Steve Keen’s DebtWatch No 31 February 2009: “The Roving Cavaliers of Credit”
on January 31st, 2009 at 11:21 am
Click on Marx's image to download this post in PDF format
“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 M2 – M1 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.
Dear Steve,
Thank you for your long answers. I’ve started reading your paper (A Marx for PKs) and find it very stimulating. As I said I’m pretty much a newcomer to the whole field, so I don’t want to (and can’t) pass final judgement on the LTV at this point.
Just one remark: I find your last paragraph (“At a time when Karl would have been raising the ramparts of logic against the financial crisis, his followers are still trying to solve the contradictions of a book published in 1894.) rather unfair towards economists who are working in a Marxist (or “Marxian”, whatever) framework.
I think there are lots of people (who are usually characterized as Marxists) who are doing valuable empirical analysis on real-world capitalist economies. Actually, the only people I know of who have provided convincing explanations of the present crisis are either post-keynesians (like you, or people at the Levy Institute, who pretty much foretold the crisis) or people who use a more or less marxian conceptual apparatus, say like David Kotz, James Crotty, Robert Brenner, Leo Panitch and others.
For me, it seems that these people are doing valuable work, whether they have a complete model of capitalist economies is of course another question.
In short, I think it’s a bit harsh to say that Marxists do nothing but argue over the contradictions of Das Kapital.
Yes it was; there are certainly some academics who acknowledge a debt to Marx (pardon the pun!) in their writings and do useful work today. I was thinking more of the crowd around what is called the “Temporal Single System” interpretation of Marx.
But most Post Keynesians, even when directly influenced by Marx, simply don’t want to acknowledge any contribution Marx might have made for fear of getting dragged into “The Value Wars”. Thus you can read papers by, for example, Randy Wray, without ever finding a reference to Marx–even though Minsky was his PhD supervisor and he was influenced by Marx.
Why? Partly because of the American reaction to the McCarthyist period, but partly also because of the amount of time wasted within Marxian circles on trying to solve the Transformation Problem, or the reduction of every given crisis to being a manifestation of the Tendency Of The Rate Of Profit To Fall. These irresolvable debates have the impact that many younger Post Keynesians never read Marx, because their lecturers discourage them from doing so in fear that they might be sucked into that vortex.
As a result, the many good insights in Marx and foundations for a decent way of thinking about the economy are lost. Hence my last paragraph–I reckon far more damage has been done to Marx by his erstwhile friends than his enemies. It’s a great pity.
I read it all, and it seems to make sense. I also read your 1995 paper on Minsky modeling of instability.
I understand that with just market (no government), the onset of high interest rates can destabilize the system.
When you add government, adjusting the interest rate is a ham-handed impact on the economy, and cannot restore an already de-stabilized economy.
So, I think we are already de-stabilized. The current plan (a la Kensian) to throw money at the problem, may not work (or probably not work), making us more in debt with few long term benefits.
So how do we get out of this mess? Hit the debt reset button like the Jewish Torra calls for every 49 years, all debts forgiven, and start over?
Is there no other solution?
Hi gcjblack,
Pretty much I expect (the Tora solution, that is). If we had merely stopped at the debt to GDP levels at the onset of the Great Depression, then paying them down gradually (and reducing some of them via bankruptcy) may have done the trick (hopefully minus a World War…). But with probably more than twice as much debt compared to GDP as in 1930, we have a “Biblical” problem to which the solution must also be Biblical in scale.
Steve,
I’m wishing to clarify an issue with the money multiplier calculations. Are you aware of the educational animation “Money as Debt”? (It is on youtube) This short film has a sequence showing the bank’s money multiplier resulting from the fractional reserve ratio. However they show that the bank’s (high powered money) deposits get multiplied twice. That is, a ‘Bank A’s deposit of $1,111.12 in the central bank permits Bank A to loan (1,111 x 9) $10,000. Which gets redeposited, this customer deposit in turn provides (using the reserve ratio 9:1) funding for a secondary loan of $9,000 (0.9 x $10,000) and reserve of $1,000. Which permits a tertiary deposit of $9,000 and loan of $8,100 etc. They show the process continuing until the money created approaches $100,000. All this from a central bank deposit of just $1,111.
Is there something wrong with this calculation? , other than Basil Moore’s finding thanks loans come before deposits?
If this were accurate (and there is a 10:1 reserve requirement) would the ratio of money stock to central bank reserves be in excess of 100:1? Even higher because of Moore’s finding? Or am I getting my money (M0, M1, M2) mixed up?
I’m trying to verify their finding that:
1) Money is debt (or near enough all debt); And
2) The debt can only be paid off with money that inturn creates more debt (hence cannot be payed back).
Anarcho,
I realize I’m really late with this post, but just wanted to point out what I think might be incorrect with your argument re: Austrians.
