Below is a guest post from Philip George, whose website is philipji.com. The post is a shortened version of a longer article you can find on his website here. Some related posts are here and here.
For nearly a century the progress of macroeconomics has been stalled by a single error, the error of regarding money as cash balances and the demand for money as the demand for cash balances. It is an error that is common to the Keynesians, the monetarists and the Austrians. And it has been taught to every economics undergraduate for generations so that it is etched into the collective consciousness of all economists.
To view it in practice look at how Milton Friedman used it. For Friedman money is an asset, one of many alternative assets, such as stocks, bonds, durable consumer goods, or even human capital. To determine the demand for money one has to compare it with the demand for those alternative assets. If Paul wishes to hold more stocks and bonds it follows that his demand for money and therefore his cash balances will come down.
So where is the error? Consider that Paul decides to hold fewer bonds than he did, preferring instead to hold more money. In Friedman’s analysis his demand for money has gone up. But the only way that Paul can reduce his holding of bonds is to sell some to Peter. So Peter’s holding of bonds goes up and his demand for money goes down. Although Peter and Paul can change their individual stocks of bonds and money, their combined stock of bonds or combined stock of money cannot change. By trading in financial assets the stock of money in the economy cannot be changed one whit.
In Friedman’s model of the economy money exists only in the form of currency. There are no banks and the only way in which money can be increased or decreased is through the agency of the central bank. To see how such a model results in errors for Austrians, see http://www.philipji.com/stupidity-of-economists.html, and for how it lands Keynesians in errors see http://www.philipji.com/paul-krugman-and-the-liquidity-trap.html.
So what is money? To answer that question, we begin with the money multiplier. In its simplest form, this is how it works. The central bank buys $100 worth of, say, government bonds, from a bond dealer. The dealer deposits the $100 in a commercial bank. Assuming that the reserve ratio is 20%, the bank has to retain $20 as a reserve; so it lends out $80. Assuming this is deposited in another bank, the second bank now has to retain 20% of this $80 as a reserve i.e. $16 and can lend out $64, which in turn is deposited in a third bank. By adding up the entire chain of new deposits it can be shown that the $100 created by the central bank’s initial purchase of a bond for $100 will result in the creation of $500 of new money.
We show the process in a simple diagram as below, where M is the reserve, m is the multiplier, and mM is the money created.
The money multiplier
So far, Keynesians, monetarists and Austrians will all be in agreement with us. Curiously none of them seems ever to have asked: What happens when this newly created money mM is spent? We now ask the question by drawing the figure below.
The money multiplier integrated with the economy
And having asked the question we are immediately confronted by a problem. At A the central bank injects M dollars into the system. The banking system, through a series of loans and deposits, converts it into mM dollars at B. When this money returns to A, it is then converted by means of the multiplier to a value of m2M at B. In the next cycle this becomes m3M at B, and on on in an ever-increasing spiral. Equilibrium, it would seem, is impossible.
There is only one way out. For equilibrium to be maintained the money created while moving from A to B must be destroyed in the movement from B to A. We answer one objection immediately. Why isn’t the entire mM dollars created at B spent? That is to say, why is M dollars retained unspent at A while moving from B to A? The answer is quite simple: in the money multiplication process described at the start of this section, when 500 dollars of new money is created, 100 dollars has to be retained by all the banks together as reserve.
The answer to the second question may be a little more difficult to appreciate. How is the amount of money mM at B destroyed so that it becomes M at A? The answer is that the destruction happens through the mechanism of saving. Each person who receives money spends some of it while saving a little and withdrawing it from the system. The total of this saving must be exactly equal to the net money created mM-M for equilibrium to be maintained. But people do not hide their savings under their mattresses. Because they are assured that the central bank will not allow the disorderly failure of banks they place their savings in the bank. We draw the result as in Fig 3 below.
Savings and money creation in the economy
Simple though it is, this is the model of the economy that has eluded economists so far. In it a) Money is created when banks lend money and is destroyed when loans are liquidated and b) Money is endogenous i.e. it can be created and destroyed without the intervention of the central bank.
Many conclusions can be derived from this model. For instance,
a) If the injection of money into the system by the central bank is multiplied by a process of bank lending, it can be sustained only if the system produces an equivalent amount of saving and this saving is loaned out again.
b) It is possible for the system to remain in equilibrium when the economy is operating at levels far below full employment.
c) It is possible to estimate the amount of money (an aggregate I call Corrected Money Supply) by estimating the amount of savings in demand deposits and by subtracting this amount from M1. See http://www.philipji.com/riddle-of-money/ For the period from 2001 to 2011 we get a graph accurately tracks the economy.
Corrected Money Supply 2001 to 2011
First a small quibble: There is no fractional reserve banking. Banks receive unlimited reserves from the Fed. It’s fractional capital banking, meaning that bank deposits are not loaned. A bank with zero deposits, but large capital, can lend large amounts.
