Steve Keen’s DebtWatch No 31 February 2009: “The Roving Cavaliers of Credit”

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Talk about cen­tral­i­sa­tion! The credit sys­tem, which has its focus in the so-called national banks and the big money-lenders and usurers sur­round­ing them, con­sti­tutes enor­mous cen­tral­i­sa­tion, and gives this class of par­a­sites the fab­u­lous power, not only to peri­od­i­cally despoil indus­trial cap­i­tal­ists, but also to inter­fere in actual pro­duc­tion in a most dan­ger­ous man­ner— and this gang knows noth­ing about pro­duc­tion and has noth­ing to do with it.” [1]

Ten years ago, a quote from Marx would have one deemed a social­ist, and dis­missed from polite debate. Today, such a quote can (and did, along with Charlie’s photo) appear in a fea­ture in the Syd­ney Morn­ing Her­ald—and not a few peo­ple would have been nod­ding their heads at how Marx got it right on bankers.F

He got it wrong on some other issues,[2] but his analy­sis of money and credit, and how the credit sys­tem can bring an oth­er­wise well-functioning mar­ket econ­omy to its knees, was spot on. His obser­va­tions on the finan­cial cri­sis of 1857 still ring true today:

A high rate of inter­est can also indi­cate, as it did in 1857, that the coun­try is under­mined by the rov­ing cav­a­liers of credit who can afford to pay a high inter­est because they pay it out of other people’s pock­ets (whereby, how­ever, they help to deter­mine the rate of inter­est for all), and mean­while they live in grand style on antic­i­pated prof­its.

Simul­ta­ne­ously, pre­cisely this can inci­den­tally pro­vide a very prof­itable busi­ness for man­u­fac­tur­ers and oth­ers. Returns become wholly decep­tive as a result of the loan sys­tem…”[1]

One and a half cen­turies after Marx falsely pre­dicted the demise of cap­i­tal­ism, the peo­ple most likely to bring it about are not work­ing class rev­o­lu­tion­ar­ies, but the “Rov­ing Cav­a­liers of Credit”, against whom Marx quite justly railed.

This month’s Debt­watch is ded­i­cated to analysing how these Cav­a­liers actu­ally “make” money and debt—something they think they under­stand, but in real­ity, they don’t. A sound model of how money and debt are cre­ated makes it obvi­ous that we should never have fallen for the insane notion that the finan­cial sys­tem should be self-regulating. All that did was give the Cav­a­liers a licence to run amok, with the con­se­quences we are now expe­ri­enc­ing yet again—150 years after Marx described the cri­sis that led him to write Das Kapital.

The conventional model: the “Money Multiplier”

Every macro­eco­nom­ics text­book has an expla­na­tion of how credit money is cre­ated by the sys­tem of frac­tional bank­ing that goes some­thing like this:

  • Banks are required to retain a cer­tain per­cent­age of any deposit as a reserve, known as the “reserve require­ment”; for sim­plic­ity, let’s say this frac­tion is 10%.
  • When cus­tomer Sue deposits say 100 newly printed gov­ern­ment $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.
  • The bank then lends $900 to its cus­tomer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its cus­tomer Kim.
  • Kim then deposits this $810 in her bank. It keeps $81 of the deposit, and lends the remain­ing $729 to its cus­tomer Kevin.
  • And on this iter­a­tive process goes.
  • Over time, a total of $10,000 in money is created—consisting of the orig­i­nal $1,000 injec­tion of gov­ern­ment money plus $9,000 in credit money—as well as $9,000 in total debts. The fol­low­ing table illus­trates this, on the assump­tion that the time lag between a bank receiv­ing a new deposit, mak­ing a loan, and the recip­i­ent of the loan deposit­ing them in other banks is a mere one week.

This model of how banks cre­ate credit is sim­ple, easy to under­stand (this ver­sion omits the fact that the pub­lic holds some of the cash in its own pock­ets rather than deposit­ing it all in the banks; this detail is eas­ily catered for and is part of the stan­dard model taught to econ­o­mists),… and com­pletely inad­e­quate as an expla­na­tion of the actual data on money and debt.

The Data versus the Money Multiplier Model

Two hypothe­ses about the nature of money can be derived from the money mul­ti­plier model:

1. The cre­ation of credit money should hap­pen after the cre­ation of gov­ern­ment money. In the model, the bank­ing sys­tem can’t cre­ate credit until it receives new deposits from the pub­lic (that in turn orig­i­nate from the gov­ern­ment) and there­fore finds itself with excess reserves that it can lend out. Since the lend­ing, deposit­ing and relend­ing process takes time, there should be a sub­stan­tial time lag between an injec­tion of new government-created money and the growth of credit money.

2. The amount of money in the econ­omy should exceed the amount of debt, with the dif­fer­ence rep­re­sent­ing the government’s ini­tial cre­ation of money. In the exam­ple above, the total of all bank deposits tapers towards $10,000, the total of loans con­verges to $9,000, and the dif­fer­ence is $1,000, which is the amount of ini­tial gov­ern­ment money injected into the sys­tem. There­fore the ratio of Debt to Money should be less than one, and close to (1-Reserve Ratio): in the exam­ple above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1.

Both these hypothe­ses are strongly con­tra­dicted by the data.

Test­ing the first hypoth­e­sis takes some sophis­ti­cated data analy­sis, which was done by two lead­ing neo­clas­si­cal econ­o­mists in 1990.[3] If the hypoth­e­sis were true, changes in M0 should pre­cede changes in M2. The time pat­tern of the data should look like the graph below: an ini­tial injec­tion of gov­ern­ment “fiat” money, fol­lowed by a grad­ual cre­ation of a much larger amount of credit money:

Their empir­i­cal con­clu­sion was just the oppo­site: rather than fiat money being cre­ated first and credit money fol­low­ing with a lag, the sequence was reversed: credit money was cre­ated first, and fiat money was then cre­ated about a year later:

There is no evi­dence that either the mon­e­tary base or M1 leads the cycle, although some econ­o­mists still believe this mon­e­tary myth. Both the mon­e­tary base and M1 series are gen­er­ally pro­cycli­cal and, if any­thing, the mon­e­tary base lags the cycle slightly. (p. 11)

The dif­fer­ence in the behav­ior of M1 and M2 sug­gests that the dif­fer­ence of these aggre­gates (M2 minus M1) should be con­sid­ered… The dif­fer­ence of M2M1 leads the cycle by even more than M2, with the lead being about three quar­ters.” (p. 12)

Thus rather than credit money being cre­ated with a lag after gov­ern­ment money, the data shows that credit money is cre­ated first, up to a year before there are changes in base money. This con­tra­dicts the money mul­ti­plier model of how credit and debt are cre­ated: rather than fiat money being needed to “seed” the credit cre­ation process, credit is cre­ated first and then after that, base money changes.

