Home > Uncategorized > Mainstream monetary theory — neat, plausible, and utterly wrong

Mainstream monetary theory — neat, plausible, and utterly wrong

from Lars Syll

In modern times legal currencies are totally based on fiat. Currencies no longer have intrinsic value (as gold and silver). What gives them value is basically the legal status given to them by government and the simple fact that you have to pay your taxes with them. That also enables governments to run a kind of monopoly business where it never can run out of money. Hence spending becomes the prime mover and taxing and borrowing is degraded to following acts. If we have a depression, the solution, then, is not austerity. It is spending. Budget deficits are not the major problem, since fiat money means that governments can always make more of them.

Financing quantitative easing, fiscal expansion, and other similar operations, is made possible by simply crediting a bank account and thereby – by a single keystroke – actually creating money. One of the most important reasons why so many countries are still stuck in depression-like economic quagmires is that people in general – including most mainstream economists – simply don’t understand the workings of modern monetary systems. The result is totally and utterly wrong-headed austerity policies, emanating out of a groundless fear of creating inflation via central banks printing money, in a situation where we rather should fear deflation and inadequate effective demand.

The mainstream neoclassical textbook concept of money multiplier assumes that banks automatically expand the credit money supply to a multiple of their aggregate reserves.  If the required currency-deposit reserve ratio is 5%, the money supply should be about twenty times larger than the aggregate reserves of banks.  In this way the money multiplier concept assumes that the central bank controls the money supply by setting the required reserve ratio.

In his Macroeconomics – just to take an example – Greg Mankiw writes:

We can now see that the money supply is proportional to the monetary base. The factor of proportionality … is called the money multiplier … Each dollar of the monetary base produces m dollars of money. Because the monetary base has a multiplied effect on the money supply, the monetary base is called high-powered money.

The money multiplier concept is – as can be seen from the quote above – nothing but one big fallacy. This is not the way credit is created in a monetary economy. It’s nothing but a monetary myth that the monetary base can play such a decisive role in a modern credit-run economy with fiat money.

In the real world banks first extend credits and then look for reserves. So the money multiplier basically also gets the causation wrong. At a deep fundamental level the supply of money is endogenous.

One may rightly wonder why on earth this pet mainstream neoclassical fairy tale is still in the textbooks and taught to economics undergraduates. Giving the impression that banks exist simply to passively transfer savings into investment, it is such a gross misrepresentation of what goes on in the real world, that there is only one place for it — and that is in the …

  1. Edward Hadas
    June 24, 2017 at 7:17 pm

    Well said, and the good news is that there are some serious people – Samuel Knafo and Christine Desan come to mind – who have explored and explained the history. The bad news is that everything in the economics establishment, from the statistics that are collected to the way politicians are expected to talk, is set up to deny the fiat nature of modern money. It’s a long an undistinguished tradition. As Desan point out, the “gold standard” was an almost pure fiat system, covered up with commodity rhetoric….

  2. June 24, 2017 at 8:51 pm

    Useful post.

    “One of the most important reasons why so many countries are still stuck in depression-like economic quagmires is that people in general – including most mainstream economists – simply don’t understand the workings of modern monetary systems.”

    I believe that another reason is that, without neoclassical orthodoxy, the capitalist emperor has no clothes.

    The neoclassical orthodoxy endures, in spite of a plethora of serious theoretical and empirical flaws — including the refusal to consider money endogenous — because of the cover it provides for this inhumane and unsustainable system. So the pedagogy keeps people in the dark, even if the pedagogue didn’t necessarily intend that. I do believe the intent is to defend the status quo in many many cases because alternatives are so uncertain. And the status quo will be dominated by predatory corporate capitalism until the latter dies of economic obesity.

  3. Paul Schächterle
    June 24, 2017 at 9:31 pm

    Regarding the “money multiplier”:

    There are banking laws regulating what banks are allowed to do and not to do. So maybe the banks are indeed required by law to have a certain minimum ratio of reserves to credits given. Maybe that affects only certain types of credits. I do not know.

    What I would be interested in is what the legal reserve requirements for banks are in certain countries, and if these legal requirements really do limit credit creation or if there are for example unregulated types of credit, or maybe if there is another reason why reserve requirements do not limit credit creation.

    • Edward Hadas
      June 24, 2017 at 9:46 pm

      Fractional reserves are mostly a mythical constraint, since loans create deposits, and deposits can fairly easily create reserves. Check out Richard A Werner, who explains this clearly

      • Paul Schächterle
        June 24, 2017 at 11:09 pm

        I do not understand how deposits could create reserves.