There is not a contradiction with entrepreneurial activity. In a non-government-controlled system, there would be no banking as is known today. The contract that I sign with a bank when I give them my deposits would be honored instead of flaunted…ie they would simply store my property(gold/grain/money/whatever), not lend it out (I would pay them for this service). They may eventually issue banknotes to ease transactions instead of gold, but it would be necessary to have full backing in the vaults. There would be a natural check from excessive lending because other banks would demand specie payment instead of banknotes if the excessive lending occurred. Further, with no FDIC, depositors would be more vigilant in monitoring their banks instead of assuming deposits are insured and letting the banks do whatever they want with the property. Some ‘entrepreneurial’ banks would maybe try to game the system, but they would eventually fail, just like many entrepreneurs fail in any endeavor. The entrepreneurship would be shown in a number of other ways (ie: creating better distribution, ensuring the safety of deposits in better ways, etc.)
This says nothing about credit. There would still be credit in this world, just not ‘artificial’ credit. I would be in charge of deciding to lend my money, banks would not be in charge of lending my money. This would result in a higher nominal cost of capital than we have today, but would also result in a more effective allocation of resources. There would still maybe be times of unwarranted enthusiasm with lending like Steve talks about, but this unwarranted enthusiasm (ie misallocation), would manifest itself in losses, which puts a stop to the ‘bubble’.
And to earlier points, there is nothing magic about gold, it is just what evolved into a store of value over time (likely due to certain physical characteristics). Who knows, some other element may evolve as the next ‘currency’. It all depends what person B will accept in a transaction. In times of disaster, all the gold in the world won’t do much good if I don’t have food. The crucial (maybe unfortunate point) is that there is NO way to absolutely, positively, without a doubt store value over time. If I don’t consume now, I’m taking a risk that my savings become worthless, no matter in what form I save. People betting on gold are just hoping that gold becomes the standard again. Maybe it will be moon-rock.
Also, regarding an earlier post regarding cycles in ancient Rome. The cycles were created by the government debasing currency. They did not have paper money, but the government diluted the gold content of coins, which is the same thing.
All that being said, thanks to Steve for an extremely interesting piece and website. I look forward to reading much more of your work.
Dear Water,
I’m sure Anarcho will have his own take here, but let me make a few points as well.
One point of my paper was that as soon as you allow any lending whatsoever–ie as soon as the role of the banks goes beyond storing your gold to issuing loans–then you have a credit system where any link between “specie” and the money supply will be broken. One implicit–sometimes explicit–proposition in 100% money arguments is that the banks only lend out other people’s deposits, so that “deposits create loans”. Therefore there is supposed to be some limit on banks’ behaviour–”they can’t lend what they don’t have”.
Instead, when it is acknowledged that the act of lending creates deposits, so that the causation is reversed, then any 100% money scheme that allows lending will break down–not into a crisis necessarily, but it will allow the endogenous expansion of money independent of the supply of gold, or whatever other “specie” is used.
Now we have never in the past had a “banking” system that has been restricted simply to storing gold and charging the owners a fee for that storage. What the Austrian view of how capitalism should be, as you describe it and as I’ve seen it described in their literature, is a capitalism without credit–i.e. a form of capitalist system that has never previously existed.
Therefore their program is a revolutionary one–far more so than what I am proposing, which is to acknowledge that credit will always exist in a capitalist economy, and to redefine two of our key markets (housing and shares) so that the possibility of leveraged-based profits there is reduced. The Austrian revolution would almost certainly break down.
Even if the revolution was maintained–so that banks became only storage depots for gold–the vision that each of us would somehow become venture capitalists, deciding how to lend our gold out in return for a share of the profits in whatever entrepreneurial venture we decided to fund and that this system wouldn’t lead to a financial crisis I also see as ill-founded. It is almost saying that we’ll have a better system if the banks cease being banks, but all of us become banks instead. If a depositor in this world gave an investor gold, it would be in return for a document promising an interest-rate return on that loan. The role of banking in this free market system would then evolve amongst the agents who were initially told that they couldn’t be banks. I don’t believe you can keep that genie in the bottle.
Even if you did, there is then the issue of how production is actually extended in capitalism by innovation. This vision of a specie-exchanging world works OK for a given technology and a constant population. But what happens when a firm needs to expand with a, say, 5 or 8 year investment horizon for a new technology or a new factory producing the same old goods? If you could actually enforce this system, inevitably only short term projects would receive loans of gold. That’s not how production or innovation work–just ask an engineer like Brightspark.
Or ask an Austrian economist like Schumpeter. This need to finance innovation is, as he explains very well in The Theory of Economic Development, is a reason why the money supply expands endogenously in a credit-based system. To try to prevent by a 100% Money, or specie-only system, would drastically reduce the capacity of a capitalist system to innovate, when this is one of the main appeals that capitalism has over potentially rival social systems like, well, socialism. If there wasn’t any innovation worth speaking of, as for example in the old Soviet Union, then what is the argument in favour of the class division of society, where capitalists get the profits from the means of production and workers are excluded from it?
Schumpeter also explained very well why this legitimate and necessary aspect of a credit system lead to an endogenous expansion of the money supply. In my mathematical model, I have simply given expression to how that works.
For those reasons, I see the Austrian vision of how a capitalist system should be reorganised as anti-evolutionary on several important fronts–yet the main appeal of Austrian economics over neoclassical was its emphasis upon the evolutionary development of capitalism, the so-called “spontaneous order” argument that is a decent and sensible addition to economic thinking. But if you need to stop the evolution of a banking system–to police it out of existence in effect, so that loans were never allowed–and you suppress the rate of innovation by a lack of appreciation of the nexus between innovation and an expansion in the money supply–then you have a revolutionary program that is based on rejecting its own core.