It doesn’t take sophis­ti­cated sta­tis­tics to show that the sec­ond pre­dic­tion is wrong—all you have to do is look at the ratio of pri­vate debt to money. The the­o­ret­i­cal pre­dic­tion has never been right—rather than the money stock exceed­ing debt, debt has always exceeded the money supply—and the degree of diver­gence has grown over time.(there are atten­u­at­ing fac­tors that might affect the prediction—the pub­lic hoard­ing cash should make the ratio less than shown here, while non-banks would make it larger—but the gap between pre­dic­tion and real­ity is just too large for the the­ory to be taken seriously).

Aca­d­e­mic eco­nom­ics responded to these empir­i­cal chal­lenges to its accepted the­ory in the time-honoured way: it ignored them.

Well, the so-called “main­stream” did—the school of thought known as “Neo­clas­si­cal eco­nom­ics”. A rival school of thought, known as Post Key­ne­sian eco­nom­ics, took these prob­lems seri­ously, and devel­oped a dif­fer­ent the­ory of how money is cre­ated that is more con­sis­tent with the data.

This first major paper on this approach, “The Endoge­nous Money Stock” by the non-orthodox econ­o­mist Basil Moore, was pub­lished almost thirty years ago.[4] Basil’s essen­tial point was quite sim­ple. The stan­dard money mul­ti­plier model’s assump­tion that banks wait pas­sively for deposits before start­ing to lend is false. Rather than bankers sit­ting back pas­sively, wait­ing for depos­i­tors to give them excess reserves that they can then on-lend,

In the real world, banks extend credit, cre­at­ing deposits in the process, and look for reserves later”.[5]

Thus loans come first—simultaneously cre­at­ing deposits—and at a later stage the reserves are found. The main mech­a­nism behind this are the “lines of credit” that major cor­po­ra­tions have arranged with banks that enable them to expand their loans from what­ever they are now up to a spec­i­fied limit.

If a firm accesses its line of credit to, for exam­ple, buy a new piece of machin­ery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s man­u­fac­turer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve require­ments, then it will bor­row that amount, either from the Fed­eral Reserve or from other sources.

If the entire bank­ing sys­tem is at its reserve require­ment limit, then the Fed­eral Reserve has three choices:

  • refuse to issue new reserves and cause a credit crunch;
  • cre­ate new reserves; or
  • relax the reserve ratio.

Since the main role of the Fed­eral Reserve is to try to ensure the smooth func­tion­ing of the credit sys­tem, option one is out—so it either adds Base Money to the sys­tem, or relaxes the reserve require­ments, or both.

Thus cau­sa­tion in money cre­ation runs in the oppo­site direc­tion to that of the money mul­ti­plier model: the credit money dog wags the fiat money tail. Both the actual level of money in the sys­tem, and the com­po­nent of it that is cre­ated by the gov­ern­ment, are con­trolled by the com­mer­cial sys­tem itself, and not by the Fed­eral Reserve.

Cen­tral Banks around the world learnt this les­son the hard way in the 1970s and 1980s when they attempted to con­trol the money sup­ply, fol­low­ing neo­clas­si­cal econ­o­mist Mil­ton Friedman’s the­ory of “mon­e­tarism” that blamed infla­tion on increases in the money sup­ply. Fried­man argued that Cen­tral Banks should keep the reserve require­ment con­stant, and increase Base Money at about 5% per annum; this would, he asserted cause infla­tion to fall as people’s expec­ta­tions adjusted, with only a minor (if any) impact on real eco­nomic activity.

Though infla­tion was ulti­mately sup­pressed by a severe reces­sion, the mon­e­tarist exper­i­ment over­all was an abject fail­ure. Cen­tral Banks would set tar­gets for the growth in the money sup­ply and miss them completely—the money sup­ply would grow two to three times faster than the tar­gets they set.

Ulti­mately, Cen­tral Banks aban­doned mon­e­tary tar­get­ting, and moved on to the mod­ern approach of tar­get­ting the overnight inter­est rate as a way to con­trol infla­tion.[6] Sev­eral Cen­tral Banks—including Australia’s RBA—completely aban­doned the set­ting of reserve require­ments. Others—such as America’s Fed­eral Reserve—maintained them, but had such loop­holes in them that they became basi­cally irrel­e­vant. Thus the US Fed­eral Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by indi­vid­u­als; banks have no reserve require­ment at all for deposits by com­pa­nies.[7]

How­ever, neo­clas­si­cal eco­nomic the­ory never caught up with either the data, or the actual prac­tices of Cen­tral Banks—and Ben Bernanke, a lead­ing neo­clas­si­cal the­o­reti­cian, and unabashed fan of Mil­ton Fried­man, is now in con­trol of the Fed­eral Reserve. He is there­fore try­ing to resolve the finan­cial cri­sis and pre­vent defla­tion in a neo­clas­si­cal man­ner: by increas­ing the Base Money supply.

Give Bernanke credit for try­ing here: the rate at which he is increas­ing Base Money is unprece­dented. Base Money dou­bled between 1994 and 2008; Bernanke has dou­bled it again in just the last 4 months.

If the money mul­ti­plier model of money cre­ation were cor­rect, then ulti­mately this would lead to a dra­matic growth in the money sup­ply as an addi­tional US$7 tril­lion of credit money was grad­u­ally created.

