Monday, July 1, 2013

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.


  1. Hi Hisham, that's precisely what was happening with QE in US. QE does not really create "credit", aka money by making banks granting loan to business activities because interest rate was at low level due to Fed action. As we know, banks borrowing short and lending long on the yield curve. If yield curve is flat, banks have no incentives to lend. As a result, economic activities will not be stimulated. Banks rather use Fed's QE money to buy risky assets than lending out.

    1. Kev,

      "Banks rather use Fed's QE money to buy risky assets than lending out."

      That's an example of fractional reserve thinking. Banks do not need the Fed creating reserves to grant new loans, that's a power they already inherently have. Under endogenous money theory, the missing link in the equation is not therefore loan supply, but loan demand.

      Lending is weak not just because banks are unwilling to lend, but because businesses and consumers are unwilling to borrow.

      Another factor - if granting credit creates money, loan defaults and loan repayments ipso facto destroy money.

      Since US banks, households, and businesses appear to have been engaged in repairing their balance sheets over the last 5-6 years (reducing leverage and increasing the demand for "safe" assets), this implies an endogenously induced monetary contraction.

      The monetary expansion by the Fed via QE can thus be interpreted as an effort to offset this contraction, hence the reason why it has not turned out to be inflationary, much less hyper-inflationary.

    2. Hi Hisham,

      Am not referring to fractional reserve here. What I meant is the way FOMC works -- that Fed buys lots of UST from PDs (banks) with their QE money. And banks use the proceeds to buy risky assets globally and thus drive up assets prices.

      It sounds exogenous, but in reality it's still endogenous as banks play the crucial role of lending it out first to consumers and businesses to create credit.

      If not, like you mentioned, it has not turned out to be inflationary at this point of time. Unless, of course, until banks start to lend out (or demand of loan starts to pick up).

    3. Kev,

      The money created through QE is directly by the Fed, not through the banking system. In that sense, it is technically exogenous.

      Open market operations to increase banking liquidity always involves creation of new money directly by a central bank independent of the credit creation process in banks, as is the literal printing of cash.

      The mistake in orthodox economics is to consider this supposedly independent process as the primary means of inducing an increase in the money supply i.e. central bank action is responsible. Whereas if money is endogenous, central banks principally react to changes in monetary conditions, subject to policy objectives.

      In that sense, expansion of liquidity via central bank action, although it looks exogenous, is actually endogenous because it is prompted by changes within the system. The principle of endogeneity is not confined to the money creation process in banks alone.

    4. Hi Hisham, just chipping into the discussion.

      My understanding as a layperson is that the entire debate on endogenous v exogenous boils down to which type of money you are looking at. From the perspective of endogenous money proponents, money held as reserves in the central bank can be created exogenously, but such money is irrelevant for the wider economy (inflation and growth) until money is created endogenously, i.e. by the creation of debt.

      Thus far, the creation of new money via QE has not led to inflation in the US simply because the money has not entered into circulation, and is still sitting in the Fed. This money is not useless of course. Loan growth is influenced by a combination of loan demand and loan supply. As reserves increase, the incentive the bank has to lend increases, and the risk premium drops. Theoretically, this is what allows the Fed to further incentivise lending when OPR has dropped to 0%. Nevertheless, as you've mentioned, the entire process is still entirely endogenous, as the excess reserves perform the same function as the lowering of interest rates.

      I note that you are not really addressing Kev's point, which is that in lieu of creating new debt, banks can use the excess reserves to purchase risky assets overseas. My view is that this is in fact what is happening, albeit indirectly. Zero interest rates and plentiful reserves incentivises the creation of a carry trade whereby investors can borrow money from US banks at low interest rates to purchase risky assets in EMs with higher yields. This has zero effect on inflation within the US, but would lead to massive hot money flows into EMs. Ergo, new money is created by QE, but it is flowing everywhere else but the US.

      Another factor is possibly that, due to investor ignorance and the persistent belief in exogenous money, the idea of QE itself incentivises the exodus of money from the US, notwithstanding that QE does not in itself create that much circulation of new money within the US. This is evidenced by the profit-taking in EMs which occurred when Dr Ben announced the tapering of QE.

      I must apologise for the very long rant.

      Anon 1986

    5. Anon 1986,

      No apologies necessary.

      I didn't address Ken's point because he made a positive statement, not a point of inquiry. I mostly agree with it anyway.

      However, some minor points of interest in your rant, and perhaps a clarification of my viewpoint:

      "...but such money is irrelevant for the wider economy (inflation and growth) until money is created endogenously"

      "As reserves increase, the incentive the bank has to lend increases, and the risk premium drops. "

      I think reserves are pretty much irrelevant for lending...period. With endogenous money creation, new lending automatically creates matching reserves. If reserves in any way regulate new credit creation, then bank capacity to lend is technically infinite as reserves are not a binding constraint. But real-world bank lending doesn't appear to behave that way.

