This post was published to The Dismal Operator at 9:51:41 PM 3/21/2014

More on Keynesianism, Endogenous Money, and Economic Growth

In my last post, I took on a post by Cullen Roche about common misunderstandings associated with
Keynesian economics. A more recent post of his touches on a similar topic, albeit in the context of the
Austrian view regarding endogenous money and savings. The catalyst for all of this was a reaction to a
recent report published by the Bank of England, which, while not really saying anything new, caused a
stir because it was a major central bank. According to Roche, the reaction intimated that the BOE report
was a rehash of Austrian theory, and he wrote to take that idea apart.
First of all, we should be very clear that many modern day Austrian economists did not
understand the importance of endogenous money. For instance, in this 2009 article
prominent Austrian Economist Robert Murphy made the case for high inflation stating:
In order to keep those reserves from working their way back into the hands of the
general public (where they can start pushing up prices), the Fed will have to raise the
interest rate it pays to persuade the banks to keep the reserves parked at the Fed. But
this simply postpones the day of reckoning, as the troublesome stockpile of excess
reserves grows even faster.
He shows a chart of M1 surging higher due to QE and concludes:
I still believe that Bernankes unprecedented infusions of new reserves will lead to rapid
price increases. These increases may not show up in the price of US financial assets, but
they will rear their ugly heads at the gas pump and grocery checkout.
This never happened of course.
Ill get to endogenous money in a bit, for now lets look at the Murphys prediction. The following are
charts of gas prices, food prices, the S&P 500 (used as a proxy for US financial assets, and a bonus chart
of average earnings. They all start on December 14, 2009, the day Murphy wrote the blog post in
question, and run until today.












The price increases are as follows: 34% for Gas, 9.1% for Food, 70% in the S&P 500, and 8.4% in wages.
The operative phrase in Murphys quote was rapid price increases, and I can already hear the
contention mounting that those price increases do not qualify as rapid. Indeed this is what the there
no inflation crowd has been resting on for quite some time. However from the supremely important
standard of living point of view, it is clear that the fact that prices have risen faster than wages is
demonstrably a bad thing. The only mistake Murphy made was to say where the price rises would and
wouldnt show up (and even then he wrote may not). This is because while central banks can pump
money into the system, they ultimately have little control over where it actually ends up. This is why you
can have no inflation in core CPI, but you can see the evidence of increased money supply in equity
prices, Mayfair real estate, Sothebys auctions and Maserati dealerships, for example.
Roche continues:
But thats not whats important. The more important part is that this is classic loanable
funds and money multiplier thinking. In other words, it is a total misinterpretation of
something like the Bank of Englands report. And this is a cornerstone of Austrian
economics. As Mises stated in his text Human Capital:
saving and the resulting accumulation of capital goods are at the beginning of every
attempt to improve the material conditions of man; they are the foundation of human
civilization. Without saving and capital accumulation there could not be any striving
toward non-material ends.
This is a bit misleading because he starts by bringing up the loanable funds model and the money
multiplier, and labels it a misinterpretation of reality, yet it is a cornerstone of the Austrian view.
However, he quotes Mises talking about savings being the foundation of economic growth. The latter is
actually a cornerstone of Austrian economics, which Ill discuss further below.
With respect to endogenous money, the charge is that Austrians generally believe in a loanable funds
model of money creation where banks lend money based on their deposit base (which is more or less
controlled by the central bank), and thus the amount of loans that can be made are restricted by this
deposit base. In short, banks get deposits, make loans later. The reality is that money is created
endogenously when banks make a loan, regardless of their deposit base. In other words, they arent
constrained by their deposits as they are in the loanable funds model. The main point of contention
between the two camps is the initiator of money supply expansion. The loanable funds view places the
responsibility on the central bank, the endogenous view to the commercial banks.
