After the Great Depression broke out, American economist Irving Fischer championed a view of the financial system now called “endogenous money“, which sees each person in the economy as a creator of credit. Viewing the economy through this lens leads to a number of conclusions that are at odds with economic orthodoxy, particularly regarding the ability to generate a credit accelerator by adding reserves to the financial system. The endogenous money view also has some interesting things to say about the role of fractional reserve banking as a credit accelerator, which is where I want to focus here.
Let me lay out the endogenous money view in layman’s terms here. In a credit-less society, production would always be consumed out of current or saved income. If I grow wheat, I might have the capacity to produce 10 bushels of wheat. But, if only 8 bushels are needed, I am only going to make 8. Sure, I could produce 10 bushels of wheat, consume 8 and stockpile 2 as inventory. But, those two bushels would eventually have to be consumed later or they would go bad. The point is that, in a credit-less society, if you wanted to buy those two bushels of wheat, you would need to do so out of accumulated income and savings.
If, on the other hand, I accept an IOU from you for the two bushels, I have effectively increased my production by 25% and can continue to do so as long as our credit arrangement is in place. That’s what the credit accelerator is all about. Credit effectively increases production. So, credit is very important to the degree it is driven by the desire of individuals and firms to consume now in anticipation of future profit or savings that today’s consumption facilitates. If you run a business, you can borrow today with an IOU in order to innovate, increase efficiency and production a lot more than if that credit didn’t exist. Economic growth is highly dependent on credit growth then because credit adds directly to current production. And long-term economic growth is therefore highly dependent on properly allocated credit decisions since you may or may not successfully innovate and increase efficiency and production with the credit you receive. So that’s credit.
The crux of endogenous money is that the economy is credit demand driven and not credit supply driven. What that means is that we are all economic agents who individually increase real economic activity simply by demanding more money credit. You and I individually have the ability to increase economic growth simply by asking for and receiving a loan on credit. Thinking about this in terms of the real economy instead of the financial economy makes this clear. In the original example I gave, I had the capacity to produce more but the demand for that production was limited by current and saved income. If you gave me an IOU to pay for additional production, I could produce it and instantly we would have greater economic growth simply because of your demand for credit.
Now I could sell your IOU to someone else to pay for goods and services if your word is good. That IOU is money – and I can use it to buy things. Notice that the supply of credit in the form of accumulated savings had nothing to do with anything that happened. No accumulated savings is necessary for this to happen; the credit itself creates the money. That’s endogenous money.
The Financial System of Endogenous Money
Thinking about this in terms of the financial system, it becomes clear then that the loanable funds model of the world in which banks act as intermediaries between people with accumulated savings and people who want or need credit is fatally flawed because the accumulated savings is not necessary for a credit transaction to occur. In the financial world, loans create deposits, just as in the example above your IOU became money as soon as our credit arrangement was made.
The big difference between the example above and today’s world is that for the United States, we live in a US dollar currency area in which the US government is the monopoly issuer of legal tender, requiring anyone that pays taxes to expunge that tax liability in US dollars or face imprisonment for not doing so. That means that the government’s credit is “good” in that it issues IOUs in the only acceptable form of payment and tax in its jurisdiction.
And let’s remember that if money is endogenous, then bank reserves are the effect and not the cause of the demand for credit. Simply put, when thinking about the financial system, banks are never reserve-constrained. They may be capital constrained but they are not reserve-constrained. Reserves really don’t matter except as a vehicle for a monopoly supplier of those reserves (i.e. the central bank) to hit an interest rate target.
The Financial Crisis and Endogenous Money
What does all of this mean in the context of today’s financial crisis? See here for the last discussion on this at Credit Writedowns. Here are the most salient points on the crisis that come to my mind:
- Monetarily sovereign governments cannot go broke involuntarily. I think, first and foremost, we have to think about the difference between a currency user like Greece and a currency issuer like the United States because even well-respected economists like Ben Bernanke make irresponsible statements conflating the issues that Greece faces with the ones that the US faces. The fact is the US only has liabilities in a currency it creates. It can’t default involuntarily on those liabilities since it can simply create more IOUs to replace the IOUs that fall due.
- Central banks control short-term rates AND dictate the term structure. We know that central banks set short-term interest rates by controlling the loan rate for overnight money, called the Fed Funds rate in the US. But the important thing to note is that this has a controlling influence on the term structure of interest rates as well. Long-term interest rates are a series of future short-term interest rates. And since bond market participants know that the Fed controls short-term rates, long-term rates predominantly reflect market participants expectations of future short-term rates, with a bit of margin for risk and the preference for short-term IOUs over longer-term ones.
- The currency is the release valve for currency revulsion. Clearly, an entity that manufacturers an increasing number of IOUs can find that those IOUs lose value in the minds of their counterparties or the general public. It’s no different for sovereign governments. Yes, the fact that you and I can only transact and must also pay a tax liability only using one of those government IOUs gives that IOU value. But, others abroad, who don’t have those constraints, will value those IOUs less, if their quantity increases enough. Put simply, holders of the government’s IOUs will develop currency revulsion and the result will be a depreciated currency and inflation, but not increased interest rates since the central bank has controlling influence on interest rates in its currency area as outlined in the paragraph above.
