Endogenous money, 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: Economics Division, Leeds University Business School, University of Leeds, Leeds LS2 9JT, UK Email: [email protected] Endogenous money, credit rationing and financial instability Malcolm Sawyer1 1. Introduction It is generally recognized in post Keynesian circles that money is credit money created through the loan processes of the banking system (‘endogenous money’). This observation places banks centre stage with regard to the expansion of economic activity. The loan— credit money creation has also been generally, but not universally, associated with investment expenditure as resulting from the loans. As Kalecki observed ‘the possibility of stimulating the business upswing is based on the assumption that the banking system, especially the central bank, will be able to expand credits without such a considerable increase in the rate of interest. 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 business cycle’ (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 classical dichotomy 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 Keynesian economics in its ‘new consensus macroeconomics’ mould where the effects of monetary policy is limited to the rate of interest (in contrast with the fascination of monetarism 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 interest rate (as set by the central bank) and the residual nature of the stock of money is recognized but a loanable funds approach to savings 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 ‘demand for money’ (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 inflation and output. This assumption is a vastly better description of how central banks behave than the assumption that they follow a money supply 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 multiplier 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 preference 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 price 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 prices 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 trade 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).