Another such contradiction I see in Austrian logic is though its analysis of capitalism emphasises disequilibrium, there is an implicit belief that the system will never move too far from equilibrium–something I see you saying in the proposition that “There would still maybe be times of unwarranted enthusiasm with lending like Steve talks about, but this unwarranted enthusiasm (ie misallocation), would manifest itself in losses, which puts a stop to the ‘bubble’”.
Instead, once you properly acknowledge that a dynamic process won’t necessarily converge to equilibrium, you also need to be aware that such a system can and normally does move a large way from equilibrium. I work in “Far From Equilibrium” dynamics, and I think my appreciation of how such systems can be systemically stable but dramatically removed from equilibrium–as in for example a Van der Pol model of an electric circuit–is partly why I just don’t buy the Austrian belief that, even though the system necessarily wouldn’t operate where “the supply and demand curves intersect, it wouldn’t be too far removed from them either, therefore we can continue thinking about markets using supply and demand equilibrium analysis, so long as we don’t actually believe that everything happens where the curves cross, like the neoclassicals do…”.
Sorry to put words in a hypothetical Austrian mouth, but I’ve yet to see an Austrian analysis that fully comes to grips with how dynamic systems actually operate, so that behind a lip service to dynamics and disequilibrium I find a belief that supply and demand curves and comparative static processes suffice to describe how a capitalist system operates. I see that as being based on a lack of appreciation of dynamics, which is an ironic by-product of the Austrian refusal to do mathematical modelling.
So I expect that even if we had an Austrian revolution and 100% money, if it succeeded it would feel no different to the Soviet Union–little innovation, great inequality and no excuse for it–and it would almost surely break down into a credit-based system without any limits on how that credit was deployed, so that asset-price speculation would be as good a use for credit as any. We would then be back in the 19th century, when there was a major financial crisis every 20 or so years. I agree that the shorter time span between crises would mean they were less extreme, but their frequency would once again let the class conflicts over whether the system should exist at all to rise once more. I don’t see that as a vision of social progress.
Hi Steve – thanks for the interesting response.
Your comments on innovation, etc are quite thought-provoking. But,(if I am thinking about this correctly), I don’t think an Austrian-model banking system precludes credit at all. There would still be lending. There would still be bonds and bond funds. There could even be more complex debt instruments like mortgage-backed securities, etc. The difference is that the government/banking system wouldn’t be getting in the way and artificially lowering the cost of credit. And, there would still be venture capital funds (as well as equity markets) that would be responsible for funding 5-8 year capital projects, etc. But, in fairness, there would probably be less ‘speculative’ investing than currently (because of the higher cost of capital), so less innovation would result. On the other hand, one could argue that maybe all of the ‘important’ innovation would still happen because the scarcity of capital would result in more innovation. If I can’t rely on cheap capital to build a new factory, maybe I need to invent other ways to increase production with my existing factors of production. (I’m kind of talking in circles here…)
Your point on the “far from equilibrium” dynamics is even more interesting to me, and I don’t know enough to refute (or support) it. I tend to agree with you that even in this type of system there could be ‘collective euphoria’, etc which would push the system far from equilibrium and result in a mis-allocation of capital, similar to our current situation. As you said, this is not a vision of social progress. I need to think about this more.
Thanks again.
Hi Water,
Thank you.
On your note that the Austrian system would allow credit, that’s my problem with the Austrian model of how a free market financial system should operate. If lending is allowed at all (and of course it must be given the laissez faire bias of Austrian thought in general) then it won’t be a commodity money or 100% money system at all. Instead, it will be a credit-based system that fits within the analysis I gave in “The Roving Cavaliers”. It therefore won’t behave as Austrians expect with a tendency to equilibrium–it will in fact be more like the 19th century trade cycle, with a finance-induced Depression every 20-30 years.
A lot of the weaknesses I see in the Austrian position on finance relates translating thinking that is only moderately wrong about genuine commodity markets–where there is an almost instantaneous exchange of money for goods–to finance markets, where there is an instantaneous creation of money and debt, but then a long-lived relationship between debtor and the bank.
It is also well worth reading Schumpeter as you think about the innovation point. If you want a quick precis before diving into the book The Theory of Economic Development, check my lectures on Managerial Economics at my Debunking Economics website. I make heavy use of Schumpeter in those lectures, especially in relation to both innovation and the nexus between the endogenous expansion of credit and the funding of innovation.
Very interesting discussion.
All these posts rely on each person’s imaginary construction of what would happen in a free market for money and banking. (By ‘free market’ I mean a market governed by the contracts of the parties, not government controls on money and banking such as policies of lowering interest rates, required reserves, bailouts and so on.
Those proposing various governmental interventions are supposing that the free market would produce negative outcomes that make the expected positive outcomes of interventions worthwhile.