If neo­clas­si­cal the­ory was cor­rect, this increase in the money sup­ply would cause a bout of infla­tion, which would end bring the cur­rent defla­tion­ary period to a halt, and we could all go back to “busi­ness as usual”. That is clearly what Bernanke is bank­ing on:

The con­clu­sion that defla­tion is always reversible under a fiat money sys­tem fol­lows from basic eco­nomic rea­son­ing. A lit­tle para­ble may prove use­ful: Today an ounce of gold sells for $300, more or less. Now sup­pose that a mod­ern alchemist solves his subject’s old­est prob­lem by find­ing a way to pro­duce unlim­ited amounts of new gold at essen­tially no cost. More­over, his inven­tion is widely pub­li­cized and sci­en­tif­i­cally ver­i­fied, and he announces his inten­tion to begin mas­sive pro­duc­tion of gold within days.

What would hap­pen to the price of gold? Pre­sum­ably, the poten­tially unlim­ited sup­ply of cheap gold would cause the mar­ket price of gold to plum­met. Indeed, if the mar­ket for gold is to any degree effi­cient, the price of gold would col­lapse imme­di­ately after the announce­ment of the inven­tion, before the alchemist had pro­duced and mar­keted a sin­gle ounce of yel­low metal.

Like gold, U.S. dol­lars have value only to the extent that they are strictly lim­ited in sup­ply. But the U.S. gov­ern­ment has a tech­nol­ogy, called a print­ing press (or, today, its elec­tronic equiv­a­lent), that allows it to pro­duce as many U.S. dol­lars as it wishes at essen­tially no cost.

By increas­ing the num­ber of U.S. dol­lars in cir­cu­la­tion, or even by cred­i­bly threat­en­ing to do so, the U.S. gov­ern­ment can also reduce the value of a dol­lar in terms of goods and ser­vices, which is equiv­a­lent to rais­ing the prices in dol­lars of those goods and ser­vices. We con­clude that, under a paper-money sys­tem, a deter­mined gov­ern­ment can always gen­er­ate higher spend­ing and hence pos­i­tive inflation…

If we do fall into defla­tion, how­ever, we can take com­fort that the logic of the print­ing press exam­ple must assert itself, and suf­fi­cient injec­tions of money will ulti­mately always reverse a defla­tion.” [8]

How­ever, from the point of view of the empir­i­cal record, and the rival the­ory of endoge­nous money, this will fail on at least four fronts:

1. Banks won’t cre­ate more credit money as a result of the injec­tions of Base Money. Instead, inac­tive reserves will rise;

2. Cre­at­ing more credit money requires a match­ing increase in debt—even if the money mul­ti­plier model were cor­rect, what would the odds be of the pri­vate sec­tor tak­ing on an addi­tional US$7 tril­lion in debt in addi­tion to the cur­rent US$42 tril­lion it already owes?;

3. Defla­tion will con­tinue because the motive force behind it will still be there—distress sell­ing by retail­ers and whole­salers who are des­per­ately try­ing to avoid going bank­rupt; and

4. The macro­eco­nomic process of delever­ag­ing will reduce real demand no mat­ter what is done, as Microsoft CEO Steve Ballmer recently noted:  “We’re cer­tainly in the midst of a once-in-a-lifetime set of eco­nomic con­di­tions. The per­spec­tive I would bring is not one of reces­sion. Rather, the econ­omy is reset­ting to lower level of busi­ness and con­sumer spend­ing based largely on the reduced lever­age in econ­omy”.[9]

The only way that Bernanke’s “print­ing press exam­ple” would work to cause infla­tion in our cur­rent debt-laden would be if sim­ply Zim­bab­wean lev­els of money were printed—so that fiat money could sub­stan­tially repay out­stand­ing debt and effec­tively sup­plant credit-based money.

Mea­sured on this scale, Bernanke’s increase in Base Money goes from being heroic to triv­ial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broad­est mea­sure of the money stock—the M3 series that the Fed some years ago decided to discontinue.

Bernanke’s expan­sion of M0 in the last four months of 2008 has merely reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quar­terly whole money stock data is monthly, so the fall in the ratio is more than shown here given the lag in report­ing of debt).

To make a seri­ous dent in debt lev­els, and thus enable the increase in base money to affect the aggre­gate money stock and hence cause infla­tion, Bernanke would need to not merely dou­ble M0, but to increase it by a fac­tor of, say, 25 from pre-intervention lev­els. That US$20 tril­lion truck­load of green­backs might enable Amer­i­cans to repay, say, one quar­ter of out­stand­ing debt with one half—thus reduc­ing the debt to GDP ratio about 200% (roughly what it was dur­ing the Dot­Com bub­ble and, coin­ci­den­tally, 1931)—and get back to some seri­ous infla­tion­ary spend­ing with the other (of course, in the con­text of a seri­ously depre­ci­at­ing cur­rency). But with any­thing less than that, his attempts to reflate the Amer­i­can econ­omy will sink in the ocean of debt cre­ated by America’s modern-day “Rov­ing Cav­a­liers of Credit”.

How to be a “Cavalier of Credit”

Note Bernanke’s assump­tion (high­lighted above) in his argu­ment that print­ing money would always ulti­mately cause infla­tion: “under a fiat money sys­tem“. The point made by endoge­nous money the­o­rists is that we don’t live in a fiat-money sys­tem, but in a credit-money sys­tem which has had a rel­a­tively small and sub­servient fiat money sys­tem tacked onto it.

We are there­fore not in a “frac­tional reserve bank­ing sys­tem”, but in a credit-money one, where the dynam­ics of money and debt are vastly dif­fer­ent to those assumed by Bernanke and neo­clas­si­cal eco­nom­ics in gen­eral.[10]

Call­ing our cur­rent finan­cial sys­tem a “fiat money” or “frac­tional reserve bank­ing sys­tem” is akin to the blind man who clas­si­fied an ele­phant as a snake, because he felt its trunk. We live in a credit money sys­tem with a fiat money sub­sys­tem that has some inde­pen­dence, but cer­tainly doesn’t rule the mon­e­tary roost—far from it.

