Did Keynes Understand Endogenous Money?
One of the core understandings of MR is the endogeneity of money. That is, almost all of the money in our monetary system is created by banks almost entirely independent of the government. It is created INSIDE the private sector. The government has essentially outsourced the creation of money to a private oligopoly of banks who compete for business. This fact is largely untouched in most of mainstream economics. And there might be a fairly good reason why.
JM Keynes is clearly one of the most influential economists of all-time. Perhaps THE most influential economist of all-time. His General Theory is a veritable bible for many economists. So it’s interesting to note that while many economists during the era of Keynes were aware of the endogeneity of money (Soddy and Fisher for instance), Keynes himself appeared extremely confused on the subject. In the General Theory he wrote:
“We can sum up the above in the proposition that in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions-motive or the precautionary-motive, which will realise itself in actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash.”
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“In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed.”
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“Thus we can sometimes regard our ultimate independent variables as consisting of (i) the three fundamental psychological factors, namely, the psychological propensity to consume, the psychological attitude to liquidity and the psychological expectation of future yield from capital-assets, (2) the wage-unit as determined by the bargains reached between employers and employed, and (3) the quantity of money as determined by the action of the central bank“
These are various forms of a money multiplier or government centric money system and they’re inapplicable to the way the system is actually designed. It’s clear that JM Keynes did not have a solid grasp of endogenous money. And perhaps that explains why so many modern day economists and economic models simply ignore the reality that banks rule the monetary roost. Perhaps the confusion over so much of modern macro stems directly from the master himself? Was the most influential economist of our times actually woefully misinformed? It appears so….
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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Just when I think you’re a Keynesian you go and pull this. In the words of Arnold, “what the hell are you”?
http://www.youtube.com/watch?v=zuuzipXwjnw
In the Treatise on Money he’s very clear that banks can and do create money
The General Theory was published after the Treatise.
It is possible for an economist to understand banks create money and still assume an exogenous stock of money.
This quote is a dead ringer for the money multiplier:
“Thus we can sometimes regard our ultimate independent variables as consisting of…the quantity of money as determined by the action of the central bank”
Of course, even neoclassicals believe banks create money. They just believe banks create money based on “the action of the central bank”.
Is there anything by Keynes proving that he didn’t believe in the money multiplier? I doubt it.
I’d be very curious of this as well. He was critical of the quantity theory, but was he critical of the idea that banks are not contrained by their reserves? I highly doubt he wrote anything of such nature. So the inconsistencies between the TOM and the GT appear to make perfect sense.
Keynes did understand endogenous credit. He wrote about the “finance motive” in 1937 in a restatement of the General Theory and covered it numerous times afterward.
I find it interesting that his most influential document is clearly confused on the matter….If he understood it he didn’t communicate it very clearly.
It’s frequently noted that Keynes was using a fixed money supply to simplify the General Theory (it was general, after all, and he built upon it later) while also showing that classical economics was fundamentally flawed even with an exogenous money supply. Keynes was aware of what he termed the “monetary theory of production.”
He very clearly provides conflicting views of the way money is created. See p. 247, p. 205, p. 84, 167, 174, 230, and 267 of the GT (1936). “the quantity of money as determined by the action of the central bank”, “the quantity of money created by the monetary authority”.
You might also read Keynes’s letter to Roosevelt dated 1933
Yep.
His own quote applied to himself:
“The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”
The person who first clearly understood money endogeneity was Nicholas Kaldor – Keynes’ follower – in 1939. (Although some Horizontalists take issue with this, I think they misread/misunderstand).
The assumption of an exogenous stock of money also gave his opponents a chance to prove him wrong – most notably Milton Friedman.
Do not understand what you mean.
Milton Friedman advocated a stable supply of money to control inflation. If that is not beleving in exogenous money I do not Know what is. Friedman was so far off with his theories that it is just coincidence if he was correct on some smalt part of economic theory.
What I meant was that since Keynes assumed an exogenous stock of money – unlike his Post Keynesian followers – this gave Milton Friedman plenty of opportunities to attempt to prove Keynesianism wrong. Which is strange.
You can refer to Kaldor’s Limitations of General Theory (1982) for a more detailed history. Don’t know if it online.
Thanks for your answer. Clear for me now.
I’m reading The General Theory now. I’ll report back if I come accross anything relevant. One interesting point that might be relevant, but I’m not sure yet if it is relevant, is sometimes the Classical authors “abtracted out” or ignored or held constant, some aspect they wished to highlight the importance us.