Yet we have no knowledge from history of what a free market in banking or money would look like, because governments have been actively intervening in them for the last 200 years, virtually always on the side of credit creation in excess of reserves held in specie, from which governments benefit in various ways. For a history of such interventions, see Rothbard ‘What Has Government Done to our Money?’.
Steve Keen’s thesis that the creation of credit is mostly a commercial activity still leaves open the question what would happen without government’s various schemes to permit and encourage lending unbacked by money in specie, to promote confidence in the banks by compulsory deposit insurance, to require a certain level of reserves, and to bail them out in a crisis.
How do we know that, absent the current policy framework, such credit creation would not be greatly curtailed, as I suspect it would be?
Let’s cut to the chase. What are the objections to a free market in money and banking? To answer that, we have to answer, what would it look like?
To start with, if government’s legal monopoly on creating money were abolished, and everyone had an equal right to create their own, then I could print Peter Hume dollars, and Steve could print Steve Keen dollars – as many as we liked. The problem would be getting Harvey Norman to accept them for a wide-screen TV.
Thus the market would evolve forms of money based on what is most widely acceptable: most probably gold and silver. But if it were something else, fine. None of the government’s business, we are supposing.
Banks would be free to back up their loans with 100% money in specie, or to hold only a fraction in reserve. They would not be allowed to say they hold 100% if they hold less, because of the common law against fraud. People could choose whatever level of backing suited them: even a variable one if they agreed to it.
Those who wanted the most security would deposit their hard-earned in a bank with 100% reserve. A run on the bank need not concern these depositors.
Those seeking higher returns and with a higher tolerance of risk, could choose to deposit their money with a fractional reserve bank, knowing that if there is a run on the bank they might lose out.
There would be no reason or justification for the government to back up those at risk from fractional reserve, because the risk would be on those who knowingly undertook it – unlike the situation now, where the effect of government involvement is to impose the risk of FRB on everyone whether they like it or not.
It is true that the FRB banks could increase the supply of money substitutes, and that this would generate, in Austrian terms, both inflation and malinvestment. But the difference from the situation now, is that losses from and bankruptcies of fractional reserve banks would provide a corrective feedback loop that is missing from the current government-backed system. The effect of such negative feedback over time would probably be to establish by custom prudential limits of minimal reserves, which would tend to protect the bank from bankruptcy at the suit of creditors, and thus to protect the depositors. I suspect the fraction held in reserve would be far far higher than the minimal reserves dictated by government, because government has only the weakest and most attenuated interest in not constantly inflating the currency – namely, the electoral processs.
What objections could there be to this simple, ethical and practical solution?
OK – I see that the majority of the money in circulation is created by an electronic ledger entry in a bank based on the promise of the debtor to repay. So the bank has lent out money that it never had.
I also read a lot about the banks being insolvent – too many bad debts. There are runs on banks. But if the money was never there in the first place and repayment of debt actually extinguishes the money – where is the problem? Not all of the debts are going bad (surely) and the banks continue to receive interest repayments on the other loans (of money they never really had either). So surely the banks should be fine … so long as they have at least enough reserves to repay the depositors?
On gold. I seem to have come to the definition of money as the recognized unit accepted for the removal of debt. The value of gold comes from its intrinsic lack of value. You dont eat it. It does not provide shelter. But it does not corrode or get used up. It can not be manufactured nor created nor faked. It makes a useful token or representation of money/wealth. It does not magically solve the problems of banking or finance. The problems come from the natural desire for man to want more. That is not in itself wrong or evil. But it is accompanied by a general level of selfishness and inability to understand delayed consequences of actions amongst others. The failure to understand exponential growth leads to exponential growth of problems.
Peter Hume:
Steve Keen has already answered these Austrian-style objections above and elsewhere. Without presuming to speak for him, I’ll just offer my own account. In the first place, credit is endogenous to the real production/business cycle, and is required to get it going: it’s not merely a matter of the banking/financial system. As for savings producing investments, well, that’s chicken-and-egg; investments in technical improvements in capitals stocks increase productivity and output, raising the real distributable surplus-product, from which extended credit/debt for such investment can be readily paid back, and then some, leaving increased profits, lowered output costs and even higher real wages. So investments can just as well produce savings and increase the supply of loanable funds.
If lending were restricted to “hard money” savings,- (and in the U.S., at least, “hard money lending” actually refers to severely predatory lending practices at usurious rates, in which the lender is actually speculating on the borrower going bust)-, then the production cycle might not even get going and would be slow to develop, if at all, a highly sub-optimal outcome, since, even with the dysfunctions that are likely to occur at the end of a production/business cycle, the increases in the capacity for generating real distributable output, real wealth in any relevant sense, is far greater than the liabilities involved in cleaning up the mess. Further, a common government issued currency not only regularizes the collection of taxes and facilitates transactions, but provides a uniform medium of accounts, which economizes on information analysis and reduces information asymmetries.
A privately based and thus multiple monetary system would greatly increase the costs of informational surveillance, (which ordinary savers and tradesmen would not be able to afford and would be disadvantaged by), and would reduce the transactional efficiency of credit-underwriting,, and, likely, increase the level of failures in the financial system, due to the difficulties in keeping track of it through multiple systems and thus the increased rate of errors. Finally, the idea that government could be completely removed from the functioning of a market system is a fantasy, since governments provide the regulatory framework of laws by which markets function, including, er, contract enforcement, as well as public goods, such as transport infrastructure, that private interests fail to produce or under-produce.