      The same can't be said of corporate borrowing or equity raising via the capital markets, which behave more in accordance with loanable funds theory - bank (or other institutional or retail) purchases of bonds don't involve money creation via credit. Reserves in this market therefore does matter, and changes in excess reserves will mainly effect the demand for securities.

      QE therefore has a direct impact on capital markets in the US and elsewhere, and at best only an indirect impact on broader credit creation via lower long term interest rates.

      I think most central banks understand this distinction. BNM for example always stresses that changes in the statutory reserve ratio is aimed at changing liquidity conditions, not the monetary policy stance.

      Empirical note: Most of the money created under QE remains at the Fed - whether IOR is a factor is anybody's guess. I think counterparty risk is probably just as big of a factor in the desire for excess reserves. Also, much of QE1 and about half of QE2 have effectively been withdrawn, as the Fed did not rollover maturing securities into new purchases. So the headline numbers for both tranches are misleading.

  2. Ergo you are on the Keen side of the Keen v Krugman debate? That's interesting to know.

    Anon 1986

    1. @anon 1986

      I've never read Steve Keen, though I've heard of him. But I can't deny the truth - economic textbook descriptions of the modern banking system simply don't conform to reality. Endogenous money theory is a lot closer.

      There's some overlap between the two however, e.g. the bond market, which is better described by loanable funds theory than endogenous money. A holistic view of the financial system really requires a mix of both. Traditional banking however is really pure endogenous money.

  3. I am surprised. As a professional engineer who got interested in economics many years ago, I had to do my own research on the "mechanics of money" and ended up with an understanding of "endogenous money" as you described. it's interesting that "properly-educated" economists are actually taught the opposite idea...

  4. Been a while, gave up on commenting here or elsewhere but doesn't hurt to indulge once a while, I guess. For those interested in the mysteries of endo money, here are some links:

    Good job by campiglio, up there.... almost that is.

    Read or hear with the salt shaker in hand, dudes and gals, for economists are as liable to be as crazy as the pollies next door or in parliament house, especially when they get into polemics like this one. So unlike engineers, that is!

    Mmmmm.. would be interesting to empirically model their behavior in moments like these, wonder what the data will show....hahahahaha (wink wink wink) ;p

    Warrior 231

    1. Warrior,

      Welcome back, and thanks for the links. I always remind myself that economists too are "endogenous"!

  5. My reaction wasn't surprise - I was pissed.

    John Quiggin has a great term describing this and many other antiquated ideas: He calls it "zombie economics". No matter how many times you kill it, it keeps coming back to life.

  6. Just a thought. I was wondering about the role of innovation/technology in aggregate demand (AD). See, if producers are using innovation to boost output using the same levels of resources/ inputs that would translate into either higher profits/wages or higher disposable incomes for workers/consumers due to cheaper goods.

    Either way, higher profits or higher income would still translate into higher AD sans credit creation by banks, right? If true, engineers will always be the bulwarks of an economy, wouldn't they. ;D

    By the way, you shouldn't use the p word up there dude. It's gross, you know......hahaha. ROFLMAO

    Warrior 231

    1. Correct, though I'd argue that innovation would be on the supply side. But then somebody could also come up with fancy packaging, or persuade people that snake oil really does work, or conduct a marketing campaign that captures consumer interest and get the same effect on the demand side.

  7. I was actually thinking in terms of AD being a combination of wages + net profits = Planned Expend like what Campigioli postulates on slides 16 onwards here:

    In such an equation, producers by default being consumers, also add to AD either through higher retained net profits or via higher wages to their slaves or via cheaper products derived from that innovation which in turn fuels higher disposable income thus higher AD. That will be demand side, right? Goobledegook? fig that out! Hahaha

    if all things being equal, higher profits/ wages/disposable incomes, by way of innovation, contributes to higher AD wouldn't it? Given that scenario, credit creation via debt via banks would not be the ONLY way wouldn't it to push up future AD for producers can leverage on innovation to drive up profits for future investments instead of leveraging on debt. Wouldn't such a scenario ( if right) be infinitesimally better?

    Some snake oil ain't all this eh?....I am planning to market it, looking for some South Sea fools or dot com mugs to pour in some moolah.

    Warrior 231

    1. Congratulations warrior, you've just rediscovered Solow! :)

  8. Oh by the way, engineers are neither endogenous or exogenous.......this one, at least, is erogenous.

    Guess what dude, I have just named my forthcoming treatise on the above 'The Erogenous Theory of Money' given that money is truly be taught in any Zombienomics Mark 2 class?

    David Stockman, OMB director during Reagan's era had a much kinder name ....vodoonomics!

    Warrior 231

  9. "The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or evade truth, not to reveal it." - John Kenneth Galbraith, Money:Whence it came, Where it Went, page 15

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