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Home , Endogenous money

Endogenous , circuits and financialisation

Malcolm Sawyer

January 2013

Abstract: The paper locates the endogenous money approach in a circuitist framework. It argues for the significance of the credit creation process for the evolution of the economy and the absence of any notion of ‘neutrality of money’. Clearing banks are distinguished from other financial institutions as the providers of initial finance in a circuit whereas other financial institutions operate in a final finance circuit. Financialisation is here viewed in terms of the growth of financial assets and liabilities, of non-bank financial institutions and changes in the predominant flow of funds between firms, households and rentiers. Some of the issues for the way in which the circuit analysis is developed are considered.

Key words: endogenous money, monetary circuit, financial instability Journal of Economic Literature classification: E40, E44

Address: Division, Leeds University Business School, University of Leeds, Leeds LS2 9JT, UK Email: [email protected] Endogenous money, credit and financial instability Malcolm Sawyer1 1. Introduction It is generally recognized in post Keynesian circles that money is credit money created through the processes of the banking system (‘endogenous money’). This observation places banks centre stage with regard to the expansion of economic activity. The loan— credit has also been generally, but not universally, associated with investment expenditure as resulting from the . As Kalecki observed ‘the possibility of stimulating the business upswing is based on the assumption that the banking system, especially the , will be able to expand credits without such a considerable increase in the rate of . If the banking system reacted so inflexibly to every increase in the demand for credit, then no boom would be possible on account of a new invention, nor any automatic upswing in the ’ (Kalecki, 1990, p.489). Decisions by banks on the provision of credit is not only a matter of the quantity (important as that is for the level of demand and thereby the level of economic activity) but also on the composition of credit recipients with regard to, for example, different types of business, different groups in society, ethnic and gender composition etc.. In a monetary production economy, the endogeneity of money recognises that money creation is an integral part of the ways in which that economy operates, rejecting any notion of the of separation between the real side and the monetary side of the economy, with the structure and evolution of the economy impacted by the credit creation process. Thus unlike the ‘weak’ endogeneity introduced by new in its ‘new consensus ’ mould where the effects of is limited to the rate of interest (in contrast with the fascination of with the quantity of money) with little consideration of how the loans (and thereby money) enters the economic system2. The

1 This paper reflects research being conducted within the project Financialisation, Economy, Society and Sustainable Development (FESSUD) (www.fessud.eu) which is a five year project funded by the European Commission Framework Programme 7 (contract number 266800). Discussions with Marco Passarella have informed the work here though without implicating him in the use to which I have put those discussions. I am grateful to Phillip Arestis for comments on earlier draft. 2 In the new Keynesian version, monetary policy can be represented by the (as set by the central bank) and the residual nature of the stock of money is recognized but a loanable funds approach to and investment is retained, and the processes by which money created is largely ignored. See, for example, Arestis and Sawyer (2005) for comparison between endogenous money as viewed by post Keynesians and by

1 stock of money is treated as something of a residual dependent on the ‘’ (and as we argue below there is not a ‘demand for money’ in any genunine sense in a world of endogenous money. Romer argues that ‘The key assumption of the new approach is that the central bank follows a real interest rate rule; that is, it acts to make the real interest rate behave in a certain way as a function of macroeconomic variables such as and output. This assumption is a vastly better description of how central banks behave than the assumption that they follow a rule’ (Romer, 2000, p.154)3. This may be so but it clearly puts the source of a horizontal supply of money curve as the behaviour of the Central Bank, and does not seriously consider the role of the banking system and their ability to create bank deposits Much of the focus of attention of the debates over endogenous money has been on the relationship between the loan rate of interest (viewed as a mark-up over the Central Bank policy interest rate) and the quantity of loans, and then by extension the quantity of money. This was reflected in the title of the first major book on endogenous money (Moore, 1988) – Horizontalist and Verticalist—with its advocacy of viewing the money supply as horizontal (in quantity of money, interest rate space) rather than the vertical money supply curve in the monetarist and related literatures. It developed in the debates between accommodationists and structuralists (e.g. Pollin, 1993, Lavoie (2006) and Dow (2006) for contrasting positions). Following Fontana (2004) those differences can be seen as relating to different modes of analysis with ‘[t]he disagreement between horizontalists and structuralists arises from the particular assumptions made about the general state of expectations of economic agents. Horizontalists rely upon a single-period framework that is built on the assumption that the state of expectations of all agents involved in the money supply process is given and constant’. Further, ‘structuralists depend on a continuation framework that explicitly takes account of the fact that the state of expectations of agents