And opposing the economy to the political realm as if they were easily abstractable amounts to adding apples to oranges, not to mention stigmatizing political processes for being, er, “democratically” responsive, whereas market would be valorized precisely in that they fail to respond to ordinary people’s needs and interests is a weirdly inverted account of what would be “simple, ethical and practical”. Besides, far from never having been tried, something like Austrian proposal for banking were in force in 19th U.S.A. from the time of Jackson onward, and the result was frequent financial panics and the economy being stuck in sub-optimal stagnation “equilibrium” for almost half the time, compared to 20% of the time in post-war U.S. recessions, (though this one will be far longer and more severe).
John, I couldn’t have put it better myself.
Unless, that is, I put in a few more paragraph breaks!
For the sake of future readers, I might edit your entry now to break that long run of text into segments.
Go ahead, no problemo. It’s been done before, though not always, on reflection, where I think they might have gone. Sometimes I just forget to paragraph, trying to pick my brains in one continuous stream of thought, while trying to correct for all the typos.
Is that the best you can do?
So basically, the justification for the state’s intervention in money and banking, for imposing fractional reserve and its empires of scamming, the bubbles, the busts, the permanent inflation and the economic disorder it spreads, the consequential crises, the massive diversion of capital into unproductive activities, the widespread bankruptcies, unemployment, inflicted poverty, social dislocation and injustice on a massive scale, the hardship, bailouts for billionaires, handouts for political favourites, the use of inflation-taxing to fund imperial military adventures with hundreds of thousands of deaths, the state’s periodic destruction of literally billions and trillions of dollars worth of capital, not to mention the encouragement it gives to Marxists and their demonstrated genocidal stupidity, is so the state can ‘help’ us all by its wisdom in economic management which we need to avoid ‘sub-optimal’ economic conditions? I can’t believe anyone would say something so thoughtless.
Let’s get this straight. We all have to put up with the state permanently defrauding the population by inflating the money supply so it can take a cut through granting privileges to banks to co-loot the population, because of the economic benefits it brings, is that right? You answer yes, don’t you? Answer please? Please don’t evade the question and answer it directly on point.
Assuming you answer yes, then prove it. How would you know whether the costs outweighed the benefits?
Without government imposing fractional reserve banking on the entire population against their will, the “the production cycle might not even get going” – no-one would produce anything! – and we would all lie down in the gutters with our tongues hanging out, dying for the want of the state’s wisdom and capacity? You have decided on behalf of other people that it would be better if the state fuck their lives up on a massive scale, because the benefit “is far greater than the liabilities involved in cleaning up the mess”. Has it ever occurred to you they might be better off without your unsolicited assistance?
And that’s if you’re right. But what if you’re wrong? What if it’s not ture that no-one could produce something unless we had the state there to create real wealth out of thin air by forcibly taking money from A and giving it to B? This is not economics, it’s voodoo. And how do you know? Don’t tell me, let me guess … you’ve done a mathematical equation. Maybe you should put your head out of your garret every now and then to check what effect your theories are having in the real world.
But it goes on.
‘If lending were restricted to “hard money” savings’….’ (I didn’t say it should be, only that people should be free to choose),
this ‘actually refers to severely predatory lending practices’.
The lenders are so evil they actually eat the flesh of the borrowers. So answer me this: what is ‘predatory’ supposed to mean, apart from the fact that you obviously disapprove? Someone has a gun at the head of the borrower forcing him to enter the contract? Admit the term is arbitrary. You have provided no objection to freedom of contract in money and banking but hoary old anti-economic moralizing that lending is morally evil that and that has its roots in millennia-old religious blind prejudice.
How do you distinguish between the fair price and the market price in any given transaction? Answer please?
“A privately based and thus multiple monetary system would greatly increase the costs of informational surveillance…”
What’s that supposed to mean? Surveillance by whom? If by the state, that’s an argument in favour of freedom, not against it.
As for the idea that the state’s forcible monopolistic intervention is to reduce the costs to market participants, the basic idea is that the state is forcing them to accept a benefit, is that right? They are too stupid to know what transaction to enter into but the state has a kind of super-competence, that imbues it with knowledge, capacity and wisdom above mortal men. This is not economics, it’s blind worship of central planning despite more disproofs in theory and in practice than you could shake a stick at.
Let’s have no pretence that the primary purpose of the state’s involvement is anything other than to increase its own power as against the rest of society. Any advantage to society is far outweighed by the disadvantages. Because if what you were saying were true, people would voluntarily pay for these services, and wouldn’t have to be forced into them, wouldn’t they?
“Finally, the idea that government could be completely removed from the functioning of a market system is a fantasy, since governments provide the regulatory framework of laws by which markets function…”
I never said it could be. I defined a free market as one governed by the contracts of the parties, remember? Besides, the fact that the government has forcibly excluded competition to provide itself a monopoly in one area – law-making – is hardly reason for doing it in another – mney and banking.
You are providing arguments in favour of a free market in money and banking, not against.