        Of course if a deposit is created because the account holder deposits cash at the bank then the cash would constitute a reserve.

        Does Mr. Werner cover this topic, and which book or paper of his would you recommend? Thanks.

    • June 26, 2017 at 8:28 pm

      Most countries don’t have reserve requirements in the 10% range that textbooks mention. It’s a few percent. But whatever the amount, reserves are always forthcoming. First a commercial bank makes mortgage loans, then it finds it needs a few % reserves, it asks the central bank to borrow reserves, and the central bank says yes. At most, having to borrow reserves imposes a tiny cost on the commercial bank. It’s not a limit of any sort.

    • Malcolm
      June 28, 2017 at 6:41 pm

      You might be interested to know that 95-97% of money in circulation (not cash notes and coin) is created by commercial banks. Only 3-5% is created by public (government) spending. The reserve deposits banks are required to hold against loans is therefore tiny. It varies from country to country and type of loan – some do not require to have any reserve. You’ll need to check out the Modern Monetary Theory Facebook pages and look for Stephanie Kelton and Randall Wray lectures on YouTube :-)

  4. William Yohai
    June 24, 2017 at 9:55 pm

    A detailed and entertaining explanation in Galbraith’s “Money”.

  5. Craig
    June 24, 2017 at 10:34 pm

    Yes, the problematic paradigm of the money system is the primary and deepest problem of economics, and its resolution would literally transform it, stabilize it, make a lot of other related problems dissipate or disappear and virtually all other aspects of the economy would fall back into their proper place where if necessary they could be regulated along the philosophical lines of the new paradigm. Historically, this is the nature and effect of a paradigm change, a maximum of transformation, a minimum of structural destruction a refinement of purpose and ethics in the area in which the paradigm change occurs. Everything adapts to a paradigm change….not the other way around.

  6. June 24, 2017 at 11:23 pm

    “What gives them value is basically the legal status given to them by government and the simple fact that you have to pay your taxes with them.”

    This phrase is repeated around like a mantra but is essentially untrue, or at least misleading. The legal status of Currency does not grant any value to a currency; it merely makes it the unit of account, store of value, medium… etc. Value comes solely from the products and services available for exchange, let us say from GDP. Another way, legal status grants something the status of a store of value (a trivial observation) but its value is determined by economic output.

    Pretending that money’s value is ‘determined’ by edict causes more misunderstanding down the way, like the MMT mantra that ‘the government can never run out of money’; sure, but it can run out of Value that money could store or represent.

    http://www.paecon.net/PAEReview/issue70/Kowalik70.pdf

    • June 25, 2017 at 4:17 pm

      I’m guessing that use of the word “value” is ambiguous here, and that Syll means not specific monetary value but value in the sense of being worth anything at all, or meaning anything at all. Fiat money has been the money of my 82 years, even with the gold standard; and the meaning of that money includes both faith in the government and its tax/police powers.

  7. Craig
    June 25, 2017 at 4:52 am

    “…sure, but it can run out of Value that money could store or represent.”

    What if you implemented a policy that integrated price deflation throughout the economy?

    • June 25, 2017 at 5:13 am

      I am not clear what you mean Craig, too vague for me to answer.

      • Craig
        June 26, 2017 at 3:48 am

        The money and pricing systems are both digital. If you implemented a policy of discounting the retail product of each business model by 35-40% and created a separate monetary authority to rebate their discounts to consumers back to them you could integrate price deflation beneficially into profit making systems and help to break up the monopoly monetary and financial paradigm of Debt and Loan Only at the same time.

      • June 26, 2017 at 5:10 am

        Do you mean that sellers would be free to set their own price but whatever the price paid the buyer would be entitled to a government rebate of X%, as a kind of reward for spending? I am assuming the money to pay for that rebate would be digitally ‘printed’ by the Government…

        If my understanding above is correct this would not be deflationary but inflationary, as it would amount to subsidising consumption with newly created funds, thereby expending the money supply at the retail consumption end of the economy. The inflationary pressure on prices would of course be offset by indirectly also stimulating production, as well as possibly reducing the demand for bank credit, but it would also inevitably add to our foreign debt since the largest chunk of consumption is directed towards imports.