the ‘new consensus macroeconomics’, and the different policy approaches which flow. For the determination of the rate of interest, the NCM has in the short-term a rate set by the central bank (presumably in pursuit of inflation targeting), around a ‘natural rate of interest’ which comes from a sort of loanable funds approach located in a non-monetised economy. 3 This type of approach suffered from an inadequate treatment of how base money would be translated into broader money. Usually, there would be some appeal to the credit between base money and some broader definition of money, but the mechanism whereby banks would create loans in response to the demand for loans and the links thereby between expenditure and money creation were generally ignored. Indeed in the NCM in general there are no banks!

2 may change in the light of realized results. In this way, structuralists are able to tackle controversial issues related to shifting monetary policies, liquidity and the credit–deposits nexus that are ignored in the horizontalist approach’ (Fontana, 2004, p.382). We have in any case argued elsewhere (Sawyer, 2008) that the supply curve when the actual supply is undertaken to meet demand takes on a horizontalist appearance in the sense that the at which a firm is willing to supply is set at the beginning of ‘the day’ and within that day supply is made to meet the demand which is forthcoming. The supply curve of, for example, a restaurant will have that horizontal appearance in that the are set at the beginning of the trading period and then any demand which is forthcoming at those prices is met (up to the capacity of the restaurant). One question is then the basis on which the price is adjusted in light of experience—if demand each day is persistently higher than expected when the price was set, at what point is the price changed; if the costs of production change at what point is the price changed. There are obvious implications for banks setting the loan interest rate, and the responses of that interest rate to changes in the central bank policy rate. In this paper, we do not explore the ways in which banks set the loan interest rate, and treat the question of whether the supply of loans can be regarded as horizontal or not as a secondary issue. It is also the case that we do not delve into how and why the central bank sets the interest rate, though this may have significant implications for the way in which the economy operates. Over the course of the cycle, the ways in which banks adjust the loan interest rate and the factors which influence the banks decisions, in conjunction with the decisions made by the central bank on the policy rate of interest will have consequences for the precise manner in which the business cycle develops. The focus of our discussion here is on the workings of the monetary circuit. The creation of money through the loan process is, of course, only the start of a process, and the circuitist approach4 provides clear expression of the loan creation and destruction processes. The endogeneity of credit money and the circuitist approach are general ideas which have to be applied to specific sets of circumstance. In this paper, we argue that features such as (i) the purposes for which loans are provided (investment purposes, consumption, or purchase of existing financial assets), (ii) the relationship between the

4 See, for example, Gnos (2006), Realfonzo (2006) and Graziani (2003).

3 financial sector more generally and the banking sector, (iii) the identity of savers and investors (that is those making fixed capital formation decisions). The ‘realities’ of the financial developments differ across countries, and those which are reflected here relate to the USA and UK economies. This should not rule out similar developments in other countries though we know that there are significant differences, e.g. in the role of the stock , in attitudes towards household debt. The terminology with regard to money and to banks can be problematic. With regard to money, of the three features which are usually quoted – , or means of payment, store of or store of wealth, the key one for the circuit analysis is the role of means of payment. In that regard, when we speak of money without qualification we mean (in the present context) a monetary aggregate close to M1, that is those financial assets whose price in terms of the unit of account is fixed and which can be readily transferred between economic agents and is accepted as means of payment (including most significantly the government). There are, of course, many other monetary aggregates, but which (apart from the M1 component) cannot be directly transferred between economic agents, albeit that in many cases the individual holder of the monetary aggregate can readily switch her financial assets from the broader monetary aggregate into M1. But as a means of payment it is the M1 definition which is appropriate: the switch of deposits between a measure such as M2 and M1 would be equivalent to a loan being granted in so much as the spending of the M1 thereby created would be the start of a circuit. In a similar vein, in economic terms banks are those institutions whose liabilities are generally accepted as a means of payment, and their ability to create money through the loan process is fundamental. A loan does not create money (in the form of a bank deposit) unless the institution who creates the loan is also one whose liabilities (bank deposits) are treated as a means of payment (hence money). In general, a financial institution which is able to create money (in this sense) also carries out a range of other functions as well. But there are a range of financial institutions which are not able to create money as their liabilities are not treated as a means of payment, and serve only to re-cycle deposits as loans and other forms of lending (and may provide other financial services). In common usage and in legal terms the term bank is used more widely to include institutions which accept deposits and which provide loans and other credits, and undertake