Now, more importantly, our Monetarily Sovereign federal government (i.e. Congress) creates dollars by budgeting and spending. Each agency of the government can issue checks in payment of their bills, according to their budget. These checks actually are instructions telling the creditor’s bank to credit his checking account.
The “instructions” are created ad hoc, and are not supported by anything other than full faith and credit. They are independent of tax collections. If federal taxes fell to $0 or rose to $100 trillion, neither event would affect by even one dollar, the federal government’s ability to create instructions (dollars).
The instant that account is credited, dollars are created. The receiving bank then forwards that check (instructions) to the Federal Reserve Bank, which credits the receiving bank’s account.
In short, dollars are created in two ways: By bank lending and by federal spending. The difference is, bank lending creates temporary dollars, which disappear when the loan is paid. Federal spending creates permanent dollars.
Of course all dollars are destroyed when they are sent to the federal government for any purpose — taxes or bill payments. That is why a federal profit is an economic loss.
Rodger Malcolm Mitchell
There is no money multiplier. Savings (deposits) are not needed to create new bank money.
Bill Mitchell
Money multiplier – missing feared dead
Money multiplier and other myths
The role of bank deposits in Modern Monetary Theory
I neglected to mention there is no economic difference between personal saving and personal spending. Both involve the transfer of dollars from one hand to another.
Further, no one knows what “saving” means. See: Does personal saving stimulate the economy?
Rodger Malcolm Mitchell
The model works perfectly fine in the absence of a central bank. The reserves are the reserves of the banking system, whether mandated by the central bank or maintained by banks for reasons of safety.
Is this an exercise in history? This model might be applicable to commodity money but in the context of a non-convertible, free-floating FIAT currency this model does NOT solve the riddle of money. Instead it adds only to the confusion about what is money.
(1) There is no such thing as the money multiplier. Even the conservative economists at the FED acknowledge this: Does the Money-Multiplier exist? (PDF)
(2) Bank lending is not reserve-constrained. It is constrained by demand (credit-worthy customers) and capital (Basel). The loan officer doesn’t call the back-office whether enough reserves are available before making the loan decision.
(3) Banks don’t hold reserves for reasons of safety. The main purpose of reserves is to guarantee the settlement of the myriad of transactions between private banks. Banks prefer to minimize their reserve holdings due to opportunity costs.
PS: I do not understand your claim “this is the model of the economy that has eluded economists so far.” Your model is the typical model someone can find in any erroneous standard economics textbook.
Reply to Stephan:
1. Is this an exercise in history? Not all all. Historic may be a better word to use.
It is a model of endogenous money, where money expands and contracts without the intervention of the central bank.
2. You say that there is no such thing as a money multiplier. Why? The ratio of money to reserves is the money multiplier. It is as simple as that. The multiplier can vary from zero to any number. The trouble comes when economists try to relate it to the reserve ratio and other variables.
This is what I said in http://www.philipji.com/riddle-of-money:
The model above is silent on how much time it takes for this to happen. Textbooks also often attempt to relate the money multiplier (5 in the above example) to the reserve ratio and other variables. Since we do not know exactly how much time this takes we dispense with these calculations and show the money multiplier in a simple diagram as below.
That is why I said the multiplier is m.
3. You referred to http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf published in 2010.
The authors state:
During the financial crisis the divergence has been even greater. Reserve balances have recently increased dramatically, going from around $15 billion in July 2007 to over $788 billion in December 2008. Despite this increase by a factor of 50, no similar increase in any measure of money, as suggested by the multiplier could be found.
I do not know why the authors are surprised. The multiplier has simply shrunk. In any case, the formulas given in textbooks refer to the maximum possible multiplier, under the assumptions that all loans end up as deposits in the banking system and all deposits are lent out (barring required reserves). The authors seem to have forgotten what they read in their undergraduate textbooks.
In any case the paper uses conventional measures of money like M2. They do not seem to have realised that the Fed has long abandoned the use of M1 and M2. The boss himself said as much in 2006. See http://www.federalreserve.gov/newsevents/speech/bernanke20061110a.htm
All that one can say of measures like M1 or M2 which expand during a recession is that they are less than worthless. As soon as the Fed develops a measure of money that contracts during a recession such as in http://www.philipji.com/item/2011-05-11/how-much-longer-until-a-crash it would be interesting to read papers by Fed economists on money.
4. You say bank lending is not reserve constrained. It is constrained by demand (credit-worthy customers) and capital (Basel).
I don’t think I would disagree much. What I would say is
a) When a commercial bank lends part of its deposits it creates money
b) When a non-bank financial institution raises capital and lends the money, it too creates money
c) When someone moves money from his savings deposit to his demand deposit for spending, he creates money. This can of course be considered as a loan to himself and therefore as falling under a or b.