        There is no shortage of quite sophisticated ideas how to reclaim what I call ‘monetary sovereignty’ from the banks, end reliance on public debt and reduce private debt. Here is my own attempt to do just that: http://www.paecon.net/PAEReview/issue70/Kowalik70.pdf

        The main problem is not shortage of workable ideas for reform, but political willingness to even openly consider them, given the immense, lethal power of the global banking cartel. Very few politicians would be brave enough to challenge the credit monopoly of the banks on in a major way, especially knowing that the parliament is studded with backstabbing agents of the financial sector.

      • Craig
        June 26, 2017 at 8:02 pm

        “If my understanding above is correct this would not be deflationary but inflationary, as it would amount to subsidizing consumption with newly created funds, thereby expending the money supply at the retail consumption end of the economy.”

        The point of “retail product” sale is the point of summation of costs and prices for any product or service, so if the discount was applied exactly at that point and time, especially at each point of sale throughout the entirety of the economic/productive process….how could it possibly result in price inflation?

        “but it would also inevitably add to our foreign debt since the largest chunk of consumption is directed towards imports.”

        Not any more than it does already, and seeings how a sufficient universal dividend would make the “problem” of unemployment basically disappear domestic producers could harmlessly re-industrialize in the most efficient and productive way possible thus weaning ourselves off of Finance’s wet dream of globalization, and also get ahead of the curve of the just beginning disruptive force of AI which will be destroying aggregate demand at a far higher rate than it ever has before. Foreign trade will remain foreign trade.

        Of course implementing every new idea is a political struggle. All the more reason to pitch it to self interested constituencies like the general populace, students in particular, and the small to medium sized business community all of whom stand to benefit from such policies.

        Cynicism is irrelevant and defeatist. “Without a vision the people (and their civilization) perish.

  8. Bill
    June 25, 2017 at 11:22 am

    Again and again I find it extremely perplexing that “Money” and its creation being the central hub of all economies has not been understood yet but economists nevertheless assume they know how economies work.

  9. June 25, 2017 at 3:38 pm

    I’m of the “money is just a measuring tool, a weight on a tray made to measure fair trade” school.
    (Equitable exchanges different forms of labor time. Reserve currencies, SDRs being monetizations of world average labor time embodied or added (WALT A) between each money transaction, each transformation into money of a commodity embodying bossed time for pay, aka each amount of labor
    time,
    But, as Mr Marx observed, if exchanges were indeed perfectly equitable, there’d be no wealth created. No surplus value, aka no (WALT A minus WALT Consumed). And once we recognize
    (WALT A – WALT C) = SV is the same quantity as Social Surplus it just depends on “which side are you on” :
    those with lots of 010010011s after $,€,£,¥ in electronic accounts only they have the password to OR those for making the accounts transparent and regulated to pay for more and better teachers and doctors and Lift drivers and artists and http code writers, and lots of paid time off Dreaming up yet inconceivable shareables.

    • June 25, 2017 at 10:29 pm

      If money were just a measure then how could you meaningfully exchange the ‘measure’ for that which is ‘measured’. The ‘measure of value’ is illogically incompatible with the ‘store of value’ functions of money. That is precisely the definitional ambiguity (or better, absurdity) that the financial leaders works hard to preserve and legitimise in order to perpetuate the associated inequity and the unearned profits for themselves that go with it.

      • June 26, 2017 at 5:35 pm

        Precisely. I want to correct my elaboration. I need to insert “monetized” (wALT A – WALT C) = common wealth.

        It is in the transformation of M1-> C -> M2 that the money grows but as a function of The C, the commodity, being Labor time. But more precisely money grows as a function of difference between the monetized (the price realized on the sale of the)labor time added and the monetized (wage, or labor price paid the laborer who added it, which can be driven down to the wage of the laborers who produce the commodity laborer must buy to work another day)
        UBS since the 90s, maybe earlier, biannually publishes comparisons of wages and prices of sample necessities in major world cities. They use the term “working time required to buy” and this obfuscates that the real value is labor time required to make, or better said, to sell, to the buyer. Market supply and demand, cartels and boycotts can vary the price, but not the use value nor labor time. Fashion can alter use value, i.e. What is wanted (defines as desired or needed) thence demand . And technology certainly alters labor time.

  10. June 25, 2017 at 8:35 pm

    Lars wries: “That also enables governments to run a kind of monopoly business where it never can run out of money. Hence spending becomes the prime mover and taxing and borrowing is degraded to following acts. If we have a depression, the solution, then, is not austerity. It is spending. Budget deficits are not the major problem, since fiat money means that governments can always make more of them.”