- The central bank’s adding bank reserves is not inherently inflationary. This means quantitative easing is not inherently inflationary except to the degree it changes private portfolio preferences or impacts commodity price inflation. The notion that adding reserves is inflationary because bank reserves provide the kindling for loans is the tail waging dog thinking of economic orthodoxy. You and I know that’s not true at all since money is endogenously determined by our collective demand for credit at prevailing interest rates. The central bank, as a monopoly supplier of reserves, is interested in controlling price i.e. the overnight rate of money and the interest rate term structure that results from this. Basic economics tells you that a monopolist which controls price cannot control quantity. In the context of the central bank and endogenous money, this simply means that the central bank must supply the banking system with all the reserves it requires to meet credit demand of credit worthy borrowers at the specific reserve requirement ratio and interest rate the central bank has set. Of course, the central bank can always change reserve requirements or overnight rates as it chooses. However, a central bank would be unable to control the interest rate for overnight money unless it supplied all of the reserves demanded by the financial system. The reason so many excess reserves are piling up is that central banks are manufacturing more reserves than are warranted by the demand for credit.
Fully Reserved Banking and Endogenous Money
That’s why I keep banging on about the demand for credit by creditworthy borrowers. Clearly, uncreditworthy borrowers – or the borrowers that financial institutions fear are uncreditworthy – have an infinite demand for credit because that credit can supply them with a limitless capacity for current consumption. However, banks remain solvent by supplying credit only to those entities which can repay their IOUs or by selling the IOUs on to less discriminating creditors. Eventually, the uncreditworthy default and their credit is then cut off, turning the credit accelerator into a credit decelerator. That’s what this financial crisis is all about. And economists and policy makers are looking for ways to stop the credit deceleration process from occurring and to stop this kind of crisis from re-occuring.
One way some economists believe we can stop this kind of crisis from happening is to move to a fully reserved banking system. In such a system, the full amount of liabilities are held in reserve as cash or highly liquid assets. The benefit of this kind of system is that it limits the number of banks that can fail from a lack of liquidity. Now clearly banks in a fully-reserved system could still fail because banks could still grant credit to enough borrowers that defaulted to cause a huge hole to open up in the bank’s balance sheet and precipitate a bank run. But, the thinking here is that bank runs would be more limited in nature since other banks would be fully reserved. The need for a lender of last resort would be diminished if banks were not at as great a risk of failure due to liquidity crises.
Nonetheless, it is clear that financial institutions like Lehman, HBOS, Anglo Irish, or Bankia would have failed without government intervention given the size of the holes in their balance sheets. Moreover, it is also clear that in each of these cases, other banks of a similarly precarious capital position would have suffered bank runs without intervention because they had the same or similar lending profiles. But I think the point still stands that more cash and liquid assets would certainly make bank runs somewhat less problematic. The first problem is that getting from here to there would be onerous. It would mean a huge downshift in credit availability, a credit decelerator worse than the Great Depression. The second problem of course is that it would reduce the profitability of banking and restrict credit growth in the future.
Or would it? Another argument in favour of fully reserved banking upon which endogenous money has implications is the argument that fractional-reserve banking increases the money supply. The theory relies on the loanable funds view in which the amount of reserves is the crucial variable for whether credit is created. But we know that is not the case.
Let’s take the existing financial system in which the central bank targets interest rates. In this example, I am a creditworthy borrower and I approach US Wells First City Bank of America for a loan. US Wells First City (UWFC for short) is fully reserved as required by law. So when I come to the bank for a loan, it doesn’t actually have the reserves to make me a loan. Under the theoretical view of credit being restricted by fully reserving, I wouldn’t get the loan. But, of course, that’s not how it works in the real world. In the real world, UWFC would simply borrow the reserves from another bank or from the Fed and stay fully reserved. The Fed would add reserves to the system as demanded by financial institutions in aggregate in order to maintain its interest rate peg.
Let’s take a 100% gold-backed fully reserved financial system as an example of how endogenous money would work. In this example, again I am a creditworthy borrower who approaches UWFC for a loan. UWFC doesn’t have the reserves to deal with this transaction. But because gold is a fully financialised commodity that is bought and sold, it is pretty easy for UWFC to buy gold on the spot market in order to increase its reserves or to borrow the reserves from another bank the way that banks borrow US dollar reserves now. And what would happen if UWFC bought or borrowed reserves.The price of the reserves would increase. That is to say the price of gold would increase by enough to increase the existing value of reserves in the financial system to accommodate the new loan. UWFC would be fully reserved as the price of its existing gold reserves would rise enough for it to make the loan to me and maintain its fully reserve status.
So, a fully reserved banking system, even one backed by gold, doesn’t actually reduce credit growth because money is endogenous. The financial system is simply the mechanism used to facilitate easy transfer of money and credit. If money is endogenous, then reserves in any financial system will always expand to meet the demand for credit. Fully reserving the banking system will not change this.
My conclusion here is that the notion that the central bank is solely responsible for the financial crisis, general capital misallocation or the credit and business cycle generally is patently false. Yes, central banks aided and abetted the crisis. I would go as far as to say, interest rate policy was a principal cause of the crisis by encouraging excess cedit growth and capital misallocation. My personal view is that central banks should be severely circumscribed in their policy actions beyond their role as lender of last resort. However, evidence from 19th century US financial history supports the notion that the absence of a lender of last resort made things considerably worse in the fractional reserve banking system of that time. Moreover, it should be clear that, because money is endogenous, fully-reserved banking is no panacea. The credit cycle is a natural part of any advanced economic system, all of which use credit. “Ending the Fed” will not end the credit cycle. But it will create unnecessary systemic risk by eliminating the lender of last resort.