The best place to start to analyse the mon­e­tary sys­tem is there­fore to con­sider a model of a pure credit economy—a toy econ­omy in which there is no gov­ern­ment sec­tor and no Cen­tral Bank whatsoever—and see how that model behaves.

The first issue in such a sys­tem is how does one become a bank?—or a “cav­a­lier of credit” in Marx’s won­der­fully evoca­tive phrase? The answer was pro­vided by the Ital­ian non-orthodox econ­o­mist Augusto Graziani: a bank is a third party to all trans­ac­tions, whose account-keeping between buyer and seller is regarded as finally set­tling all claims between them.

Huh? What does that mean? To explain it, I’ll com­pare it with the man­ner in which we’ve been mis­led to think­ing about the mar­ket econ­omy by neo­clas­si­cal economics.

It has deluded us into think­ing of a mar­ket econ­omy as being fun­da­men­tally a sys­tem of barter. Every trans­ac­tion is seen as being two sided, and involv­ing two com­modi­ties: Farmer Maria wants to sell pigs and buy cop­per pipe; Plumber Joe wants to sell cop­per pipe and buy pigs.

Money sim­ply elim­i­nates the prob­lem that it’s very hard for Plumber Joe to find Farmer Maria. Instead, they each sell their com­mod­ity for money, and then exchange that money for the com­mod­ity they really want. The pic­ture appears more complicated—there are two mar­kets intro­duced as well, with Farmer Maria sell­ing pigs to the pig mar­ket in return for money, Plumber Joe doing the same thing in the cop­per mar­ket, and then armed with money from their sales, they go across to the other mar­ket and buy what they want. But it is still a lot eas­ier than a plumber going out to try to find a pig farmer who wants cop­per pipes.

In this model of the econ­omy, money is use­ful in that it replaces a very dif­fi­cult search process with a sys­tem of mar­kets. But fun­da­men­tally the sys­tem is no dif­fer­ent to the barter model above: money is just a con­ve­nient “numeraire”, and any­thing at all could be used—even cop­per pipe or pigs—so long as all mar­kets agreed to accept it. Gold tends to be the numeraire of choice because it doesn’t degrade, and paper money merely replaces gold as a more con­ve­nient form of numeraire.

Impor­tantly, in this model, money is an asset to its holder, but a lia­bil­ity to no-one. There is money, but no debt. The frac­tional bank­ing model that is tacked onto this vision of bar­ter­ing adds yet another mar­ket where depos­i­tors (savers) sup­ply money at a price (the rate of inter­est), and lenders buy money for that price, and the inter­ac­tion between sup­ply and demand sets the price. Debt now exists, but in the model world total debt is less than the amount of money.

If this mar­ket pro­duces too much money (which it can do in a frac­tional bank­ing sys­tem because the gov­ern­ment deter­mines the sup­ply of base money and the reserve require­ment) then there can be infla­tion of the money prices of com­modi­ties. Equally if the money mar­ket sud­denly con­tracts, then there can be defla­tion. It’s fairly easy to sit­u­ate Bernanke’s dra­matic increase in Base Money within this view of the world.

If only it were the world in which we live. Instead, we live in a credit econ­omy, in which intrin­si­cally use­less pieces of paper—or even sim­ple trans­fers of elec­tronic records of numbers—are hap­pily accepted in return for real, hard com­modi­ties. This in itself is not incom­pat­i­ble with a frac­tional bank­ing model, but the empir­i­cal data tells us that credit money is cre­ated inde­pen­dently of fiat money: credit money rules the roost. So our fun­da­men­tal under­stand­ing of a mon­e­tary econ­omy should pro­ceed from a model in which credit is intrin­sic, and gov­ern­ment money is tacked on later—and not the other way round.

Our start­ing point for analysing the econ­omy should there­fore be a “pure credit” econ­omy, in which there are pri­vately issued bank notes, but no gov­ern­ment sec­tor and no fiat money. Yet this has to be an econ­omy in which intrin­si­cally use­less items are accepted as pay­ment for intrin­si­cally use­ful ones—you can’t eat a bank note, but you can eat a pig.

So how can that be done with­out cor­rupt­ing the entire sys­tem. Some­one has to have the right to pro­duce the bank notes; how can this sys­tem be the basis of exchange, with­out the per­son who has that right abus­ing it?

Graziani (and oth­ers in the “Cir­cuitist” tra­di­tion) rea­soned that this would only be pos­si­ble if the pro­ducer of bank notes—or the keeper of the elec­tronic records of money—could not sim­ply print them when­ever he/she wanted a com­mod­ity, and go and buy that com­mod­ity with them. But at the same time, peo­ple involved in ordi­nary com­merce had to accept the trans­fer of these intrin­si­cally use­less things in return for commodities.

There­fore for a sys­tem of credit money to work, three con­di­tions had to be fulfilled:

In order for money to exist, three basic con­di­tions must be met:

a) money has to be a token cur­rency (oth­er­wise it would give rise to barter and not to mon­e­tary exchanges);

b) money has to be accepted as a means of final set­tle­ment of the trans­ac­tion (oth­er­wise it would be credit and not money);

c) money must not grant priv­i­leges of seignor­age to any agent mak­ing a pay­ment.” [11]

In Graziani’s words, “The only way to sat­isfy those three con­di­tions is …:

to have pay­ments made by means of promises of a third agent, the typ­i­cal third agent being nowa­days. When an agent makes a pay­ment by means of a cheque, he sat­is­fies his part­ner by the promise of the bank to pay the amount due.

Once the pay­ment is made, no debt and credit rela­tion­ships are left between the two agents. But one of them is now a cred­i­tor of the bank, while the sec­ond is a debtor of the same bank. This insures that, in spite of mak­ing final pay­ments by means of paper money, agents are not granted any kind of privilege.

For this to be true, any mon­e­tary pay­ment must there­fore be a tri­an­gu­lar trans­ac­tion, involv­ing at least three agents, the payer, the payee, and the bank.” ( p. 3).