4 other financial services. Banks on this broader view combine, often within a single institution, the loans creation process and the matching of borrowers and lenders (often identified with investment and savings). The term clearing bank is used to refer to a financial institution or part of a financial institution whose liabilities are accepted as means of payment and which can be readily transferred between economic agents. The term investment bank is used to mean financial institutions which accepts deposits and provides loans and credit but whose liabilities are not treated as a means of payment. For the purposes of analysis the clearing bank functions are to be separated from the investment bank functions, which means that a single financial institution incorporating both sets of functions would for analytical purposes be regarded as two separate, albeit linked, financial institutions. In the context of the monetary circuit, it is the clearing banks which are at the start of the process, provide loans which generate bank deposits (and thereby money), that is ‘initial finance’, whereas it is the investment banks (and other financial institutions) which are involved in ‘final finance’. 2. Endogenous money and the simple circuit The ideas behind the monetary circuit analysis and endogenous money are closely related, and the analyses of endogenous money depend on the nature of the monetary circuit into which it is placed. We begin by considering a simple monetary circuit and in a later section discuss how the monetary circuit analysis should be developed in light of the processes of financialisation. ‘The MCA [monetary circuit analysis] describes the functioning of a sequential economy, which involves three macro-agents: banks, firms and workers. The banking system creates money, ex niholo, in accordance with the idea that loans make deposits; firms pay and produce commodities; and workers supply labor power’ (Forges Davanzati, 2011, p. 34) The simple view of the circuitist approach could be summarized as follows. It is set in an endogenous money system in which banks play a central role in the provision of credit. A firm approaches a bank for a loan in order to undertake investment; provided that the firm and its proposals are deemed credit-worthy, the bank provides the loan. For the bank, it sets an interest rate at which it will provide loans to credit-worthy customers, and in effect operates in a ‘horizontalist’ manner in the sense that having set the interest rate it meets the demand for loans with which it is presented (or more that the interest rate on loans is

5 set for each credit rating category, and requests for loans which are deemed credit worthy met at an the interest rate set for that credit rating category). For simplicity a single loan interest rate is invoked here, but the essential argument would not change if there were a number of loan interest rates each for a specific risk-class of customer. The loan interest rate is subject to change by the bank, and such change can be triggered by a change in the Central Bank policy interest rate, by the bank reassessing its liquidity position or its perceptions of the demand for loans. The circuit opens, the firm purchases investment utilizing the loan, corresponding bank deposits are created (hence money supply expands), the bank deposits circulate as a means of payment. The investment expenditure generates production and employment, wages are paid to workers who spend most of the money received and save the remainder. Endogenous money is created by banking system through loans to firms. It necessarily involves a credit/debt relationship – raising the relationship between lender and borrower and the basis of which credit is extended. As the loan is debt bearing an interest rate, it is (almost) inevitable that the demand for loan is closely linked with plans for expenditure, though as we will suggest below the expenditure can be on , on labour or on acquisition of financial assets. It is a part of a monetary system – a circuit. Loans are extended and repaid, money is created and destroyed. It should be noted that the terminology from exogenous money still infects endogenous money5. Godley (1999, pp. 397-8) argues that ‘the term ‘demand’ for money strains language, for it badly described a situation where people aim to keep their holdings within some normal range but where the sums they end up with are determined in large part by impulse purchases, windfalls and other unexpected events’. There is not a demand for (transactions) money if the term demand is used as elsewhere in economic analysis, when money is held as a temporary convenience. Whilst there may be something which is recognisable as the supply of loan in the willingness to provide loans, banks have to accept bank deposits as the counter-part which cannot be described as ‘supply of deposits6. A circuit not only opens but, of course, also closes. Loans are taken out and then repaid, bank deposits (and hence money) created and destroyed. Money (in the form of the means

5 Sawyer (2009) for extended discussion. 6 There will though be anything which can be described as a supply function (or curve) in that banks are setting the price (interest rate) at which they are willing to provide loans.