    True, to a large extent, but not the essence of the problem. Government, the State, has relegated money creation to private banks, which now create some 97% of our money supply. They do so out of thin air when providing a loan. Moreover, following economic dogma, governments only trust and allow private banks to bring money into our economy. Therefore, when central banks create money through quantitative easing the money is not provided directly to government – with which it could, for example, pay off the national debt (especially that caused by bailing out the banks) as well as invest in greening the economy, education, research and health care. No, the money created has to go to the commercial banks which are expected to sluice it into the economy, thus providing economic stimulus. Unfortunately, in an economic downturn banks see more commercial potential in making the QE money available to clients for speculation and for mortgages for overpriced housing (hey, haven’t we seen that before?) than for investment in the “real” economy. Small wonder, then, that QE leads to new bubbles in financial markets and the housing market, but not or barely to a growing economy – apart from the limited growth generated by people, business and government taking on even more debt than before the crisis.

    Our financial system is dysfunctional. Our governments do little about it except tinkering in the margins where a radical overhaul is needed. As a number of organizations argue, notably Positive Money in Britain and the American Monetary Institute and the Public Banking Institute in the US, governments should take back the right of seigniorage: the right to create money. That would allow creating debt-free money for direct use by the State – what Lars is arguing for. And it would allow a better tuning of the quantity of money to the economy and broader, the needs of society. To ensure the right to create money is not abused by eager and spend-thrift politicians the mentioned organizations propose creating an independent Fourth Power or branch of government, the Monetary branch, which decides on money creation and management without interference by the other branches. Kind of like today’s central banks, but without the influence of private banks on those.

    Nothing of the kind is yet in sight, though several central banks and governments are studying the options. One would expect the banking sector to be the main opponent to having taken away its lucrative money creation privilege, and it is certain to offer fierce resistance. But for the time being banks can still hide between the broad back of mainstream economic dogma. Mainstream economics, with its unquestionable faith in markets and ingrained distrust of government, will defend the current monetary system to its last breath. The most formidable obstacle to a new monetary system, then, is economics: a market of private banks is the only way to ensure a money supply in line with supply and demand.

    Monetary reform along the lines proposed by the above mentioned organizations is the only way to effectively address not only our economic problems, but also our environmental and social ones. For more see my booklet “Our Money”, a free download from http://positivemoney.org/wp-content/uploads/2015/10/Our-Money-06-4-2015-A5-Download-Positive-Money-28-8-2015-2.pdf

    For a financial-economic analysis how money is created see a.o. Richard Werner, A lost century in economics: Three theories of banking and the conclusive evidence. International Review of Financial Analysis, Volume 46, July 2016, 361–379, http://www.sciencedirect.com/science/article/pii/S1057521915001477?np=y

  11. June 26, 2017 at 4:56 pm

    I’m of the “money is just a measuring tool, a weight on a tray made to measure fair trade*”school.

    But, as Mr Marx observed, if exchanges were indeed perfectly equitable, there’d be no wealth created. No surplus value, aka no monetized World Average Labor Time Added (WALT A) minus WALT Consumed.

    And once we recognize (WALT A – WALT C)monetized***= SV = SS = the Common Wealth**, then it’s just a matter of how you respond to the song. “Which side are you on? Which side are you on?” The side of those with lots of 010010011s after $,€,£,¥ in electronic accounts only they have the password to? OR The side for making the accounts transparent and regulated to pay for more and better teachers and doctors and Lift drivers and artists and http code writers, and lots of paid time off Dreaming up yet inconceivable shareables.

  12. June 26, 2017 at 9:19 pm

    I sort of agree but that should be the starting point of discussion. All money is a social token, including gold. The commodity value of gold as a useful metal is tiny compared to the real economy, and if it were higher we wouldn’t keep gold idle in vaults. Money is a token that gets its value from real goods, not the other way round.

    Also I doubt that pure fiat of MMT money would work. Both are coercive: You must accept my notes or else, you must pay taxes or else. People will rebel against this if they can. Prosperous economies are built on carrots. Money gets its value when people who can produce stuff agree to give you their stuff for money, because it lets them buy other stuff from their peers. And if the state wants to play any role in this, it has to own the means to produce desirable stuff like electricity or transportation.

    As to why the fairy-tales in the textbooks? I’d ask the academic economists that question, by my guess is to hide to what extent money, the creation and supply of it, is privatised. Under the guise of technocracy, states depend on bankers. Central bank money creation is “inflationary” and verboten, while commercial bank money does what it likes. Perhaps the politics of this situation make the textbooks inaccurate.