Thus in a credit econ­omy, all trans­ac­tions are involve one com­mod­ity, and three par­ties: a seller, a buyer, and a bank whose trans­fer of money from the buyer’s account to the seller’s is accepted by them as final­is­ing the sale of the com­mod­ity. So the actual pat­tern in any trans­ac­tion in a credit money econ­omy is as shown below:

This makes banks and money an essen­tial fea­ture of a credit econ­omy, not some­thing that can be ini­tially ignored and incor­po­rated later, as neo­clas­si­cal eco­nom­ics has attempted to do (unsuc­cess­fully; one of the hard­est things for a neo­clas­si­cal math­e­mat­i­cal mod­eller is to explain why money exists, apart from the search advan­tages noted above. Gen­er­ally there­fore their mod­els omit money—and debt—completely).

It also defines what a bank is: it is a third party whose record-keeping is trusted by all par­ties as record­ing the trans­fers of credit money that effect sales of com­modi­ties. The bank makes a legit­i­mate liv­ing by lend­ing money to other agents—thus simul­ta­ne­ously cre­at­ing loans and deposits—and charg­ing a higher rate of inter­est on loans than on deposits.

Thus in a fun­da­men­tal way, a bank is a bank because it is trusted. Of course, as we know from our cur­rent bit­ter expe­ri­ence, banks can dam­age that trust; but it remains the well­spring from which their exis­tence arises.

This model helped dis­tin­guish the real­is­tic model of endoge­nous money from the unre­al­is­tic neo­clas­si­cal vision of a barter econ­omy. It also makes it pos­si­ble to explain what a credit crunch is, and why it has such a dev­as­tat­ing impact upon eco­nomic activity.

First, the basics: how does a pure credit econ­omy work, and how is money cre­ated in one? (The rest of this post nec­es­sar­ily gets tech­ni­cal and is there for those who want detailed back­ground. It reports new research into the dynam­ics of a credit econ­omy. There’s noth­ing here any­where near as poetic as Marx’s “Cav­a­liers of Credit”, but I hope it explains how a credit econ­omy works, and how it can go badly wrong in a “credit crunch”)

How the Cavaliers “Make Money”

Sev­eral economists—notably Wick­sell and Keynes—envisaged a “pure credit econ­omy”. Keynes imag­ined a world in which “invest­ment is pro­ceed­ing at a steady rate”, in which case:

the finance (or the com­mit­ments to finance) required can be sup­plied from a revolv­ing fund of a more or less con­stant amount, one entre­pre­neur hav­ing his finance replen­ished for the pur­pose of a pro­jected invest­ment as another exhausts his on pay­ing for his com­pleted invest­ment.” [12]

This is the start­ing point to under­stand­ing a pure credit economy—and there­fore to under­stand­ing our cur­rent econ­omy and why it’s in a bind. Con­sider an econ­omy with three sec­tors: firms that pro­duce goods, banks that charge and pay inter­est, and house­holds that sup­ply work­ers. Firms are the only enti­ties that bor­row, and the bank­ing sec­tor gave loans at some stage in the past to start pro­duc­tion. Firms hired work­ers with this money (and bought inputs from each other), enabling pro­duc­tion, and ulti­mately the econ­omy set­tled down to a con­stant turnover of money and goods (as yet there is no tech­no­log­i­cal change, pop­u­la­tion growth, or wage bargaining).

There are four types of accounts: Firms’ Loans, Firms’ Deposits, Banks’ Deposits, and House­holds Deposits. These finan­cial flows are described by the fol­low­ing table. I’m eschew­ing math­e­mat­i­cal sym­bols and just using let­ters here to avoid the “MEGO” effect (“My Eyes Glaze Over”)—if you want to check out the equa­tions, see this paper:

1. Inter­est accrues on the out­stand­ing loans.

2. Firms pay inter­est on the loans. This is how the banks make money, and it involves a trans­fer of money from the firms deposit accounts to the banks. The banks then have to acknowl­edge this pay­ment of inter­est by record­ing it against the out­stand­ing debt firms owe them.

3. Banks pay inter­est to firms on the bal­ances in their deposit accounts. This involves a trans­fer from Bank Deposit accounts to Firms; this is a cost of busi­ness to banks, but they make money this way because (a) the rate of inter­est on loans is higher than that on deposits and (b) as is shown later, the vol­ume of loans out­stand­ing exceeds the deposits that banks have to pay inter­est on;

4. Firms pay wages to work­ers; this is a trans­fer from the firms deposits to the households.

5. Banks pay inter­est to house­holds on the bal­ances in their deposit accounts.

6. Banks and house­holds pay money to firms in order to pur­chase some of the out­put from fac­to­ries for con­sump­tion and inter­me­di­ate goods.

This finan­cial activ­ity allows pro­duc­tion to take place:

1. Work­ers are hired and paid a wage;

2. They pro­duce out­put in fac­to­ries at a con­stant level of productivity;

3. The out­put is then sold to other firms, banks and households;

4. The price level is set so that in equi­lib­rium the flow of demand equals the flow of output

The graphs below show the out­come of a sim­u­la­tion of this sys­tem, which show that a pure credit econ­omy can work: firms can bor­row money, make a profit and pay it back, and a sin­gle “revolv­ing fund of finance”, as Keynes put it, can main­tain a set level of eco­nomic activ­ity. [13]

These sta­ble accounts sup­port a flow of eco­nomic activ­ity in time, giv­ing firms, house­holds and banks steady incomes:

Out­put and employ­ment also tick over at a con­stant level:

That’s the absolutely basic pic­ture; to get closer to our cur­rent real­ity, a lot more needs to be added. The next model includes, in addi­tion to the basic sys­tem shown above:

1. Repay­ment of debt, which involves a trans­fer from the Firms’ deposit account to an account that wasn’t shown in the pre­vi­ous model that records Banks unlent reserves; this trans­fer of money has to be acknowl­edged by the banks by a match­ing reduc­tion in the recorded level of debt;

2. Relend­ing from unlent reserves. This involves a trans­fer of money, against which an equiv­a­lent increase in debt is recorded;

3. The exten­sion of new loans to the firm sec­tor by the banks. The firms sector’s deposits are increased, and simul­ta­ne­ously the recorded level of debt is increased by the same amount.