“…as well as public goods, such as transport infrastructure, that private interests fail to produce or under-produce.”
Just because someone wants to get a particular good without paying the market price for it, doesn’t mean it’s ‘under-produced’.
What about surfing holidays for me? Can I get the state to force other people to pay for them? Why not? They are “under-produced” aren’t they? The state pays for football fields and velodromes as ‘public goods’.
What about sex? That’s a public good isn’t it? Why not? There was a case recently in Australia of people claiming the costs of visiting brothels – health massage – through the government’s compulsory health scheme. We all have a ‘right’ to a health ‘system’, don’t we? Answer please? According to your arbitrary definitions, there is nothing that is not a public good, and government has a right to control not just money and banking, but anything and everything.
The arguments against a free market in money and banking cannot withstand critical scrutiny, are a denial of economic science, and are used to justify fraud, destruction, and anti-social behaviour on a massive scale.
Governmental control of money and banking should be abolished.
Firstly Peter, you are new to the conversations here so you possibly don’t realise my emphasis on keeping the tone less than abusive. “Is that the best you can do?” is a suitable start to a flame war, but not a suitable contribution to a debate.
Since you start that way however, may I point out that your statement belies that you have not done particularly well here either. I would hope at least that you had read the post to whose discussion you are attempting to contribute. One essential point of that post was that “fractional reserve banking” is a fallacious description of the actual workings of our economy. Predictions that can be made from that model of money creation are strongly contradicted by the actual data.
Read the post and then see where the comments you try to dismiss out of hand actually come from. Address that and your contributions here will still be welcome.
I apologise for offending, and thanks for your kind hosting.
Your article refutes the neo-classical, Keynesian and monetarist schools, but not the Austrian theory of money and credit, which is consistent with all the real-world observations you make.
I submit that your article depends on a false distinction between credit money and fiat money.
It is a false dichotomy to oppose a ‘credit money system’ to a ‘fiat money system’ for the following reasons. Money in specie can be commodity money, like gold, valued by weight; or fiat money, taking its value from the stamp on it, not the commodity – paper or plastic – on which the stamp is made.
You could lend someone a unit of commodity money – an ounce of gold – which he has to pay back to you in specie. And you could lend someone a unit of fiat money – a ten-dollar note – which he has to pay back in specie. Thus ‘credit money’ (your claim to the money in specie after lending and before repayment) and fiat money are not mutually exclusive. Fiat money is merely one kind of money in specie.
What is causing the entire problem under discussion is not credit money being created greatly in excess of fiat money per se, since if our currency was a commodity money, and if the credit money was being created greatly in excess of that commodity money, we would still have the same problem. Therefore the distinction between credit money and fiat money cannot be maintained as the cause of the problem.
The problem is the creation of money substitutes in excess of reserves of money in specie that cannot be redeemed on demand.
(The reason they cannot be redeemed on demand is because of governmental interventions in money and banking, including an express or implied privilege to suspend redemption in specie in breach of contract, in the event of a run on the bank, and other supports of banks which would otherwise be sued to perform their contracts, or suffer loss or bankruptcy.)
To define my terms:
Money in the broad sense includes a) money in specie and b) money substitutes.
a) Money in specie is money truly so-called. There are two kinds. Commodity money, such as gold. And fiat money, such as in Australia the familiar plastic coloured government ‘banknotes’ that we have in our wallets. Fiat money takes its value not from the commodity value of the plastic, but from the government stamp that declares its value to be ‘ten dollars’.
b) Money substitutes derive their value from a claim to underlying money in specie. They are exchanged as money, and so are ‘money’ in the broad sense, but not money truly so-called, ie money in specie.
If the money substitute can be redeemed on demand for money in specie, for example a certificate of deposit of gold 100% backed by gold in the vault, it is called a ‘money certificate’.
But if the money substitute cannot be redeemed on demand for money in specie, it is called a ‘fiduciary medium’. It is this latter category that is the locus of all the mischief, the abuse of which has caused the current economic crisis, and that is the source of virtually all of the debt in issue in your article.
To discuss credit, or the economic crisis, without distinguishing these basic factual concepts of money in the broad sense, is what caused the neoclassicals, Keynesians and monetarists to fall into the error you note in your article.
However the same error affects your analysis and conclusion. It is not permissible, I submit, to talk of ‘credit’ without distinguishing what has been lent, because it makes all the difference to the whole question in issue whether the particular credit is redeemable in specie. If it was, there would be no issue – the problem is that it’s not. Therefore the critical distinction is not between ‘credit money’ and ‘fiat money’, it is between money substitutes that are redeemable in specie, and those that are not.
However assuming, in your favour, that by ‘credit money’ you meant ‘fiduciary media’ (money substitute unbacked by money in specie) and by ‘fiat money’ you meant ‘money in specie’, then your argument is that the banks’ creation of fiduciary media is what is creating the debt bubble, not the government’s printing of money. This is correct.
But the fact that the banks are creating new ‘money’ – fiduciary media – does not justify the conclusion that our money system is not a fractional reserve banking. On the contrary, by definition, fiduciary media are money substitutes issued over and above the fraction of money in specie held in reserve: that’s what’s causing the whole problem!
