do not need to tap any existing savings/investment pool.

Galbraith then turns to why central banks are pursuing high interest rates. The answer is not pretty.

By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK

I owe thanks to those who drew my attention to a new paper published by James Galbraith in the last few days. The blurb from the Levy Economic Institute of Bard College in the USA says:

In the paper, James Galbraith first demolishes arguments for the loanable funds model of banking, still beloved by most macroeconomists and so absurdly untrue that it is shocking that they can still teach this nonsense to most undergraduate students.

What he then argues is that there is no such thing as a market rate of interest. Firstly he says that is because there is no free market in money given the barriers to entry that banking has.  More importantly, that is because of the power of central bank regulation on this issue.

As a result he suggests that the aim of all interest rate policy should be to keep rates as low as possible. This, he argues, was Keynes’ preferred option. As Galbraith summarises this:

Interest was the return to the provider of funds, typically the idle rentier. Thus, a low rate of interest and a high rate of investment would yield, in the long term, a “euthanasia of the rentier”—leaving capitalist society in the hands of its active elements, namely businesses, their workers, consumers, and the government—perhaps requiring a “socialization of investment.”

Galbraith makes it quite clear that he is on the side of this euthanasia of the rentier. He argues that regulation has to deliver the active economy that we need.

As he then notes, since Keynes’ death, everyone has rowed back from this critical idea. Having reviewed the failures resulting from doing so, Galbraith asks:

The analysis above leaves an open question. Apart from the illogical and the illusory, are there solid—if not necessarily defensible—reasons why the Federal Reserve would raise interest rates?

He offers two. The first is this:

Two possibilities come to mind. The first is venal. The Federal Reserve works, in the main, for the largest banks, and since 2008 it pays interest directly on their reserves. Thanks to “quantitative easing,” the policy of buying at-risk assets such as mortgage-backed securities from the private sector and warehousing them in special purpose vehicles, the big banks are flush with reserves. Paying interest gives them income; paying more interest gives more income. In return for this, nothing is demanded. As smaller banks with unstable deposit bases are hit by runs, the biggest banks can (and do) ride to the rescue, consolidating their hold on the banking system as a whole. All of this must be very well appreciated by the big bankers.

I think this is highly likely to be true.

His second explanation is this:

The other possible reason is global and strategic. Although legal responsibility for the dollar rests with the Treasury, not the Federal Reserve, power over the dollar exchange rate rests largely with the central bank, its interest rate, and their effect on capital flows. Although the topic rarely surfaces in public, there is little doubt that preserving the centrality of the dollar as the global reserve asset is a paramount US policy goal. So it was when Paul Volcker assumed office in 1979, flying back from an IMF meeting in Belgrade to announce the first “Volcker shock,” and so it remains today.

US hegemony is, then, core to interest rate policies. It is, once again, very hard to disagree.

As Galbraith notes, the first of these issues is relatively easy to address. The second is much harder. Doing so would, as Galbraith puts it, “shatter the illusion of American prosperity.”

How does he conclude? Like this:

In sum, there is no alternative, consistent with minimum economic functionality, to a policy of low interest rates. Keynes was right. … But such a policy cannot be effective, in fact no policy can be effective, without a radical restructuring of the US economy as a whole. For this, definancialization, effective control of the speculative/predatory elements in the financial classes, and acceptance of—what is inevitable—a multipolar financial world are the key first steps. There is little doubt, at this stage, that the adjustment will be quite harsh at first. Adjustments typically are. But after forty years in the pursuit of a failed strategy, an easy path forward is not realistic.

Once more, I agree. As I have said here recently, to survive we have to break from the model of economics that we have that has been driven by the power of advertising to promote consumerism, all of which exists with the ultimate goal of firstly making us unhappy and secondly of keeping us in debt.

That model was always bad for well-being.

Now that model is also destroying the planet.

We have no real choice but change. But as is becoming very apparent, politicians are finding it very hard to deliver against that need because of their own indebtedness to big business and the financial hierarchy of power.