4. Invest­ment of part of bank prof­its by a trans­fer from the bank­ing sector’s deposit accounts to the unlent reserves.

5. Vari­able wages, grow­ing labour pro­duc­tiv­ity and a grow­ing population.

The finan­cial table for this sys­tem is:

As with the pre­vi­ous model, this toy econ­omy “works”—it is pos­si­ble for firms to bor­row money, make a profit, and repay their debt.

With the addi­tional ele­ments of debt repay­ment and the cre­ation of new money, this model also lets us see what hap­pens to bank income when these para­me­ters change.

Though in some ways the answers are obvi­ous, it lets us see why banks are truly cav­a­lier with credit. The con­clu­sions are that bank income is bigger:

  • If the rate of money cre­ation is higher (this is by far the most impor­tant factor);
  • If the rate of cir­cu­la­tion of unlent reserves is higher; and
  • If the rate of debt repay­ment is lower—which is why, in “nor­mal” finan­cial cir­cum­stances, banks are quite happy not to have debt repaid.

In some ways these con­clu­sions are unre­mark­able: banks make money by extend­ing debt, and the more they cre­ate, the more they are likely to earn. But this is a rev­o­lu­tion­ary con­clu­sion when com­pared to stan­dard think­ing about banks and debt, because the money mul­ti­plier model implies that, what­ever banks might want to do, they are con­strained from so doing by a money cre­ation process that they do not control.

How­ever, in the real world, they do con­trol the cre­ation of credit. Given their pro­cliv­ity to lend as much as is pos­si­ble, the only real con­straint on bank lend­ing is the public’s will­ing­ness to go into debt. In the model econ­omy shown here, that will­ing­ness directly relates to the per­ceived pos­si­bil­i­ties for prof­itable investment—and since these are lim­ited, so also is the uptake of debt.

But in the real world—and in my mod­els of Minsky’s Finan­cial Insta­bil­ity Hypoth­e­sis—there is an addi­tional rea­son why the pub­lic will take on debt: the per­cep­tion of pos­si­bil­i­ties for pri­vate gain from lever­aged spec­u­la­tion on asset prices.

That clearly is what has hap­pened in the world’s recent eco­nomic his­tory, as it hap­pened pre­vi­ously in the runup to the Great Depres­sion and numer­ous finan­cial crises before­hand. In its after­math, we are now expe­ri­enc­ing a “credit crunch”—a sud­den rever­sal with the cav­a­liers going from being will­ing to lend to vir­tu­ally any­one with a pulse, to refus­ing credit even to those with solid finan­cial histories.

I intro­duce a “credit crunch” into this model by chang­ing those same key key finan­cial para­me­ters at the 30 year mark, but decreas­ing them rather than increas­ing them. Firms go from hav­ing a 20 year hori­zon for debt repay­ment to a 6.4 year hori­zon, banks go from increas­ing the money sup­ply at 10% per annum to 3.2% per annum, while the rate of cir­cu­la­tion of unlent reserves drops by 68%.

There is much more to our cur­rent cri­sis than this—in par­tic­u­lar, this model omits “Ponzi lend­ing” that finances gam­bling on asset prices rather than pro­duc­tive invest­ment, and the result­ing accu­mu­la­tion of debt com­pared to GDP—but this level of change in finan­cial para­me­ters alone is suf­fi­cient to cause a sim­u­lated cri­sis equiv­a­lent to the Great Depres­sion. Its behav­iour repro­duces much of what we’re wit­ness­ing now: there is a sud­den blowout in unlent reserves, and a decline in the nom­i­nal level of debt and in the amount of money cir­cu­lat­ing in the economy.

This is the real world phe­nom­e­non that Bernanke is now rail­ing against with his increases in Base Money, and already the wide­spread lament amongst pol­icy mak­ers is that banks are not lend­ing out this addi­tional money, but sim­ply build­ing up their reserves.

Tough: in a credit econ­omy, that’s what banks do after a finan­cial crisis—it’s what they did dur­ing the Great Depres­sion. This credit-economy phe­nom­e­non is the real rea­son that the money sup­ply dropped dur­ing the Depres­sion: it wasn’t due to “bad Fed­eral Reserve pol­icy” as Bernanke him­self has opined, but due to the fact that we live in a credit money world, and not the fiat money fig­ment of neo­clas­si­cal imagination.

The impact of the sim­u­lated credit crunch on my toy economy’s real vari­ables is sim­i­lar to that of the Great Depres­sion: real out­put slumps severely, as does employment.

The nom­i­nal value of out­put also falls, because prices also fall along with real output.

This fall in prices is dri­ven by a switch from a regime of grow­ing demand to one of shrink­ing demand. Rather than there being a con­tin­u­ous slight imbal­ance in demand’s favour, the imbal­ance shifts in favour of supply—and prices con­tinue falling even though out­put even­tu­ally starts to rise.

The unem­ploy­ment rate explodes rapidly from full employ­ment to 25 per­cent of the work­force being out of a job—and then begins a slow recovery.

Finally, wages behave in a per­verse fash­ion, just as Keynes argued dur­ing the Great Depres­sion: nom­i­nal wages fall, but real wages rise because the fall in prices out­runs the fall in wages.

This com­bi­na­tion of falling prices and falling out­put means that despite the fall in nom­i­nal debts, the ratio of debt to nom­i­nal out­put actu­ally rises—again, as hap­pened for the first few years of the Great Depression.

Though this model is still sim­ple com­pared to the econ­omy in which we live, it’s a lot closer to our actual econ­omy than the mod­els devel­oped by con­ven­tional “neo­clas­si­cal” econ­o­mists, which ignore money and debt, and pre­sume that the econ­omy will always con­verge to a “NAIRU[14] equi­lib­rium after any shock.