The endogenous view does bear a closer reflection of reality, but it is not a complete view as stated. If a
bank decides to make a loan that would take it below its required reserve ratio, it is then faced with a
scramble to find reserves. This scramble for cash puts upward pressure on interest rates in the money
market. The central bank can step in at this point to inject cash into the system so as to replenish the
reserves of the bank making the loan, suppressing the interest rate back down to its target level. Frank
Shostak, an Austrian economist, describes this point in further detail (PK here refers to Post Keynesian
economists):
In this way of thinking it would appear the central bank has nothing to do, at least
directly, with an expansion in the money supply. (In fact most central bankers would
agree with this). The key source of money expansion is commercial banks that, via an
expansion in lending, set in motion an expansion in the money supply. (For PK
economists, commercial banks liabilities are seen as the primary money used by non-
banks. The demand for loans, plus the willingness of banks to lend, determines the
quantity of loans and thus of deposits created).
The supply of loans, in this way of thinking, is never independent of demand banks
supply loans only because someone is willing to borrow bank money by issuing an IOU
to a bank. To conclude, then, according to this way of thinking, the driving force of bank-
credit expansion and thus money-supply expansion is the increase in the demand for
loans and not the central bank as the money multiplier model presents.
Is the Money Multiplier a Myth or Reality?
Superficially it does make sense to conclude that central bank policies are of a passive
nature: the central bank just aims at keeping the money market in balance. A careful
investigation of all this does, however, reveal that the central bank's so-called passivity
is just a spurious label. In reality, central banks are very far from being passive. In fact
without the central bank being active it would be impossible for banks to expand
lending and set the multiplier process (the creation of credit out of "thin air") in motion.
Let us say that for whatever reason banks are experiencing an increase in the demand
for loans. Also, let us assume that the supply of loanable funds is unchanged. According
to PK, banks will oblige this increase. The demand-deposit accounts of the new
borrowers will now increase. Obviously the new deposits are likely to be employed in
various transactions. After some time elapses, banks will be required to clear their
checks and this is where problems might occur. Some banks will find that to clear checks
they are forced either to sell assets or to borrow the money from other banks
(remember the pool of loanable funds stays unchanged).
Obviously, all this will put an upward pressure on money market interest rates and in
turn on the entire interest-rate structure. Higher interest rates in turn are likely to force
marginal borrowers "out of the game." Also, some banks will go belly up as a result of
not being able to honor their checks. Ultimately this will put downward pressure on
bank lending, which in turn will offset the initial expansion in credit.
To prevent the rise in the overnight interest rate above the interest-rate target, the
central bank will be forced to pump money. Once the central bank pumps money to
maintain a given interest rate target, it in fact gives the green light to the money
multiplier process (the creation of credit out of "thin air"). But surely this
accommodation cannot be labeled as passive; it is very much active. Again to protect
the interest-rate target, the central bank is forced to pump money. So the conceptual
outcome as depicted by the multiplier model remains intact here. The only difference is
that banks initiate the lending process, which is then accommodated by the central
bank.
The Cliffs Notes is as follows:
Loanable Funds View:
1. Central Bank increases monetary base
2. Banks Increase Loans
Endogenous View (in practice):
1. Banks increase loans
2. Central Bank steps in to increase monetary base, preventing interest rate from rising.
There is no functional difference between the two in reality, because the central bank is beholden to
maintaining the interest rate it arbitrarily decreed at some point in the past. Thus Austrians who are
describing the world in the framework of the loanable funds model are at most guilty of not including a
simple footnote describing the functional equivalence of the endogenous view as above.
Central to that Austrian description of the world, at least in terms of economic growth, is the discussion
of savings. Roche writes:
As Mises stated in his text Human Capital:
saving and the resulting accumulation of capital goods are at the beginning of every
attempt to improve the material conditions of man; they are the foundation of human
civilization. Without saving and capital accumulation there could not be any striving
toward non-material ends.
And this is why we see so many Austrian economists argue that savings must be higher
in order to have a healthy economy or worse and that interest rates must rise in order
to fuel greater saving. In the Austrian world we must all save more before we can
become better off. This is not necessarily true though. As I explained previously:
saving does not necessarily finance investment. Lets say I spend $100 on your candy
bar and you save that income immediately. Your saving is $100 if even for the briefest
moment. In other words, your income not consumed is $100. If you then consume $50
on dinner then you dissave $50 via consumption. But that dissaving becomes someone
elses saving immediately. In other words, your saving does not increase aggregate
saving because your spending is someone elses saving. But lets say a firm invests $100
in plants and equipment. The firm has not dissaved. The firm has invested. In this
case, the firm has $100 in plants and equipment and the seller has $100 in new
income. Indeed, it is often investment that creates saving. I assure you Keynes
understood this point even if he wasnt technically a trained economist.
