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Interpretations from Irving Fisher and Joseph Schumpeter 1. Introduction

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Interpretations from Irving Fisher and Joseph Schumpeter 1. Introduction The role of banks in crisis occurrence: interpretations from Irving Fisher and Joseph Schumpeter Timothée Coulibaly1 and Matthieu Llorca2 Draft version Paper to be presented at the 23rd ESHET Conference (2019) at Lille Abstract: This paper investigates the relationship between money creation by banks and economic and financial crises occurrence with a particular focus on the works of Schumpeter and Fisher. What first stands out in the analyses of ideas of both authors is, their disagreement concerning the roles that banks play in crises occurrence in the financial sector. For Schumpeter (1911; 1939), money creation by banks allows for economic development whereas for Fisher (1935) it worsens economic fluctuations. Differences in research agenda of the two authors make it possible to reconcile these viewpoints and identify common causes as well as aggravating factors to crises. Subsequent sessions of this paper explore approaches that could offer options to reduce the likely occurrence of crises. Keywords: Schumpeter; Fisher; Banks; Crises; Cycles 1. Introduction Since the global financial crisis of 2008, it is observed that there is a renewed interest in scholarly literature in the analysis of economic and financial cycles; and the relationship between both concepts, also called macro-financial linkages (Claessens et al., 2012)3. Several authors showed evidence of negatives effects of financial crises on economic activity suggesting causality going from financial factors to real factors (Jordà et al., 2013). Financial crises are often followed by recessions with severe decline in economic activity and slow recovery than normal recessions. Causality also goes from real sector to financial sector. Real 1 [email protected]. Laboratoire d’Economie de Dijon (LEDi) | University of Bourgogne Franche-Comté 2 [email protected]. Laboratoire d’Economie de Dijon (LEDi) | University of Bourgogne Franche- Comté 3 Borio (2014) provide a review of empirical studies of macro-financial linkages. 1 business cycles theory explains economic fluctuations largely by real factors. Financial factors play little or even no role in these fluctuations. This bidirectional link makes a need for better understanding of macro-financial linkages. An important cause of financial crises recognized in literature is credit boom (Demirgüç-Kunt and Detragiache, 1998; Schularick and Taylor, 2012; Drehmann et al., 2012; Aikman et al., 2014). This suggests a role of banks in crises occurrence. Credit booms often end with financial crisis followed by negative effects on economic activity. Through financial accelerator, financial sector can amplify economic shocks (Bernanke et al., 1999). When agents in real sector have financial constraints, their financial leverage to financial sector become large, thereby increasing linkages between real and financial sectors. Theoretical literature on the function of banks in the economy focuses the analysis on intermediation function. Banks are intermediaries whose business is to collect deposits and undertake maturity and liquidity transformation regarding their information provision4. Money creation has little place in these analyses despite the fact that banks create money (Werner, 2014). This function of banks is recognized by central bankers, heterodox economists following Keynes and several authors of twentieth century including Fisher and Schumpeter (Jakab and Kumhof, 2015; Werner, 2016)5. Money creation is done through credit creation. This suggest therefore a link between money creation by banks and credit boom. An issue arises on the role of money creation by banks in occurrence of economic and financial crises and cycles. It is then important to take into account money creation by banks in analysing macro-financial linkages and cycles. This can be done through Fisher and Schumpeter’s works, considering that they describe the practice of money creation by banks; give an explanation of the role of banks in economic fluctuations; and provide solutions to alleviate fluctuations. Schumpeter shows an important role of banks in economic development through money creation. Banks are not simple intermediaries but their money creation function allows for economic development by extending means of payment of the economy. Banks create money to finance entrepreneurs carrying innovative plans. These new means of payment 4 See Diamond and Dybvig (1983); Diamond (1984); Bond (2004). Fama (1980) shows that when competitive, banks’ activity is compatible with general equilibrium and Modigliani-Miller theorem on the pure irrelevance of pure financing decisions. Bhattacharya and Thakor (1993) provide a review. 5 Schumpeter (1954) mentions that the idea that money is not irrelevant in the economy prevails among economists in twentieth century. 2 create an ad hoc situation that enables entrepreneurs to pursue new forms of production and realise “different combination of means of production” (Schumpeter, 1911, p. 65). According to Schumpeter (1911), determinants of cycles are related to real factors. Through, his creative destruction concept, he further shows that cycles and crises are normal phenomena in economic development process. In contrast, for Fisher money creation by banks amplifies cycles and explains large economic fluctuations and depressions. In The Purchasing Power of Money (Fisher, 1911), he shows that variations of money have only effects on price level in the long term. This suggests there are no effects of money on production in long term. In his 1930’s works, Fisher shows that price level fluctuations are caused by money creation by banks. Inflation and deflation are induced by money creation by banks thus, the root causes of inflation and deflation are the negative effects of economic decisions that is reflected through money creation by banks: This ability of banks to create money causes runs and panics on banks. According to Fisher, solution to economic fluctuations and crises, would come from banking reforms which should aim to confine banks to their intermediation function and return monetary creation prerogative to public authorities. Schumpeter’s proposals have not shared much on how to avoid crises as he sees crises as normal occurrences; however, he shared views to alleviate fluctuations and crises causing by factors that he called “abnormal process”. In this respect, similarities can be noted in both authors’ ideas about economic fluctuations. Schumpeter’ abnormal process can be related to Fisher’ over-indebtedness stated in the latter’s debt-deflation theory. Another difference between the authors is related to their difference in research agenda. The starting point of cycles corresponds with innovation according to Schumpeter and Fisher. But Schumpeter’s aim is to find “real” factors of economic development whereas Fisher identifies monetary factors of economic fluctuations. We begin in section 2 by presenting the theoretical roles of bank in both authors’ ideas, specifically we examine the roles of money creation and the money creation practices by banks. In section 3, we present determinants of cycles and crises, and how both scholars analyse the role of money creation by banks as cause of economic fluctuations; correspondences are also showed. Section 4 provides proposals to deal with economic and financial crises. 3 2. Role of bank and money creation 2. 1. Bank according to Schumpeter The role of banks according to Schumpeter is related to economic development. In his Theory of Economic Development, Schumpeter (1911), explains economic development with the concept of stationary equilibrium. In this regard, the economy is considered as a real economy of exchange. Property is private and the economy is characterized by labour division and free competition. Economic activity is as a circuit and is consistent with Say’s law. In this sense, he says that “… a demand is, so to say, ready awaiting every supply, and nowhere in the system are there commodities without complements” (Schumpeter, 1911, p. 8). Circuit is static because agents’ behaviours are not subject to significant changes. Production is made by following producer’s experience based on past quantities requested and prices. A need for money comes about when determining value of goods produced in relation to production factors; labour and land (Schumpeter, 1911, pp. 30-31). Circuit replicates itself or is extended through an increase of population or a renunciation of present consumption in favour of a rise in the production of goods to get more goods in the next period. Banks’ function in this circuit is to provide a better allocation of savings (Schumpeter, 2005, p. 157). Banks’ activities would thus consist an optimal allocation of savings. Schumpeter offers an explanation of economic development in which innovation plays a key role. According to him, innovation is “the setting up of a new production function” (1939, p. 87). The term covers introduction of new products or production methods, opening of new markets and new forms of organization. Through innovation, the amount of goods and services produced increases when using the same proportion of factors of production6 as those used in a static economy. The increase in production through “new combinations” of factors of production is done by a special category of economic agents namely entrepreneurs. For Schumpeter, it is the entrepreneur who innovates and allows the circuit to extend or move. Entrepreneur in Schumpeter idea refers not only to an individual person
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