    • June 26, 2017 at 10:51 pm

      Thank you Pavlos Papageorgio, for “money gets its value when people who can produce stuff agree to give you their stuff for money because it lets them buy other stuff from their peers”
      I
      I’d like to see that phrased to include a definition of labor. …when people agree to spend time doing what another wants (desires OR needs) in exchange for means/money they can exchange for what they want from yet another(s). Money as a means for exchanging different forms of world average labor time, i.e. Labor theory of value. I worry we lose our chance at socialism by falling for GI or UBI money income schemes to soften effect, more importantly, deter thinking and preparation for expansion of more AI

  13. Risk Analyst
    June 26, 2017 at 11:31 pm

    After all this, it is still not clear what money is. The old textbooks had money defined as currency, or currency plus checking accounts, or the aforementioned plus time deposits and so on in buckets called M1 or M2 or M3 and such. But if you go to the very latest Federal Reserve Monetary Policy report dated February 2017, what do you find? There is not a single mention of the money supply in the whole report. No M1 or M2 or M-anything. Even the Fed seems to have admitted that they influence interest rates and let the money supply set itself endogenously. There are lots of interesting discussions about economic indicators like unemployment in their Monetary Policy report, but not one word that I can find about any money supply.

    Why are the Mankiws of the world still providing the old framework? Interesting question. Perhaps the Mankiws sell what people are buying. Note that in the midst of the financial crisis, Fed Gov. Mishkin quit the Fed because he saw the huge demand and potential income possible from revising and getting out another version of his college textbook (as reported in Wikipedia and in Bernanke’s Courage to Act p. 172). Mishkin’s book has lots of pages on the money multiplier.

    • Craig
      June 27, 2017 at 2:27 am

      Money is most basically accounting, and most specifically its subset cost accounting. Take the data there and do the calculus on the rate of flow of total costs and so prices and the rate of flow of total individual incomes and that ratio exposes modern technologically advanced capital intensive economies.

      • Craig
        June 27, 2017 at 2:28 am

        exposes modern technologically advanced capital intensive economies’ most basic problem.

      • Risk Analyst
        June 27, 2017 at 5:45 am

        Yes, I think that topic is interesting but also how financialization seems to generate money or assets with moneyness. For example, if Miss Julia Investor moved $15,000 in 2013 from her checking account to a mutual fund with tech stock exposure and sold it now, she would have doubled that money and could buy a cute silver Audi sedan. So where did that “money” come from? No one was worse off and had to empty their checking account to pay her. The money just showed up because other investors thought tech companies went up in value. And Miss Julia does not know any macroeconomists and thought both that her checking account was money, but also thought of her investments as money. And in a way, her Audi is like money because she could sell it and buy a Caribbean Cruise. She does not know nor really is concerned that some macroeconomist is trying to figure out how and where to create and delete ledger entries to make his definition of money agree with her activities.

      • Craig
        June 27, 2017 at 9:02 am

        Yes asset inflation is the fly in the ointment of many an economic theory. Liberal/Keynesian theorists tend to pretend it won’t happen in theirs, and Conservative/Libertarian/Austrian theorists are obsessed with stopping it or embrace deflation and the pain it causes.

        What is necessary is to take adult responsible control of money and pricing….but with gracious and unobtrusive policies strategically timed and placed so as to benefit both the individual and enterprise

      • Risk Analyst
        June 27, 2017 at 6:19 pm

        And ignoring asset prices is pervasive too. In the last posting of the Real World Econ Review there are two different articles on money with both trying to use a T account to explain money creation. The second I see a T account graph in such an exposition, its credibility in my opinion goes to zero. The Fed’s idea of monetary policy involves interest rates and raising or lowering asset prices like bonds, equities and houses to achieve their goals. Likely not a single Fed economist could tell you the current measure of M2 within a hundred billion dollars, and yet we still get these articles as if this is 1950.

  14. June 30, 2017 at 2:53 pm

    I’ve had to turn to an etymological dictionary to find the meaning of the terms ‘exogenous’ and ‘endogenous’. The one means “growing from the outside” (like a tree) and the other “growing from the inside”. The evidence points to the monetary subsystem being exogenous, i.e. with the banking circle growing what eventually becomes dead wood in central banks.

    The important question, though, is whether the monetary system is a subsystem of the economic system. If the purpose of the economic system is to enable people to survive and the purpose of what we have now is chrematism (i.e. to make money), then chrematism is exogenous to economics and the more it succeeds by controlling its risks, the more it reduces the once endogenous economy to dead wood.

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