The Endogenity Of Money

I’ve been meaning to write a post about my…conversion…to endogenous money theory for many moons now, but its always been on the back burner. The reason why I think endogenous money is important is because conceptually, it provides a much more accurate view of how the financial and monetary system in the modern era actually works.

And the reason why I’m posting about it now is because somebody did a remarkably good summary of endogenous money theory (excerpt):

Endogenous Money 101

Money is at the centre of all modern capitalist economies. Understanding its nature and origins is therefore of great importance. At the heart of Post Keynesian monetary theory is the idea of endogenous money.

This is opposed to the mainstream exogenous money supply theory: the idea that the central bank has direct control over the money supply and its growth. The latter theory is wrong, and I review that major points of endogenous money below.

To summarise the summary:

The current mainstream view of money creation in an economy is based on the idea of fractional reserve banking (link to Wikipedia article). Money is created through the action of a central bank in making ”high-powered money” (cash and demand deposits) available to the banking system, which banks then lend on to borrowers.

Since only a fraction of the original money is kept by banks as reserves (hence “fractional reserve”), this lending adds substantially more to the money supply than the original injection of cash and deposits. For example, if banks keep 10% of the new cash as reserves, a central bank injection of RM100 million into the financial system would result in the end in an increase of RM1 billion in new “money” (RM100,000,000 x 1/0.1).

Hence, the orthodox (and populist) view that central banks control broad money supply, and are thus fully responsible for regulating credit and inflation, and broader economic activity. This is the theory that is taught in most economics textbooks (when it is mentioned at all), and what I used to believe in until a few years ago.

The problem with this ubiquitous and pretty story is that it’s simply not true – banks do not actually create money based on the amount of reserves they hold. In fact, the reality turns the whole theory of fractional reserve banking on its head – reserve levels are ex-post, not ex-ante, to the credit creation process. And when that happens, the whole complexion of monetary policy and the role of central banks in the money creation process changes completely.

Here’s the truth – banks create new money through the granting of credit. This involves double entry accounting with the creation of an asset (the loan) and the creation of a liability (a deposit). Money creation is thus a function of economic activity (loan demand and the willingness of a bank to extend credit), and not the other way around. Also note here that reserves do not enter the picture at all except in the context of a bank’s management of its own liquidity, which is after the fact.

You don’t have to take endogenous money theory as empty theorising either – I’ve worked in a bank before, and nobody on the credit side ever bothers with reserves. That preoccupation is invariably left to the treasury department.

Central bank intervention in adding or subtracting high powered money does not really change these dynamics, except for the effect on the time preference of money i.e. the interest rate. Even then, the instrument of choice for most central banks – short term interbank rates – have only a limited pass-through into longer term borrowing rates i.e. movements of short term rates do not fully translate into movements of longer term rates.

Nor is cash truly an arbiter of the level of reserves. Within a banking system, payments from deposits created by the granting of credit can always be sequestered by receiving banks into their own deposit accounts at the central bank, thereby creating new “reserves” independently of central bank action. In some ways then, money created through credit simultaneously creates a potentially equal and matching “reserve”. Thus the whole idea of reserves regulating the granting of loans is diametrically opposite from what actually happens in a bank.

Fractional reserve banking as a theory would have been operative only if money creation was not endogenous but exogenous i.e. coming from outside the system. Thus fractional reserve banking would be a reality under a gold standard or a currency board. But under a fiat money system, where money creation is driven by economic activity and not by an independent stock of gold or foreign currency, fractional reserve banking simply ceases to have any meaning.

In fact, the term “fiat money” is a complete misnomer, because it presumes that the money creation process is wholly governed by government “fiat” (i.e. central bank action). Again, this is empirically false.

The implications of endogenous money theory are pretty far reaching. If true – and I believe it is – it puts a completely different spin on monetary policy actions, on the relationship between the central bank and the financial system, and the relationship between money and the broader economy. The causal links between money, banking and the rest of the economy run counter to what they would be under fractional reserve banking – ignore those differences at your peril.