5. You say banks don’t hold reserves for reasons of safety.
Very interesting.
6. You say: PS: I do not understand your claim “this is the model of the economy that has eluded economists so far.” Your model is the typical model someone can find in any erroneous standard economics textbook.
Why do I say that? Because in Keynes there are no banks at all. In Friedman money rains from the sky. The closest any economist has come to developing a model of the economy in which money is endogenous and created and destroyed through the agency of financial institutions is Hyman Minsky.
“When a commercial bank lends part of its deposits it creates money.”
Banks do not lend part of their deposits. Deposits are irrelevant. A bank lends by crediting a borrower’s checking account. No dollars are transferred. The bank merely presses a computer key and voila, the balance in the borrower’s checking account is changed.
Dollars have no physical presence. They simply are numbers on the bank’s balance sheets — numbers the bank can change at will (subject to banking laws). If your bank had zero depositors and zero deposits, it still could mark up your checking account by trillions (again, subject to banking laws). Bank lending is not constrained by deposits. Period.
Rodger Malcolm Mitchell
“When someone moves money from his savings deposit to his demand deposit for spending, he creates money.”
Depends on your definition of “money.” Are you talking about M0, M1, M2, M3, L or the measure I personally consider the best: Total Outstanding Domestic Non-financial debt? (Sadly, the three most inclusive measures all have been discontinued.)
Banks don’t hold reserves for reasons of safety; they can get all the reserves they want, instantly, from other banks or from the government. You are confusing reserves with capital.
I agree that bank lending is constrained economically by demand and legally by capital.
The fact that some money measures expand during recessions merely reflect the government’s efforts to fight recessions.
Rodger Malcolm Mitchell
Philip,
many thanks for your reply. I was also rather unhappy after I posted my comment about my wording. Historic is way better. These things happen if you sip a cup of coffee in the morning thinking these guy isn’t really aware what he’s talking about and send a reply not in your mother tongue.
I will reply to the points you raised tomorrow. Good stuff! Today I’ve no time because of the time difference. It is 18:30 here and the sun is shining and my German mercantilist economist friends are waiting. Over a beer they will once again explain to me why we must pillage Greece, subjugate its labor force and impoverish any Greek citizen who isn’t competitive (like pensioners).
Reply to Rodger:
1. You said deposits are irrelevant.
That is for an investment bank. For commercial banks they are absolutely vital.
2. About the money multiplier
a) When an investment bank raises capital and lends money (say, by buying some security from a company) it creates money.
b) When a commercial bank buys, say commercial paper, it creates money.
c) The difference is that investment banks as a whole cannot multiply the investments placed with them. (When I place $100 with an investment bank I no longer have access to it for a particular period) The commercial banking system can multiply the deposits placed with them. (When I place $100 as a demand deposit with a bank I have acccess to it at the same time that the bank can lend the amount, less reserves)
d) So you have a situation where the multiplier for investment banks is 1. And for commercial banks, it is any number with a lower limit at zero. So you can place all financial institutions in a black box and say that the multiplier is m.
3. Are you talking about M0, M1, M2, M3, L or the measure I personally consider the best: Total Outstanding Domestic Non-financial debt?
None of them. Look up Riddle of Money to see my monetary aggregate. The Great Depression and the Great Recessions are also called Great Contractions. In general, money contracts during a recession. So, any accurate monetary aggregate should reflect that.
Phillip,
1. Your commercial bank’s lending is not constrained by deposits. It is constrained by capital. While there technically is a reserve requirement, it essentially is meaningless, as banks receive all the reserves they need from other banks or from the Fed. If your commercial bank had zero deposits, it still could lend, so long as it had capital.
The reserve multiplier is a myth. Correctly, it is a capital multiplier.
The only advantage of deposits is they are cheaper for the bank than borrowing from other banks or the Fed.
3. What you have named “Corrected Money Supply” appears to be known worldwide as “M0,” and (if I understand your definition) is nothing more than coins and currency in circulation. I suggest this is a very poor measure of the money supply, as it accounts for a minute fraction of money transaction.
In the past month, how much have you paid for with checks and credit cards vs. dollar bills and coins?
Rodger Malcolm Mitchell
1. If a financial institution has no deposits it is not a commercial bank. It may be an investment bank or a trading company.
2. What I call Corrected Money Supply is not coins and currency in circulation. Read the article http://www.philipji.com/riddle-of-money/
Philip,
1. You’re missing the point, which is: Bank lending is not constrained by bank deposits. How about this: If a commercial bank had only $1,000 in deposits it still could lend millions, if it had sufficient capital.
2. You said, “Now, during recessions, two things happen. First, people save more. Second, because interest rates are close to zero, they are more tardy in moving their savings to some other kind of deposits that yield more interest.”