One of the main points of my prior piece on Keynesianism was that all progress requires sacrifice.
Academic success, for example requires the sacrifice of countless hours towards tedious study and
revision. When it comes to the economic success in improving the material conditions of man, that
required sacrifice is in the form of savings. For the benefit of the Keynesian influenced who may read
this, it may be easier to describe savings as funds used to consume of capital goods, so as to assuage
your predilection to view consumption as the key to life.
In that previous Keynes piece, I pointed out that in order to get from the current state of affairs to a
better one, there has to be investment in capital goods, production of goods and services, and
consumption of those goods in that order. In other words, consumption is the last thing that happens in
a campaign to improve the standard of living. Keynesians mistakenly treat it as though it is the first
thing. Investment in capital goods and labor precedes everything, and what funds investment are funds
that are not allocated to consumer goods, aka savings. This is why Austrians are obsessed with savings,
and are correct in doing so.
As with the endogenous money vs loanable funds debate above, the above notion of savings
faces some scrutiny when compared to actions in the real world. However, as with the loanable
funds scrutiny, the end result is ultimately functionally in line with reality. It is true that savings
dont have to rise in order to fuel investment. Lowering the interest rate through an easier
monetary policy can achieve that as well. As with endogenous money, stopping there doesnt
complete the picture. By enabling more investment through easy monetary policy, there is no
need to build savings, which can continue to be deployed on consumer goods. This keeps the
price of those goods elevated, as opposed to falling in the event savings increased. The
increased investment goes to completion, and an increased amount of goods comes onto the
market. This is where the problems reveal themselves, because the newly produced goods need
to be sold at higher prices to be profitable, owing to undertaking costs in an environment in
which prices did not fall thanks to policy. A larger quantity of goods produced combined with a
limited capacity to pay elevated prices puts downward pressure on prices, leading to inventory
build ups, layoffs and recession. Ultimately it isnt that savings are necessary to invest, but they
are necessary if one would like the resulting growth to be sustainable.
Ill close with a further analysis of Roches thought experiment to clear up some of the conceptual
issues:
Lets say I spend $100 on your candy bar and you save that income immediately. Your
saving is $100 if even for the briefest moment. In other words, your income not
consumed is $100. If you then consume $50 on dinner then you dissave $50 via
consumption.
Correct, although for clarification Id say simply: in consuming dinner for $50, you are saving the other
$50.
But that dissaving becomes someone elses saving immediately. In other words, your
saving does not increase aggregate saving because your spending is someone elses
saving.
The dinner consumption does represent the instant saving of the restaurant, sure. At this point the
original $100 in savings is split between your savings of $50 and the restaurant who now has $50 in
savings at this exact moment.
But lets say a firm invests $100 in plants and equipment. The firm has not dissaved. The
firm has invested. In this case, the firm has $100 in plants and equipment and the seller
has $100 in new income. Indeed, it is often investment that creates saving.
Roche is correct in saying that by spending on capital goods, the firm has invested. However, in the case
of the restaurant owner and me, our combined savings of $100 are funds that are simply not invested at
this point in time. It could be that we both put our money into the bank. Without rehashing the loanable
funds controversy again, in order for the bank to pay us a return on our savings, the bank has to make
loans itself, which it does, with our savings as part of the reserves it uses to do so. The bank could have
in fact loaned the $100 to the firm in question (hey, he never said where the firm got the money from!).
The bottom line here is that the restaurant owner and I are simply a step removed from the investment
process. Were not directly involved in the investment, but we gave funds to someone else (the bank)
who gave those funds to someone else (the firm) who invested.
Keynesians trip up on this because if youre not the one doing the direct investment, your actions dont
show up in aggregate demand, or GDP or other similar statistics. But the reality is that they do play a
functional role in the advancement of economic growth.