For example, according to Maurice Dobb in The Machinery Question and the Making of Political Economy (in Chapter 4…), while many economists and historians say that Ricardo ignored the importantance of technological change and free trade becaus since were “abstracted out” of his model, Dobb says the truth is the opposite: by holding them constant, and demonstrating the falling rate of profit of capital, Ricardo was demonstrating the importance of technological change and free trade in overcoming a faling rate of profit (and a stationary state).
Maybe such an “abstracting out” is also at work in the GT. Maybe not. I’ve got my eye out for it as I’m reading it.
Cullen,
You are an monetarist by heart, that is why you decide to pick on Keynes. I agree that Keynes did not fully understand enogenous money, however it was followers of him that used his work to develop the theory, the Post-Keyesians. Still you blame him for the quantity theory of money. And also, At Keynes time, endogenous money was not mainstream.
Seems to me tatt you are doing this as an attack on MMT and the Post-Keynesians.
Well, that’s a first. I’ve never been called a monetarist. And for someone who is in favor of counter-cyclical govt policy and hates the way the Fed intervenes via QE I think you’re off by a country mile there.
I like the post-keynesians. But they don’t get everything right. I knock a lot of schools here. Austrians, Keynesians, Monetarists, etc. I am an equal opportunity critic of bad economic thinking. I’ve been hard on the MMT people in recent months, but that’s just because they love to troll the site here. They should stop coming around doggin a man in his own pad. (if you get that movie reference you win a gold star).
I don’t write the critical pieces because I am attacking people. I attack ideas and explain why I think they’re wrong. All in the pursuit of better understanding. That’s all. It’s never personal with me, but some people take criticism very personally instead of viewing it constructively. As if they have the whole world figured out and if anyone criticizes their view then they’re either an idiot or a jerk….Maybe we’re evolving ideas here and developing a most accurate portrayal of the world? And maybe criticism is a good part of that process? I think so. I certainly get criticized a lot. And I try to take it constructively….
Been reading your blog for a long time and Know you are very objective. Did not mean to imply that you have anything personal against people from other economic schools.
Let me clarify. As we all Know, people differ on how symphatetic they are towards the private and the public sector. Know people who could only work for one of those sectors. Some people can not have a boss and will be self-emplyed. The public sector guys will tend to favor Keynes, and the private sector guys seems to favor Friedman. Very generally speaking.
This seems to blue peoples jugdement when it comes to what role the private and public sector should play in society. For some the public or private sector is all bad. I come from Norway and here the same purpose is deemed more morally justifiable if it is conducted by the public sector than the private sector.
However, my understanding, evolved partly from your blog, is that if one understands the way the monetary system work one will be able to support fiscal stimulus, Even if one consider oneself a private sector guy. As you mentioned in your answer you support counter-cycle govt policies, so I should not have critizised you for thinking that way. Appoligize for that.
Not sure if I make myself clear, however, when I try to explain Ideas from MMT or MR to people they seem to think of it as extremely left wing. And this is in Norway were almost everbody is socialist, Even those who think they are not, and I personally do not consider me one. I am not thinking about JG either, which I Know is not a part of MR. I am also highly critical of how the government spends money in this country.
My point is that if I understand you correctly, you want to explain how the system works so they best can decide how to conduct policy regarding their political beliefs. Not try to create a theory of how the system works based of one’s political belief. I do not think mann people would oppose counter-cycle policies if they understood the monetary system, but socialists would probably spend more and conservatives would cut taxes.
By the way, did not Get the reference.
What do you disagree with post Keynesian about? Pretty much everything you have written here has already been written by post Keynesians, including this critique of Keynes and endogenous money. Not that this is a bad thing, I think both you and the post Keynesians are right.
But a big problem with MMT is that they make unwarranted claims to originality, it would be nice if MR didn’t do that.
Depends on what you mean by post-keynesian? PKers range in ideas and understandings fairly broadly. I have been fairly critical of many of MMT’s ideas in recent months. So there’s quite a divide there.
I learned just about everything I know from someone else. My papers online are filled with citations and thank yous. Unfortunately, the nature of blogging makes for poor citations. Sorry about that. I don’t ever mean to imply that we’ve come up with purely new ideas. A lot of what we’re discussing has been written about by someone in the past. Hence why I post pieces like the Soddy quote here….Obviously, I didn’t come up with all that which is why I am crediting Soddy for originally understanding endogenous money….I’m just a young punk absorbing information and trying to compile it in the manner that is most easily teachable.
Let us assume the quantity of money IS determined by the central bank.
What does that ability mean for the average American? Does that abiity make his life materially better, than if the central bank was more constrained in its ability to create money.
Don Levit
Cullen
You need to read his later work in 1937 “Alternative theories of the rate of interest” to actually see Keynes clearly thinking in terms of endogenous money
““financial provision” before the investment takes place; that is to say, before the corresponding saving has taken place… may be provided either by the new issue market or by the banks ;—which it is, makes no difference.” ” (246)
“if the banking system chooses to make the finance available and the investment projected by the new issues actually takes place, the appropriate level of incomes will be generated out of which there will necessarily remain over an amount of saving exactly sufficient to take care of the new investment.