It also shows the impor­tance of the nom­i­nal money stock, some­thing that neo­clas­si­cal econ­o­mists com­pletely ignore. To quote Mil­ton Fried­man on this point:

It is a com­mon­place of mon­e­tary the­ory that noth­ing is so unim­por­tant as the quan­tity of money expressed in terms of the nom­i­nal mon­e­tary unit—dollars, or pounds, or pesos… Let the num­ber of dol­lars in exis­tence be mul­ti­plied by 100; that, too, will have no other essen­tial effect, pro­vided that all other nom­i­nal mag­ni­tudes (prices of goods and ser­vices, and quan­ti­ties of other assets and lia­bil­i­ties that are expressed in nom­i­nal terms) are also mul­ti­plied by 100.” [15]

The mad­ness in Friedman’s argu­ment is the assump­tion that increas­ing the money sup­ply by a fac­tor of 100 will also cause “all other nom­i­nal mag­ni­tudes” includ­ing com­mod­ity prices and debts to be mul­ti­plied by the same factor.

What­ever might be the impact on prices of increas­ing the money sup­ply by a fac­tor of 100, the nom­i­nal value of debt would remain con­stant: debt con­tracts don’t give banks the right to increase your out­stand­ing level of debt just because prices have changed. Move­ments in the nom­i­nal prices of goods and ser­vices aren’t per­fectly mir­rored by changes in the level of nom­i­nal debts, and this is why nom­i­nal mag­ni­tudes can’t be ignored.

In this model I have devel­oped, money and its rate of cir­cu­la­tion mat­ter because they deter­mine the level of nom­i­nal and real demand. It is a “New Mon­e­tarism” model, in which money is crucial.

Iron­i­cally, Mil­ton Fried­man argued that money was cru­cial in his inter­pre­ta­tion of the Great Depression—that the fail­ure of the Fed­eral Reserve to suf­fi­ciently increase the money sup­ply allowed defla­tion to occur. But he a triv­ial “heli­copter” model of money cre­ation that saw all money as orig­i­nat­ing from the oper­a­tions of the Fed­eral Reserve:

Let us sup­pose now that one day a heli­copter flies over this com­mu­nity and drops an addi­tional $1,000 in bills from the sky, which is, of course, hastily col­lected by mem­bers of the com­mu­nity. Let us sup­pose fur­ther that every­one is con­vinced that this is a unique event which will never be repeated… [16]

When the heli­copter starts drop­ping money in a steady stream— or, more gen­er­ally, when the quan­tity of money starts unex­pect­edly to rise more rapidly— it takes time for peo­ple to catch on to what is hap­pen­ing. Ini­tially, they let actual bal­ances exceed long— run desired bal­ances…” (p. 13)

and a triv­ial model of the real econ­omy that argued that it always tended back to equilibrium:

Let us start with a sta­tion­ary soci­ety in which … (5) The soci­ety, though sta­tion­ary, is not sta­tic. Aggre­gates are con­stant, but indi­vid­u­als are sub­ject to uncer­tainty and change. Even the aggre­gates may change in a sto­chas­tic way, pro­vided the mean val­ues do not… Let us sup­pose that these con­di­tions have been in exis­tence long enough for the soci­ety to have reached a state of equi­lib­rium…” (pp. 2–3)

One nat­ural ques­tion to ask about this final sit­u­a­tion is, “ What raises the price level, if at all points mar­kets are cleared and real mag­ni­tudes are sta­ble?” The answer is, “ Because every­one con­fi­dently antic­i­pates that prices will rise.” (p. 10)

Using this sim­plis­tic analy­sis, Mil­ton Fried­man claimed that infla­tion was caused by “too many heli­copters” and defla­tion by “too few”, and that the defla­tion that ampli­fied the down­turn in the 1930s could have been pre­vented if only the Fed had sent more heli­copters into the fray:

dif­fer­ent and fea­si­ble actions by the mon­e­tary author­i­ties could have pre­vented the decline in the money stock—indeed, pro­duced almost any desired increase in the money stock. The same actions would also have eased the bank­ing dif­fi­cul­ties appre­cia­bly. Pre­ven­tion or mod­er­a­tion of the decline in the stock of money, let alone the sub­sti­tu­tion of mon­e­tary expan­sion, would have reduced the contraction’s sever­ity and almost as cer­tainly its dura­tion.” [17]

With a sen­si­ble model of how money is endoge­nously cre­ated by the finan­cial sys­tem, it is pos­si­ble to con­cur that a decline in money con­tributed to the sever­ity of the Great Depres­sion, but not to blame that on the Fed­eral Reserve not prop­erly exer­cis­ing its effec­tively impo­tent pow­ers of fiat money cre­ation. Instead, the decline was due to the nor­mal oper­a­tions of a credit money sys­tem dur­ing a finan­cial cri­sis that its own reck­less lend­ing has caused—the Cav­a­liers are cow­ards who rush into a bat­tle they are win­ning, and retreat at haste in defeat.

How­ever, with his belief in Friedman’s analy­sis, Bernanke did blame his 1930 pre­de­ces­sors for caus­ing the Great Depres­sion. In his paean to Mil­ton Fried­man on the occa­sion of his 90th birth­day, Bernanke made the fol­low­ing remark:

Let me end my talk by abus­ing slightly my sta­tus as an offi­cial rep­re­sen­ta­tive of the Fed­eral Reserve. I would like to say to Mil­ton and Anna: Regard­ing the Great Depres­sion. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” [18]

In fact, thanks to Mil­ton Fried­man and neo­clas­si­cal eco­nom­ics in gen­eral, the Fed ignored the run up of debt that has caused this cri­sis, and every res­cue engi­neered by the Fed sim­ply increased the height of the precipice from which the even­tual fall into Depres­sion would occur.

Hav­ing failed to under­stand the mech­a­nism of money cre­ation in a credit money world, and failed to under­stand how that mech­a­nism goes into reverse dur­ing a finan­cial cri­sis, neo­clas­si­cal eco­nom­ics may end up doing what by acci­dent what Marx failed to achieve by delib­er­ate action, and bring cap­i­tal­ism to its knees.

Neo­clas­si­cal economics—and espe­cially that derived from Mil­ton Friedman’s pen—is mad, bad, and dan­ger­ous to know.

