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The Demand for Endogenous Money: a Lesson in Institutional Change

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The Demand for Endogenous Money: a Lesson in Institutional Change The Demand for Endogenous Money: a Lesson in Institutional Change Peter Howells University of the West of England, Bristol 1. Introduction When Davidson and Weintraub (1973) first drew attention to the endogenous nature of the money creation process they were responding to a quantity theory analysis of inflation which was popular at the time. But although their paper was a landmark in the cogency with which it put the case (and in putting it forward in a leading ‘mainstream’ journal), it was not the first to argue that a country’s money stock might be elastic with respect to the needs of trade. Traces of this view can be found in debates over the cause of inflation in Tudor and Stuart England and in the ‘banking’ and ‘bullionist’ controversies of the nineteenth century. Neither was it the last of course. In later years Chick (1986), Dow (1993), Howells (1995), Kaldor (1982, 1985), Lavoie (1984), Niggle (1991), Pollin (1991), Wray (1990) and others have all supported and refined this fundamental proposition. The greatest campaigner, however, has been Basil Moore whose 1985 book took the argument (and the evidence) to unprecedented levels of detail. So secure have the fundamentals of the argument become, that the literature in recent years has been entirely preoccupied with refinements. Furthermore, as central banks have placed a growing premium on the ‘transparency’ of their operations, it has become clear beyond the slightest doubt that central bankers regard the money supply as endogenously determined and that they accept their own role in making it so. Charles Goodhart, whose work has for years combined the analytical insights of economics with a keen appreciation of the practice of central banking has done as much as anyone to encourage a realistic approach to money supply analysis and has largely succeeded in the UK at least, by frequently denouncing the ‘misinstruction’ inherent in the base-multiplier model (Goodhart, 1984, p.188). Just ten years later he observed that ‘Almost all those who have worked in a [central bank] believe that this view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system....’ (Goodhart, 1994, p.1424). Just what those institutional features are (and how far they penetrate to the core of the modern banking system) he showed more recently in describing the arrangements that lay behind the US Fed’s adoption of the language of monetary base control in 1979-82 (Goodhart, 2002, pp.16-17). And there is nothing peculiar about the Fed. For the Bank of England we have the statement from the Bank’s Deputy Governor (now Governor) with responsibility for monetary policy. ‘In the United Kingdom, money is endogenous - the Bank supplies base money on demand at its prevailing interest rate, and broad money is created by the banking system’ (King, 1994 p.264). And Borio’s (1997) survey of central bank operating procedures in industrial countries shows that they are all essentially similar: the central banks set a short-term ‘official’ rate of interest which forms the basis for the structure of commercial rates. At that rate, the central bank supplies whatever volume of reserves is required by their banks to meet the demands of their clients. So Basil, Paul Davidson and the other campaigners were right. The money supply in modern banking systems is endogenous. The central bank sets its official dealing rate. Banks add a mark-up and endeavour to meet all the credit worthy demand for loans that is forthcoming at that rate. At the going rate of interest, the strength of this demand depends upon factors elsewhere in the economy and the supply of new loans creates a corresponding flow of new deposits. In the rest of this paper I wish to return to one of the debates which I described earlier as ‘refining’ the endogeneity theory. This concerns the demand for endogenous money or, more formally, the mechanism whereby the ex ante flow of loan-created deposits is matched, ex post, with an aggregate willingness to hold them. For five years, from 1994, Basil and I differed profoundly over this question. In addition to what we published in the journals, there is at least one substantial file of emails and faxes testifying to the care with which Basil read my criticisms and to the detail in which he (always patiently and courteously) responded. So far as theory is concerned, I still see no reason to change my original view but I do think that the last few years have seen dramatic changes in institutions, certainly in the UK, that should bring our positions closer together. This is a timely reminder of Sir John Hicks’s adage that ‘Monetary theory...cannot avoid a relation to reality...It belongs to monetary history in a way that economic theory does not always belong to economic history.’ (Hicks, 1967 p.153). In the next section I outline ‘the problem’, giving credit, I hope, to all those before me who have felt there is something lacking in the simple ‘loans create deposits’ principle. In section 3, I outline the recent changes which I think bear upon our problem and offer some concluding remarks in section 4. 2. Loans create deposits It is an obvious criticism to make of base-multiplier models of money supply determination that they are fundamentally ‘uneconomic’. The multiplier is based upon two key ratios – the public’s cash ratio and the banks’ reserve ratio – which are treated as fixed (in the simplest versions) or subject to very slow and predictable change (in more advanced versions). Both ratios, however, are the outcome of complex portfolio decisions which one might have expected mainstream economics, with its rational, maximising calculus, to be able to recognise as subject to changes in relative interest rates, risk, regulations, technology etc. Cuthbertson (1985) is an exception . 1 Furthermore, the models completely ignore all questions of the demand for money (or the demand for its credit counterparts for that matter). An open market purchase (for example) of government bonds increases the base and the money supply increases by the amount of the purchase times the value of the multiplier, with no thought given to the fact that the additional money must be held by someone. So no portfolio preferences here either. It has been my view for a number of years that Basil’s exposition of the endogeneity argument makes the same mistake, albeit starting from the opposite – credit counterparts – end. It provides a detailed and (I am happy to accept) 2 accurate account of how banks determine the amount of lending which they wish to do, in response to the demand for credit which they face. But it contains no account of how the flow of loan-induced deposits is bound to be matched by a corresponding increase in the demand for those deposits, an increase, in other words in the demand for money. Let me say at once that Basil’s account of endogeneity is not the only one to overlook this problem (and I was not the first to point it out). We return to this in a moment. But let us be clear first that there is a potential problem. The problem begins with the fact that the demand for bank loans emanates from one set of agents with their own motives (for them it is an income-expenditure decision) while the demand for money emanates from another set with different motives (for them it is a portfolio decision). Granted, the two groups partially overlap but they are not identical. So long as this distinction exists, then there must be a question of how the flow of new deposits, created by a subset of agents with income-expenditure deficits, is to be matched with the population’s desire to arrange their wealth in such a way that they are willing to hold the additional money. And hold it they must (a) in order to satisfy the banks’ balance sheet identity in which loans equal deposits and (b) because money is defined exclusively as deposits held by the non-bank private sector – in Dennis Robertson’s memorable phrase, ‘All money which is anywhere, must be somewhere’ (Robertson, 1963, p.350). So far as Basil’s work was concerned, the first person to raise question of what had become of the demand for money was Charles Goodhart (1989). The paper, in the Journal of Post Keynesian Economics , was titled ‘Has Moore Become too Horizontal’ which, given the central argument, was perhaps less appropriate than the one that Basil adopted for his 1991 reply – ‘Has the demand for money been mislaid?’. The issue that was debated in these two papers (and in Goodhart’s (1991) rejoinder) was whether or not it made sense to talk of a demand for money, independent of the money supply where credit money was concerned. If there was no sense in visualising an independent demand function for money, then there was no sense in the idea of a disequilibirum. In Basil’s words ‘One cannot have a supply of credit money independent of the demand for credit money, any more than one can have a supply of haircuts independent of the demand for them’ (1991, p.126). His argument was that, like haircuts, credit money was produced ‘to contract’ and thus supplied by banks only in response to a demand for it. But this argument, as I pointed out subsequently (Howells, p.91) contained two distinct errors. The first was that it confused ‘money’ and ‘credit’. What banks were responding to was a demand for credit .
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