6 of payment) is generally held temporarily between receipt and disbursement. A bank deposit only remains in existence when held by someone. An increase in the stock of money (bank deposits) clearly depends on the ‘transactions holding’ of bank deposits having increased, though hoarding of money is also possible which can disrupt the circuit (and hoarding is generally seen here as rather temporary as other financial assets are a more attractive way in which to hold savings).. This could arise, for example, if other circuits were opening up and the general level of economic activity rising. But in accounting terms, the increased holding of financial assets (that is in this case bank deposits) corresponds to savings having occurred. In order for an individual’s holding of money to have risen, their inflow must have exceeded their outflow, and savings occurred (assuming here that the inflow did not come from sale of financial assets). However, it is significant to consider the expenditure decision which is related to the commencement of the circuit and the extension of the loan. In the simple circuit outlined above the expenditure decision will be an investment one, but there are clearly other possibilities, notably consumer expenditure (debt financed), and acquisition of financial assets. The discussion here concerns a private closed economy in that government and the foreign sector are not explicitly included and extensions to government budget positions and to capital account flows will be needed with regard to the ways in which a circuit can be started (e.g. by government expenditure) and the flow of funds between sectors. We discuss first the case of investment expenditure, then consumer expenditure and finally asset purchase. In order to do so the monetary circuit has to be embedded in a broader view of the operations of the macroeconomy. Following a broadly Kaleckian approach, investment is undertaken by firms, and would generate a corresponding amount of savings (considering here a closed private economy) during the circuit, and in effect at the end of the circuit sufficient savings will have been generated to exactly equal to the investment, and hence exactly equal to the loans initially provided. The portfolio of assets and liabilities are now re- arranged—those who have saved can lend to the firms who have taken out loans, the loans repaid and on the other side of the balance sheet bank deposits be extinguished. The provision of final finance has elements of a loanable funds approach about it – the savings have been generated and now flow back into the funding of the investment which has already occurred.

7 The direction in which the funds from savings flow can be of significance. One representation is that it is households who undertake savings and the flow is predominantly from households to firms. Another representation is that savings out of wages is low and the predominant source of savings is profits (in the form of retained earnings). In either case, the volume of savings generated is equal to the volume of investment. But which of these representations holds (or indeed if others hold) has some significance. In the latter case, the volume of profits which arise is of the same order of magnitude as the investment, and for firms as a collective provides the returns from which the loan charges can be paid and repaid. In the former case, the firms have paid off loans but continue to have debt obligations now to the household sector, and the requirement to those debt obligations in the future. When a loan is taken out for consumption purposes, the circuit, of course, still operates . The differences occur with regard to the sustainability of the process, the repayment of loans and the direction of flow of final finance. Debt financed consumption is an unsustainable process since unlike investment it does not offer the possibility of generating the income from which the debt will be serviced and repaid. The acquisition of consumer debt is dissaving, and consumer spending in undertaken which generates income (in a way comparable to spending on investment) from which savings are made. Loans are issued, deposits circulate and loans repaid. It could be argued that whereas over some range investment generates profits (as in the Kaleckian equation) which form the basis of repaying the loan, consumer expenditure does not in the same way. It would be the case that a higher rate of spending by households which is debt financed would tend to generate a higher level of economic activity and of wages, but at least in simple models overall savings by households would be lower. The sustainability condition for household debt of the rate of interest on loans being less than the rate of growth (of wages) is unlikely to be met, and a consumer debt fuelled expansion will come to an end. The third case to be considered is when loans are taken out in order to purchase financial and other existing assets. Given the usual relationship between the rate of interest on loans and the rates of interest on a range of financial assets (that the former is greater than the latter), loans relating to the acquisition of financial assets will have elements of Ponzi finance about them in the sense that the acquisition is made with the perception that the capital gains from the financial asset will be sufficient to offset the difference between the