In these circumstances, the term ‘endogenous’ is ambiguous too and that argument cannot be sustained. The newly created ‘money’ (ie fiduciary media) is endogenous in the sense that it is created in the private sector: so much is not in dispute. But it’s not endogenous in the sense that it wouldn’t be created without government control of money and banking: that’s what’s enabling, or rather privileging it to happen.
In order to understand what is the root cause of the debt in question, we have to ask what would be the case in the absence of governmental intervention. You omit to do this, and the omission leads you into error, because you assume, correct me if I am wrong, that the governmental interventions do not affect the creation of credit. But in the absence of government policy privileging and backing the banks to create money substitutes unbacked by money in specie, there would be runs on the banks which would cause those with insufficient reserves to go broke. Thus the phenomenon in question is caused by government, not ‘endogenous’ to banks creating the new money substitutes.
Also your method involves:
* Assume the whole panoply of governmental intervention as a background fact: monopoly of legal tender, fiat money, the express or implied privilege against redemption in specie, required reserves, the central bank manipulating interest rates, and so on.
* Observe the creation of fiduciary media grossly in excess of money in specie by banks.
* Assume that the whole panoply of governmental intervention with money and banking has got nothing to do with this phenomenon: it is ‘endogenous’ to banks.
* Fail to inquire into the critical variable, namely what, in the absence of said interventions, would enable the banks to create unredeemable money substitutes on such a scale without being bankrupted by runs on banks?
* Beginning your understanding of the monetary system with credit, whereas credit is a credit of money or money substitutes. So both logically and historically, the beginning of credit is in what is being lent: money in the broad sense. The understanding of the monetary system must begin with money itself (distinction between commodity and fiat money in specie), then proceed to money substitutes (distinction between money certificates and fiduciary media), and then and only then is one in a position to understand the entire problem of money and credit that we are faced with.
Therefore I submit that Austrian theory refutes your argument; your argument does not refute Austrian theory.
Now I have answered your question, but you have not answered mine, which I reiterate: what objection could there be to a free market in money and banking? I do not mean the *political* arguments – a desire to get something for nothing, paid for by someone else under compulsion – such as our friend gave – the supposed benefits of ‘public goods’ that are ‘under-produced’: like today’s news of government’s funding of cancer research for dogs perhaps? I mean the economic arguments: in the absence of government control of money and banking, why would the debt problem the subject of your article not be eliminated, or greatly reduced, by the simple, ethical and practical solution of letting people choose whether their deposits be redeemable on demand or not, with banks that fail to honour their contracts, suffering losses or bankruptcy without bailouts or privileges, which is as it should be?
(It appears from your article that you are not familiar with Ludwig von Mises 1912 work The Theory of Money and Credit. In it he describes in detail what is happening in the current crisis with a clarity that is amazing, considering it was written before the first world war. Murray Rothbard in ‘What Has Government Done to Our Money?’ refutes the assumption that the phenomenon we are observing can be called ‘endogenous’ to the banks, and shows that they are the intended results of government policy. )
Ethics of private production of money: http://mises.org/story/3340
What’s causing the deflation: http://mises.org/story/3353
Dear Peter,
I don’t have time today to respond to this fully, but I will try to do so over the weekend.
Briefly though, you have misinterpreted my argument if you believe that I was asserting that credit money and fiat money are mutually exclusive. I asserted instead that both exist, but control goes from credit to fiat and not vice versa, which is the belief that underpins the “Money Multiplier” model of credit creation. Therefore we need in the first instance a model of money creation in the absence of fiat money, into which fiat money will be introduced at a later date.
Perhaps you need to read the argument somewhat more carefully.
We are agreed that the ‘Money Multiplier’ model is wrong. But that does not establish either the Marxian view or your own, especially if you carry forward the assumptions, confusion and error of the neoclassicals. We already know Marx was wrong in his theory of value, because he carried forward the error of the neoclassicals (LTV). Given that fact, how could his theory of money be correct? Doesn’t the theory of value apply to money?
Would you be so good as to answer the following questions?
Isn’t it true that in your argument the relevance of fiat money is in its being money in specie?
In other words if our money in specie, instead of being fiat money, were commodity money but otherwise the same total value and distribution, and the same proportion and relation to what you call ‘credit money’, then the problem would be the same, wouldn’t it? If banks were able to multiply credit money, and therefore debt, out of all proportion to money in specie without having to redeem it on demand, the problem would be the same, wouldn’t it?
If not, why not?
If so, then the significance of the fiat money is that it is money in specie, not that it is fiat money per se.
Isn’t it true that, if all of what you call ‘credit money’ were redeemable in specie, (and assuming that government were not inflating the supply of money in specie), then the original problem would not exist?
If not, why not? What would the moral or economic problem of debt be if it were all redeemable in uninflated money in specie on demand?
We don’t need to try to understand money and credit by starting with a non-existent ‘model’ of credit with unrealistic assumptions that do not distinguish between money truly so-called, and money substitutes redeemable and not redeemable in specie. That is a recipe for confusion and error.