Debtwatch Statistics February 2009

My dis­cus­sion of the most recent monthly data is abbre­vi­ated given the length of this Report, but it now appears that the debt bub­ble has started to burst. Pri­vate debt fell by $A$5 bil­lion in the last month, the first fall since 2003, and the steep­est monthly fall on record.

As a result, Australia’s Debt to GDP ratio has started to fall.

How­ever, it might rise once more if defla­tion takes hold. This was the Depres­sion expe­ri­ence when the debt to GDP ratio rose even as nom­i­nal debt lev­els fell. Leav­ing that pos­si­bil­ity aside for the moment, it appears that Australia’s peak pri­vate debt to GDP ratio occurred in March 2008, with a ratio of 177% of GDP includ­ing busi­ness secu­ri­ties (or 165% exclud­ing busi­ness securities).


[1] Marx, Cap­i­tal Vol­ume III, Chap­ter 33, The medium of cir­cu­la­tion in the credit sys­tem, pp. 544–45 [Progress Press]. http://www.marx.org/archive/marx/works/1894-c3/ch33.htm. Emphases added.

[2] Notably the “labour the­ory of value”, which argues erro­neously that all profit comes from labour, the notion that the rate of profit has a ten­dency to fall, and the alleged inevitabil­ity of the demise of cap­i­tal­ism; see my papers on these issues on the Research page of my blog under Marx.

[3] Kyd­land & Prescott, Busi­ness Cycles: Real Facts and a Mon­e­tary Myth, Fed­eral Reserve Bank of Min­neapo­lis Quar­terly Review, Spring 1990.

[4] “The Endoge­nous Money Stock”, Jour­nal of Post Key­ne­sian Eco­nom­ics, 1979, Vol­ume 2, pp. 49–70.

[5] Basil Moore 1983, “Unpack­ing the post Key­ne­sian black box: bank lend­ing and the money sup­ply”, Jour­nal of Post Key­ne­sian Eco­nom­ics 1983, Vol. 4 pp. 537–556; here Moore was quot­ing a Fed­eral Reserve econ­o­mist from a 1969 con­fer­ence in which the endo­gene­ity of the money sup­ply was being debated.

[6] This pol­icy “worked” in the sense that Cen­tral Banks were suc­cess­ful in con­trol­ling short run inter­est rates, and appeared to work in con­trol­ling infla­tion; but it is now becom­ing obvi­ous that its suc­cess on the lat­ter front was a coincidence—the era of low infla­tion coin­cided with the dra­matic impact of China and off­shore man­u­fac­tur­ing in gen­eral on con­sumer and pro­ducer prices—and it led to Cen­tral Banks com­pletely ignor­ing the debt bub­ble that has caused the global finan­cial cri­sis. As a result, inter­est rate tar­get­ting is also going the way of the Dodo now.

[7] see Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Require­ment Sys­tems in OECD Coun­tries” , Finance and Eco­nom­ics Dis­cus­sion Series, Divi­sions of Research & Sta­tis­tics and Mon­e­tary A¤airs, Fed­eral Reserve Board, 2007–54, Wash­ing­ton, D.C;. The US rule implies that the main rea­son for the “reserve require­ment” these days is to meet house­hold demand for cash.

[8] Bernanke 2002: Remarks by Gov­er­nor Ben S. Bernanke Before the National Econ­o­mists Club, Wash­ing­ton, D.C., Novem­ber 21, 2002. Defla­tion: Mak­ing Sure “It” Doesn’t Hap­pen Here. Empha­sis added.

[9] Microsoft resorts to first lay­offs, cut­ting 5,000“, Yahoo Finance Jan­u­ary 22nd 2009.

[10] And, for that mat­ter, by Aus­trian eco­nom­ics, whose analy­sis of money is sur­pris­ingly sim­plis­tic. Though Aus­tri­ans advo­cate a pri­vate money sys­tem in which banks would issue their own cur­rency, they assume that under the cur­rent money sys­tem, all money is gen­er­ated by frac­tional reserve lend­ing on top of fiat money cre­ation. This is strange, since if they advo­cate a pri­vate money sys­tem, they need a model of how banks could cre­ate money with­out frac­tional reserve lend­ing. But they don’t have one.

[11] Graziani A. (1989). The The­ory of the Mon­e­tary Cir­cuit, Thames Papers in Polit­i­cal Econ­omy, Sprin, pp.:1–26. Reprinted in M. Musella and C. Pan­ico (eds) (1995). The Money Sup­ply in the Eco­nomic Process, Edward Elgar, Aldershot.

[12] Keynes 1937, “ Alter­na­tive the­o­ries of the rate of inter­est” , Eco­nomic Jour­nal, Vol. 47, pp. 241–252: p. 247

[13] The para­me­ters were an ini­tial loan of $100, loan rate of inter­est of 5%, deposit rate of 1%, 3 month lag between financ­ing pro­duc­tion and receiv­ing the sales pro­ceeds, 1/3rd of the sur­plus from pro­duc­tion going to firms as prof­its and the remain­der to work­ers as wages, a one year lag in price adjust­ments, a money wage of $1, worker pro­duc­tiv­ity of 1.1 units of phys­i­cal out­put per worker per year, and a one year lag in spend­ing by bankers and a two week lag by workers.

[14] “Non-Accelerating Infla­tion Rate of Unem­ploy­ment”, another one of Milton’s myth­i­cal constants.

[15] Mil­ton Fried­man 1969, “The Opti­mal Quan­tity of Money”, in The Opti­mal Quan­tity of Money and Other Essays, Macmil­lan, Chicago, p. 1.

[16] Mil­ton Fried­man 1969, pp. 5–6

[17] Mil­ton Fried­man and Anna Schwartz 1963, A Mon­e­tary His­tory of the United States 1867–1960, Prince­ton Uni­ver­sity Press, Prince­ton, p. 301.

[18] Remarks by Gov­er­nor Ben S. Bernanke At the Con­fer­ence to Honor Mil­ton Fried­man, Uni­ver­sity of Chicago, Chicago, Illi­nois Novem­ber 8, 2002 On Mil­ton Friedman’s Nineti­eth Birth­day.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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