8 interest rate returns on the financial asset and the interest rate on loans. This again makes for an unsustainable process. The simple point to make here is that the identity of those receiving loans and the purposes for which the loans are used are, not surprisingly, significant for the ways in which the circuit develops. It would be the expectation that consumer debt would tend to have short- lived and de-stabilising effects on the economy; and in a similar vein loans used for asset acquisition involved in asset price bubbles. Loans for investment purposes which generate profits may be more sustainable. The savings—investment relationship is central to the monetary circuit and endogenous money. The endogenous money view fits with the investment causes savings view (of Kalecki, Keynes and others) with bank loans provide the required finance for investment to occur. In contrast the mainstream approach has portrayed a loanable funds in which savings and investment are brought into equality through the operation of the rate of interest (underpinned by a ‘natural rate of interest’ – ‘the rate of interest which would be determined by if no use were made of money and all lending effected in the form of real capital goods’, Wicksell 1936, p.102). Whilst the loanable fund approach clearly involves the transfer of funds from one group (savers) to another (investors) it cannot be said to be inherently related with a monetary production economy. The monetary circuit could be said to combine these two elements in the following sense. The opening of the circuit is clearly related (in the simple circuit) to the financing of investment, and then the workings of the macroeconomic system following the investment expenditure being carried through generate a corresponding amount of savings. When the savings have occurred, there arises the question of the form in which those savings are held in terms of the type of financial assets, and corresponding what is the form of ‘final finance’ for the investment which has occurred. There would then in effect be a financial asset circuit within which there is a matching of owners of financial assets with the issuers of financial assets. There may, of course, be mismatches through the portfolio requirements of savers being out of alignment with the array of financial assets which are offered. 3. Credit ‘rationing’ and the circuit It is widely recognized that the allocation and generation of credit cannot be understood as involving a perfectly competitive market where both suppliers and demanders face parametric prices, and more significantly there is the assumption of anonymity of both

9 sellers and buyers in the trading of homogenous commodities. The providers of loans (and funds more generally) will for rather obvious reasons have concerns over the credit worthiness of the borrower and the perceived likelihood of repayment of loan and interest. Since endogenous money is introduced into the through the loan process, the conditions under which in effect money is created have to reflect the conditions under which loans and credit are provided. But further since loans are taken out for the purpose of expenditure the nature of the economic agents who take out loans and the purposes for which they do so are significant for the ways in which the financial and real sectors interact. The availability of loans as far as an economic agent is concerned will be subject to the ‘principle of increasing risk’ (Kalecki, 1937) which applies to all forms of lending. In his words, the cost of finance facing the individual firm where ‘the entrepreneur is not cautious enough in his investment activity, the creditor who imposes on his calculation the burden of increasing risk, charging the successive portions of credits above a certain amount with a rising rate of interest’ (Kalecki, 1990, p.288). From these rather simple comments, a number of significant implications flow. First, in so far as some notion of supply of bank loans (and if the translation of loans into bank deposits is followed through the supply of money) is used7, it is not universally horizontal. This contrasts with the view of Moore when he writes that ‘The supply of credit money is never quantity-constrained in the absence of credit controls. The nominal supply of credit money is perfectly elastic at a rate based on the central banks’ administered minimum lending rate’ (Moore, 1988, p.263 Second, the decisions by clearing banks on who receives loans (and on what conditions) will influence the level of and content of investment, and thereby influence the future path of the economy. A given amount of loans (and thereby a given creation of bank deposits and money) will have different effects depending on the ways in which the loans are allocated. The notion of neutrality is in any event difficult to contemplate if that means using a non- monetary economy as the basis of comparison. But further the ways in which money is brought into the economic system influences the current and future path of the economy. Another way of expressing this is that endogenous credit money is closely bound up with a