We need to understand money and credit by understanding what the money is and where it came from in reality; and what money substitutes are and where they came from in reality. That will answer whatever question the model is intended to answer, and better. You can’t start with credit without first being clear what money is, and what money substitutes are, because that is what credit is a credit *of*. And you can’t just assume governmental interventions are ‘exogenous’ to the issue, because that is to beg the question: morally, economically and politically.
Last question please: in the absence of government intervention, what would stop those banks from going broke who issued money substitutes grossly in excess of what they could redeem in specie, from people demanding redemption?
Dear Peter,
You obviously need to read more of the posts I have made here, and my academic papers, before conversation with you is going to be productive.
For instance, I expect in your statement:
“We already know Marx was wrong in his theory of value, because he carried forward the error of the neoclassicals (LTV). Given that fact, how could his theory of money be correct? Doesn’t the theory of value apply to money?”
That you see the “labour theory of value” as Marx’s theory of value–and that therefore anything derived from Marx will be wrong and therefore that my theory of money, which is derived from Marx, is therefore wrong?
If I’ve guessed right, then please read the four papers on Marx on my Research page where I show that the labour theory of value is wrong. I have an interpretation of Marx which rejects that theory–so it is highly unlikely that “my theory of money” has the foundations, or the content, that you are presuming for it.
I also honestly can’t understand your comment that Marx “carried forward the error of the neoclassicals (LTV)”, unless you believe that Smith and Ricardo are neoclassicals. If that’s a slip of the pen, fine; but if not, from somewhere you appear to have got the argument that Marx’s predecessors were NEOclassical? They belong to what is called the Classical school–which is quite antithetical to the Neoclassical school on the topic of value.
Please clarify what you mean by those topics; if your answers make sense to me, then I’m willing to continue the conversation. But if not, I think you had better spend some time reading a much broader literature than you have to date.
Steve, I just read this from George Soros
“The scale of the problem is more than in the Great Depression because of the leverage involved. The ratio of debt to gross domestic product has increased from 160 percent in the 1920s to 350 percent last year, and is set to rise to 500 percent, he said. ”
A whopping 500 % ! What do you think Soros are saying, I dont get it. That the leverage will go up further, or that the GDP will contract so badly that the current 350 %, turns into 500 % of the much smaller GDP ?
http://www.bloomberg.com/apps/news?pid=20601087&sid=a60APVwmz01g&refer=home
A bit of both prudentbear,
The government bailouts are adding to debt (Soros is using the aggregate figure including government debt); the failure of counterparties in the insane derivatives trade will add to debt–each 1% netted out will add $6 billion to the recorded debt level, and god knows what the total will ultimately be; and both real output and prices will tank as they did in 1930-32.
The US’s private debt to GDP ratio was 175% in late 1929; it hit 235% simply via deflation and falling output as nominal debt levels fell. The same will happen in spades again this time, along with the additional madness of derivatives.
‘He fell like a tower, and his armour rang upon him.”
Homer
Steve Keen having gone down in a welter of evasion, appeal to absent authority and personal argument, will anyone accept my challenge to answer the questions I have asked, consistent with defending Steve Keen’s hypothesis?
“Shrieks of silence”, their only reply.
What this means is that the problem is not ‘endogenous’ to the banks. It is caused by government policies of inflating the money supply, including by extending to banks the explicit or implicit privilege of suspending redemption in specie, as well as the whole panoply of governmental fraud aka monetary policy, which should be abolished.
Late comments on an excellent post -
The multiplier of course is garbage. You’ve demonstrated this at the macro level empirically. It’s also obvious at the micro operational level of a bank treasury function, and corresponding central bank operation, including forecasting and OMO functions.
Your synthesis of the fiat and credit money domains is the most elegant construct I’ve seen in explaining all this. It’s missing in too many other PK type explanations.
Interesting also that you focus on gross debt rather than the net government / non government financial positions that some of your blogging colleagues (PK?) dwell on. I also find the Chartalist theme to be strangely inconsistent with the net government deficit emphasis. Seems to me the Chartalist rationale is sufficient but not necessary for commercial acceptance of HTM. Also, operational liberation is emphasized elsewhere to the point of deemphasizing a still required policy process (i.e. policy interest rate and expenditure and tax and deficit parameters, based on educated and appropriate assessment of economic capacity and inflation or deflation risk)
I disagree a bit on Bernanke. Although he talks up the monetary effect (e.g. helicopter) in speeches etc., I think the recent monetary base expansion is a by product of the Fed stepping in to assume part of the commercial bank credit function. The fact that he’s paying interest on reserves suggests implicitly to me that he’s paying little attention to the money multiplier argument. In fact, he’s explicitly dissuading the banks from acting on such an erroneous interpretation by paying interest on reserves.
Your lending reserve construct is a little difficult to incorporate. Of course, it doesn’t really correspond to traditional financial accounting, whereas most of the other components in the model do. This makes it slightly unwieldy to synthesize, but not impossible at all. It reminds me most closely of excess capital, although that is definitely financially accountable. And it’s relevant. A fundamental error with the money multiplier story is that it pretends to ascribe bank credit rationing according to liquidity rather than capital. That, plus the story on liquidity (i.e. reserves) is completely wrong, of course.