I don’t see any of those effects: http://research.stlouisfed.org/fredgraph.png?g=JY
and
http://research.stlouisfed.org/fredgraph.png?g=K0
The last time rates were even close to zero was way back in the ’60′s, and 7 recessions occurred since then until we again approached zero.
Actually, the closest relationship the graphs show is: During the times between recessions, the Fed increases rates to fight inflations, then begins to cut rates to fight recessions.
Obviously, that doesn’t work, because inflation is not the opposite of recession — but that’s another story.
Rodger Malcolm Mitchell
Reply to Rodger:
1. Bank lending is not constrained by bank deposits. How about this: If a commercial bank had only $1,000 in deposits it still could lend millions, if it had sufficient capital.
I agree completely. Except that it would be a very stupid bank that lent only its own capital.
Take a look at http://www.google.com/finance?q=NYSE:C&fstype=ii
Citigroup has total equity of $171,037 million. Its total debt is $616,488 million. On the other hand, its total assets are $ 1,947,815. This is much more than the capital (sum of equity and debt).
I am not an expert on reading financial statements, so you can correct me if I am wrong.
Deposits are simply the cheapest way of raising funds.
2. You said, “Now, during recessions, two things happen. First, people save more. Second, because interest rates are close to zero, they are more tardy in moving their savings to some other kind of deposits that yield more interest.”
You have not understood what I said. You showed me the St Louis Fed graph for savings deposits. I am not talking of savings deposits. I am talking of savings as in Aggregate Personal Savings. And I am estimating the percentage of savings in Demand Deposits.
Philip,
1. Banks do not lend reserves. Banks do not lend capital. Banks are constrained by capital. When a bank lends, that lending creates reserves. Lending is the cheapest way to create reserves, as the banks actually get paid to do it.
2. I was merely showing you that your statement seems incorrect. During recessions, interest rates are not close to zero and people do not save more. As for savings, I’ve looked at all kinds of measures — http://research.stlouisfed.org/fredgraph.png?g=Ka — and I don’t see the effect you describe. Perhaps you can show the graph that reflects your data.
Rodger Malcolm Mitchell
To Rodger
Take a look at http://research.stlouisfed.org/fred2/series/PMSAVE?cid=112 to see that people save more during recessions
Philip,
The eye sees what the eye wants to see:
http://research.stlouisfed.org/fredgraph.png?g=KP
http://research.stlouisfed.org/fredgraph.png?g=KQ
http://research.stlouisfed.org/fredgraph.png?g=KR
I’m afraid your theory about interest rates going to zero and savings increasing is a mirage. The fact: Interest rates do not go to zero, and savings increase at various times, sometimes during recessions, sometimes between recessions. There is no correlation. Back to the drawing board.
Rodger Malcolm Mitchell
The exact trajectory doesn’t matter. The values of savings are used to calculate Corrected Money Supply and to show why M1 increases even during recessions, when we would expect money supply to contract.
A theory should be able to make falsifiable predictions. And the prediction I make is that in a few months there will be a financial crash and another recession similar to the last one.
If that happens perhaps you will return to Riddle of Money and understand better what I am saying. If not, I will heed your suggestion to return to the drawing board.
Philip,
Your claims have been wrong. Therefore, any prediction you make will be based on faulty assumptions. If your prediction proves correct, it will merely be an example of the “stopped clock” syndrome.
As we have had a recession, on average, once every five years, and it now has been almost two years since the official end of the last recession, I agree that “in a few months” (however long that is) we will have another recession.
I especially agree, because:
1. I foresaw the last recession, based on reduced deficit growth
2. Congress and the President, not understanding the difference between Monetary Sovereignty and monetary non-sovereignty, are determined to starve an already starving economy by cutting the federal deficit.
So, in a “few months,” we very well might have another recession, depending on how severe the deficit cuts are. But your lack of factual substantiation is like saying, “My theory is the iPod will cause a hurricane in Florida, and if there is a hurricane in Florida, that will prove my theory.”
Philip, if the facts are wrong, any hypothesis based on those facts is wrong, and any predictions will be based on luck.
Rodger Malcolm Mitchell
I predict a recession because money has reached unsustainable levels. No one even knows how to measure money. I am not surprised that you find it hard to understand what I am saying.
This conversation is going nowhwere.
Ah, good, old, reliable “unsustainable.” It’s the first cousin to “ticking time bomb.” If you want to learn more about “unsustainable,” please visit: http://rodgermmitchell.wordpress.com/2010/04/27/the-federal-debt-is-unsustainable/
When you have a hypothesis based on actual facts, I’ll be glad to discuss it with you. Meanwhile, I’m amazed that Open Economics, a site I previously had enjoyed, would publish such fact-free nonsense. Come on, kids. Do your homework.
Rodger Malcolm Mitchell