7 See Sawyer (2008) for argument that the demand-supply terminology is unhelpful in the context of money and credit.

10 path dependency view of the economy as the ways in which money is created and spent influences the ways in which the economy changes over time. Third, the credit allocation processes depend on risk assessments which in an uncertain world can only be perceptions of frequency of default etc., rather than based on well- established probability distributions. There have been many large literatures on how banks and other financial institutions approach lending to different social, ethnic groups and gender and in effect discriminate against some and practice financial exclusion. There are other literatures on lending to SMEs (small and medium size enterprises), lending for innovation, research etc., which have tended to express concerns over the lack of finance for those type of firms and activities. Fourth, the interactions of the willingness of clearing banks to provide loans and the demands for loans to finance expenditure lie at the heart of the generation of cycles (‘booms and busts’) of economic activity. The loosening or tightening of credit worthiness criteria by clearing banks and changes in their perceptions of the default risks (dependent on the macroeconomic conditions in general and profitability in particular) lies on one side. The demand for loans (particularly related with investment and expansion of production but not limited to that) lies on the other side. This much is well-known (though it would suggest that other ideas on the generation of business cycles, e.g. Goodwin cycles based on - conflicts) have to incorporate an analysis of the banking system which permits the expansion and contraction of economic activity to occur. 4. Financialisation and the circuit Financialisation has been variously described and for our purpose that given by Epstein (2005) will serve: ‘financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies’. Of particular relevance here is the growth of financial institutions, the shifts in their main areas of operation (relatively away from the clearing banks function), and the rise in the ratios of household debt to GDP and of financial assets to GDP. There have also tended to be changes in the flow of funds between households and firms. There are three features which we suggest are relevant (noting that those features are ‘stylised facts’ which relate to a greater or lesser extent across industrialised economies, but notably the UK and the USA.

11 First, household borrowing from clearing banks and from other financial institutions has become relatively more important (as compared with corporate borrowing). Whilst the household sector usually remains a net saver (though exceptions, e.g. UK in 2007), there is substantial borrowing by households offset by other households who are (and often a household may be both dissaving as well as saving when the latter takes the form of contractual savings into pension funds etc.). Second, the financial sector has grown in economic significance, and specifically the role of investment banks, shadow banking etc. relative to clearing banks. As a minimum this reinforces the need to pay attention to the financial circuit. The growth of the role of the financial sector has included an increase in trading in financial assets (relative to GDP) whereas there has not been any substantial rise in savings (relative to GDP). The degree of intermediation has risen. The ‘final financing’ of expenditure would appear to be the portfolio arrangement of the savings which have been generated during the completion of the circuit. One conclusion which could be drawn from that is there is no notion of ‘over-savings’ (compare the argument of Bernanke and others that the can be viewed through the prism of ‘over-saving’: savings only occurs because investment has taken place (with the argument suitably amended for government expenditure). Another conclusion (or should it be question) relates to stability—that is does the portfolio reallocation generate elements of instability, or is it just a straightforward allocation. At first glance, it would seem to be the latter, which may face some issues in so far as the demands for different types of financial assets do not match the supply of different types of assets. However, the experience prior to the financial crisis may suggest otherwise, and the answer to the question may have significance for debates over separation between clearing banks and ‘casino banking’. By the former we have in mind the relative growth of financial institutions (including investment banks) relative to clearing banks, or alternatively put the clearing bank functions have declined relative to the other functions of the financial system. The growth of mortgage-backed securities, derivatives etc. has meant a rise in the ratio of financial assets to GDP and relative to the capital stock of the economy. This growth in the activities of the financial sector and the resources used in the trading in financial assets would appear to do little to increase the volume of savings and investment in the economy. In our terminology, it is the clearing banks which stand at the start (and end) of the loan process, and it is the

