Money, loans and economics
from Merijn Knibbe
In a blogpost, Paul Krugman asks, while defending the heuristic use of neo-classical economics : “What would truly non-neoclassical economics look like? It would involve rejecting both the simplification of maximizing behavior, going for full behavioral, and rejecting the simplification of equilibrium, going for a dynamic story with no end state.” Well, I personally do agree very much with the last part of the sentence – it’s also called ‘history’. But that’s not the point. There is more the matter with neo-classical economics. Lets give the floor to Charles Goodhart and his lament and amazement about why neo-classical economists did not even took notice of ‘money’ anymore, in his lecture “Whatever became of the monetary aggregates”
Let me turn, finally, to my main point. This is that the so-called neo-Keynesian basic model is based on inter-temporal utility maximisation by a representative agent, based on the assumption that all debts are ultimately paid in full, otherwise known in the jargon as the transversality condition. But this means that everyone is perfectly credit worthy. Anybody’s IOU can, and would, be accepted in exchange. There is no need for commercial banks, and there are none in Woodford’s iconic book, Interest & Prices . Indeed it is hard to see why there should be any need for a specific monetary asset, since everybody’s IOUs can be used for exchange purposes. All fixed-interest financial assets are effectively identical, and there is one single interest rate in any period, though it may shift over time as borrowing and savings propensities alter. Moreover nobody, and no firm, is liquidity constrained, ever. Indeed the conditions necessary for a no-default system to operate, either complete financial markets for every possible contingency or perfect information, are, I believe, identical to those that will allow a full Arrow-Debreu-Hahn Walrasian equilibrium to operate. As we know, money is not necessary in such a system. Thus, by basing their model on the transversality condition, the Neo-Keynesians are turning their model into an essentially non-monetary model. So it is no surprise that monetary variables are inessential in it. In reality, many agents in the economy, both persons and smaller companies, cannot sell assets, since they do not have sufficient saleable assets, or borrow, except at exorbitant interest rates. They are effectively liquidity constrained, with their expenditures limited to their current income and their few current assets. As Maurice Peston write in his 1980 book (Chapter 1),
“In Keynes’s General Theory consumption is determined by income to a very considerable extent because the latter constrains the former. The poor household has no liquid or marketable assets and can hardly borrow. It can only spend its income.”
It is that constraint that modern Neo-Keynesian theory assumes away. Perhaps as we all become richer, and come to own more assets, such constraints will in practice bind less and less, and then money and commercial banks – and traditional Keynesian analysis – will indeed become less important. But I do not believe that that time has yet come. For a recent excellent empirical article on this, see Nier and Zicchino, (2006). For the time being, the degree to which the current income, plus liquid asset, constraint bears on current expenditures depends to a considerable extent on the willingness of, and the terms on which, banks will lend to the private sector. This is a key reason why I believe that the rate of growth of bank lending to the private sector is as, or a more, important monetary aggregate than broad money by itself. Obviously it makes no real difference whether an established company sells a bond to, or raises a loan from, a bank, but a small company, or person, can usually only borrow from a bank, and then only in loan form. So, shifts in bank willingness to extend such loans, as banks become more, or less, risk averse, will have the effect of shifting the constraints affecting the economy. In particular, when the growth rate of the money stock is declining, whole segments of the economy that were previously not income constrained may suddenly become so, and at a time when income is probably also dropping.
By the way
- the non-monetary economy described by Goodhart did to an extent exist in the pre 1850 village economy, not because everybody was wealthy but because everybody knew each other (and had, therewith, access to consumer credit provided by the blacksmith, shoemaker, bakery etcetera). But this credit used the going unit of account and can therewith be considered ‘money’, though it was indeed emitted without the interference of banks.
- in the last sentence Goodhart of course more or less describes the present situation in Greece, Ireland, Italy and Spain – though he could of course not have anticipated that countries like Ireland and Greece should not only witness a decline of the growth rate of money (M-3 without cash) – but an actual decline of the absolute amount of 30%, while the rate of decrease is increasing, according to the latest data (May/June).
- mind that he, unlike neo-classical economists, uses a “loans create deposits” framework (though he tends to mix up loans and deposits)
- the statement that poor households have no access to kinds of credit is not true and a fundamental misunderstanding about the nature of monetary economies