There can only be one winner here. The trouble is power is on the side of losing.

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  1. Ignacio

    Next step for this outstanding economist would be to describe a roadmap for such reforms. May be he has done it but I am not aware. That roadmap should be polítics 101 for any progressive party and the way to purge the Starmers of the world prentending to have social concerns.

    1. Neutrino

      The existing structure isn’t likely to be changed materially without some force majeure. The stakes in both of Galbraith’s explanations are too high, and the overlapping interests of those stakeholders so entrenched, that any orderly transition would be fought vigorously. A good first step is in consideration now in Congress, eliminating the insider trading opportunities.

    2. Kouros

      Why are you demanding from an economist economic solutions when it is clear from what has been presented, that the solutionsare first and foremost political?

    3. Science Officer Smirnoff

      Galbraith gives us this: (emphasis added)

      As for speculation with cheap money—a phenomenon of which he was definitely aware—Keynes argued that it was harmless so long as it was merely a few “bubbles on a steady
      stream of enterprise” (Keynes 1936, Chapter 12). The task of keeping it that way was for the conservative instincts of bankers and, if that failed, for strict regulation by public authority

      (obvious and out of reach)

  2. p fitzsimon

    The current interest on the 10 year bond is 3.9%. Given inflation is 4% plus aren’t we at 0% interest right now?

  3. Susan the other

    RM is clarity incarnate. So is Jamie Galbraith. To intentionally shatter the illusion of our prosperity isn’t really that frightening. Everyone knows it’s the Wizard of Oz. Making a currency perform as an asset was one of history’s screwiest ideas. When you think about it, it survived for almost a century, it’s astonishing. But that magic trick probably originated with an ancient obsession for gold. What amuses me is that even still it’s hard to convince anyone that gold is fiat too. If we could just turn human obsession itself into our currency we might be able to get that mental wheel out of the ditch – and none too soon because we must have an ecologically responsible civilization if we want to survive. The only asset is the environment, including the social environment. Let’s peg currency, all currencies, to the environment and make our new motto “Do no harm.”At that stage it would seem silly to pay interest on money – the only logical interest would go into repairing and maintaining the only asset. Certainly wouldn’t bother me. But then how will they ever bribe another politician?

  4. UserFriendlyyy

    JP Morgan Chase has it’s fingerprints all over this. from the change from a (uncollateralized) reserve backed system to a (collateralized) repo backed system. To now getting to gobble up other banks that instability has caused. It’s not good.

  5. JohnH

    How does a low interest rate drive out rentiers, when they merely invest in speculative assets rather than productive ones?

    1. Rolf

      With respect to Keynes, I think he thought ‘rentier euthanasia’ is what the endgame should be, consistent with creating sufficient prosperity to enable everyone to live ‘wisely, agreeably, and well’.

      He argued in his General Theory that interest was a penalty to the marginal efficiency of capital, and that low interest rates promoted real investment consistent with full employment. The rentier can exploit the scarcity of land because land is scarce; but Keynes saw no intrinsic reason for capital scarcity justifying high interest rates, except under conditions where consumer spending at full employment exceeded savings, while capital availability was simultaneously limited. He saw ‘rentier euthanasia’ as good and desirable, because rent, whether extracted from land or from capital, rewarded no complementary sacrifice on the rentier’s part.

    2. Rob

      Me thinks that any rentier worth his salt prefers to make money without taking big risks. Almost definitionaly, that’s what separates him from a speculator

  6. Altandmain

    The third reason is simply that employers hate it when there is a worker shortage. High interest rates are able to induce a recession or weaken the bargaining power of workers. This is under the pretext of lowering inflation. In reality it is class warfare.

    This is what Paul Volcker did in the 1980s and what Jerome Powell is trying to do.


    Of course, then there’s the problem that the Federal Reserve will do nothing to address Greedflation nor the supply chain problems that began with the pandemic. In that regard, they’ve scapegoated worker salaries and are not addressing the real root causes of inflation.

    So apart from the 2 reasons listed in the article, there’s a clear third.

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