12 rest of the financial system which is largely involved in the final finance portfolio re- arrangement. Third, within the financial circuit the gross flow of funds needs to be examined. Traditionally the perceptions on the direction of flow have fallen into one of two camps. The one (in the simple Keynesian analysis) was the equivalent that at the end of the circuit and the ‘final finance’ the flow of funds was households (as savers) to firms (as investors). The other envisaged that retained profits would be the major source of savings funding investment. It is asserted here that the second is particularly relevant, and further there has been a tendency for retained profits to rise (as profits rise relative to income) and for investment restrained (under financialisation) leading to corporations tending to be net lenders. Investment, consumer expenditure and the circuit The initial portrayal of the circuit relates to investment undertaken by firms which is loan financed. It is often argued that consumer debt has become much more extensive than hitherto, and at least part of that comes from bank loans. The growth of consumer debt has been linked with the financial crisis with the argument that rising inequality and the stagnant real wages (at least in the USA) pushed many households to take out debt as a means of sustaining their consumption. The question posed here is what differences does it make in terms of the circuit approach if the circuit is initiated by consumer debt rather than firms borrowing for investment purposes. In the latter case, investment stimulates economic activity, profits and wages rise and savings occurs. The degree to which profits would rise would depend on relative savings habits of workers and firms. In the case where workers do not save, then the generated profits would be equal to investment divided by propensity to save out of profits. The generation of profits would provide the basis for the servicing of loans, and at the end of the circuit would enable the loans to be replaced by retained earnings as the basis of the funding of investment. Further, as Lavoie (1996) argues ‘when investment increases, profits increase as well, unless other elements induce reduced profits, such as a higher rate of savings by households or a deficient trade balance. Assuming away these external factors, the realized leverage ratio is just as likely to fall, although entrepreneurs and their bankers are willing to increase the debt ratio. Individual efforts to increase leverage ratios may lead to lower aggregate debt to equity ratios, while any effort to reduce leverage ratios may lead to higher actual leverage ratios (p.286). Debt based consumer spending has the effect of

13 raising income, wages and profits (as would be anticipated) and to some degree the higher wages enables some servicing of the debt. But it does not create a productive asset which can be the future basis of servicing of the debt. Flow of funds The flow of funds (final finance) at the end of the circuit also needs to be considered. Although the loan creation by banks comes at the start of the circuit, there are two important aspects of what in effect happens at the end of the circuit. The first of these relates to the pattern of surplus and deficit units and the flow of funds between them. The traditional view has been that the flow of funds is from households (savings) to firms (investment), though there were always post Keynesian authors who stressed the significance of retained earnings (equal to savings out of profits). The specific issue here relates to the argument that savings out of profits have tended to rise (with shift from wages to profits) and investment decline (under impact of financialisation) such that corporations become net lenders rather than net borrowers, and hence the flow of funds is from corporations to households (lending with households incurring debts), to government (who through budget deficit is absorbing net savings) and to the foreign sector. Financial sector transactions The circuit approach clearly relates to the opening of the circuit with bank loans (and money created) and then the closing of the circuit when loans are repaid (and money destroyed). Savings occur during the circuit and financial assets acquired as a consequence. Whilst loans provide initial finance, the final finance comes from the creation and sale of other financial assets. Transactions which occur within the financial sector (including the banks) as the asset (and liability) portfolios are rearranged. The role of the financial institutions other than clearing banks is then one of portfolio rearrangement rather than the initial finance for investment. The growth of the financial institutions (other than clearing banks) and the growth of financial assets (relative to GDP and to the capital stock) would then be viewed in terms of the re-arrangement of financial asset portfolios rather than the stimulation of savings or the (initial) financing of investment. 5. Concluding comments This paper would assert the significance of the endogenous money approach where credit money is created by the banking system (including the Central Bank, though that has not been given any attention here) through the loan process, and the circuitist approach more

14 generally. An endogenous money approach would necessarily cast aside notions of the ‘neutrality of money’ and should be seen as a part of a path dependency approach to macroeconomics. We have pointed to the relevance of distinguishing between clearing banks and other financial institutions where the former are institutions whose liabilities are transferable between economic agents and are treated as means of payment. Clearing banks are then the part of the financial system which is involved in the ‘investment causes savings’ perspective whereas the rest of the financial system can be viewed as involving the re-arrangement of the holdings of financial assets and liabilities. Thus the roles of the clearing banks and of other financial institutions needs to be distinguished, and that the other financial institutions operate to re-allocate savings which have already occurred (as a result of investment) and do not themselves create funds realised. The circuit approach has to incorporate the different uses for which loans are extended and the significance of different forms of expenditure for the stability/instability of the economic process. The final finance of the circuit involves flows of savings between sectors of the economy, and the significance of the direction of those flows fully incorporated.

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16 Basingstoke: Palgrave Macmillan, 2009 Wicksell, K (1936 [1898]), Interest and Prices : A Study of the Causes regulating the Value of Money, London: Macmillan : Translation of Geldzins and güterpreise; translated from the German by R. F. Kahn; with an introduction by Bertil Ohlin.

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