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 Bernanke’s 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.

I’ll get to endogenous money in a bit, for now let’s look at the Murphy’s 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 Murphy’s 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 wouldn’t 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, Sotheby’s auctions and Maserati dealerships, for example.

Roche continues:

But that’s not what’s 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 England’s 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, and it is a cornerstone of the Austrian view. However, he quotes Mises talking about something different, savings being the foundation of economic growth. The latter is actually a cornerstone of Austrian economics, which I’ll 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 aren’t 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 described 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.  Let’s 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 else’s saving immediately.  In other words, your saving does not increase aggregate saving because your spending is someone else’s saving.   But let’s 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 wasn’t 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 capital goods,’ so as to assuage the predilection to view consumption as the breath of 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 don’t 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 doesn’t 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 the reality of 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 isn’t that savings are necessary to invest, but they are necessary if one would like the resulting growth to be sustainable.

I’ll close with a further analysis of Roches’ thought experiment to clear up some of the conceptual issues:

Let’s 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 I’d say simply: in consuming dinner for $50, you are saving the other $50.

But that dissaving becomes someone else’s saving immediately.  In other words, your saving does not increase aggregate saving because your spending is someone else’s 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 let’s 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. We’re 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 you’re not the one doing the direct investment, your actions don’t 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.

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6 comments

  1. You picked the worst part of the recession for your charts – zoom out and even just on the S&P alone you’ll see that it took until May of last year just to reach the 2000 and 2007 peaks. So by charting I can prove we’ve had ZERO inflation. So my impression of your article is that you’re really not out for the truth and I stopped reading.

    1. What do you mean by ‘zoom out?’ Roche quoted an article making a prediction about prices of assets and other things like food and gas. To test the validity of that prediction, it would make sense to start from the date the prediction was made, which I did to the exact date. Your criticism is vastly misplaced.

  2. “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.”

    No, it’s a cycle. It’s only for intellectual convenience that we talk about the first thing that happens in a cycle.

    Before you invest in capital goods, you must be convinced that enough people will pay enough for those goods that you can sell them for an acceptable price.
    Demand precedes investment in the cycle. If demand is too low you will not invest. But of course, if production is too low a lot of people will be too poor to consume. And if investment is too low then production is limited.

    It’s a cycle and all the parts need to be in balance. When consumption is too high so that investment is too low, that’s bad. When investmente is too high and consumption is too low, that’s also bad.

    It cycles best when all the parts are balanced.

    1. J Thomas. Thanks for the comment. I do understand your point, and wrote about it in the previous post I mentioned. Here’s the excerpt dealing with your concern:

      “Said differently, investment precedes production, which always precedes consumption. Thus the act of consumption cannot ‘drive’ investment. Seeing that consumers are clamoring for a product or service might cause a producer to think ‘hmm maybe I should produce that product,’ but at the exact time of that revelation, no product had been produced. What spurs the producer into action is the desire (expressed or anticipated) consumers have for a product. Desire is not the same as economic demand, which can only be expressed after the producer has invested in and produced the product, which can then be exchanged for money. A misunderstanding of this concept tends to lead a lot of Keynesian analysis astray.”

      https://thedismaloperator.wordpress.com/2014/03/18/is-keynesianism-misrepresented/

      We’re on the same page seemingly, except where you say ‘demand’ you really mean ‘desire’

  3. I guess I mean predicted demand. It isn’t just guessing that people will want the product, but that they will buy it.

    Meanwhile for consumers it’s more complicated. If they think hard times are coming when it will be harder to get necessities then they’ll reduce their debt and try to save.

    On the other hand If they expect good times and they think a better asset is about to be released, they might wait and buy the better one later, or they might not.

    Meanwhile JIT production doesn’t need to predict as much. To some extent they can just make stuff as fast as it sells. I expect this is easier with more automation, because then you aren’t as much keeping your workforce guessing how much work they’ll have.

  4. Hi there, after reading this remarkable piece of writing i am too delighted
    to share my experience here with mates.

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