The control of finance is, indeed, a potent, though sometimes dangerous, method for regulating the rate of investment (though much more potent when used as a curb than as a stimulus).
Yet this is only another way of expressing the power of the banks through their control over the supply of money—i.e. of liquidity.” (248)
I don’t think any of this is inconsistent with the Hawtreyan view that the central bank controls the banking system, but the banks are able to have enormous influence through their multiplication of reserves. In other words, Keynes never rejected the money multiplier. He understood that banks have a huge influence, but not any better than anyone working under the standard MM did….
Do you know if Keynes ever explicitly rejected the MM?
Cullen
Do you know if Keynes ever explicitly rejected the MM?
Not exactly but below comes pretty close.
Yet this is only another way of expressing the power of the banks through their control over the supply of money—i.e. of liquidity.” (248)
In Chapter 15 GT … Keynes explicitly raises the issue of how a change in money supply comes about … either as a counterpart to increased income … or ‘by a relaxation of the conditions of credit by the banking system’ [GT: 200]…
“It will, therefore, be safe for us to take the latter case as typical….” (GT 200-201)
So Keynes of the General Theory (1936) appears midway between the argument that the State controls the creation of money, and that the banking system does.
Keynes 1937 thinking is rather different, obviously endogenous.
You are correct in trying to put this into the proper context. The title of your post “Did Keynes Understand Endogenous Money?” would be fairly applicable to the monetary system existing during his time.
We have to be fair and realize there are limitations relevant at origin of something (eg, airplane) might not affect what it evolves into (eg, jet airplane).
In other words, just because Wilbur and Orville Wright did not explicitly have a vision for jet airplanes does not mean they did not understand aerodynamics.
I love watching the Keynesians squirm as they realize that their idol didn’t understand banking.
Oh not really. The Keynesian principle of effective demand completely changed the profession and how the world runs.
I wouldn’t say he didn’t understand banking (that’s harsh). I’d say he didn’t understand it in its entirety. But the world was a very different place in his time. The modern system was mostly undeveloped or underdeveloped. Many changes have occurred since he died long ago and his impact on understanding is probably more influential than anyone else. He obviously wasn’t perfect on banking, but then again, I am beginning to think that no one in the world is….
I think *some* of the more neo-classically inclined economists such as Nick Rowe or David Glasner might not have a problem with the MR description of banking mechanics or even the concept of the “endogeneity of money.” However, they would probably argue that the CB does have a lot of influence over endogenous money creation because of their ability to set the overnight interest rate. I think Rowe argues that explicitly by stating that between six-week meetings of the CB board in Canada to set a new interest rate, everything works as stated in MR and that the money supply “is perfectly elastic wrt the overnight rate.” However, over a longer time horizon (like 2 years), and because the CB targets an inflation rate rather than an interest rate, the supply of endogenous money is “perfectly inelastic” wrt the overnight rate and instead is “perfectly elastic” wrt the inflation rate.
I’ve tried to decipher this last bit by Rowe several times and failed.. but I’ll say that he and Glasner would say that the CB has a BIG influence on the supply of money through this overnight rate… at least in the long term (over time periods big enough such that their rate changes can have the desired effect).
I can see where the CB can have an influence over these long time periods, but I don’t think it has “control.” What are you thoughts Cullen?
Perhaps my disagreement w/ Rowe and Glasner is a matter of degree. They both seem to imply a greater level of influence than I would ascribe to the CB’s interest rate setting.
I’d suggest that in the medium term the central banks have control over demand through interest rates. They can increase or decrease demand by lowering or raising rates. That is why the Treasury model of stock prices is so influential.
When the CB raises interest rates it reduces the desire to borrow and spend/invest, crimping demand. As demand falls and there is net repayment (net balance sheet deleveraging) the banks are unable to increase overall supply because demand has gone. So in that sense the CB can stop an increase in supply which amounts to an element of control over supply.
They do this by significant increase in rates which stops demand because hurdle rates of return get too high and asset prices can start to fall. Falling asset prices further impact the desire to borrow and invest in those assets whose prices are falling. The banks can’t destroy money (perhaps other than through writeoffs of bad loans) and they can’t force people not to deposit/repay, so they either buy existing debt (private or government)(thereby lowering the yield on that debt as they bid up the price) or fund government deficits by buying newly issued government securities or increase reserves at the CB. So net repayment by the private sector transfers part of the stock from the non-bank private sector to the bank sector which must then find other sources of investment opportunities other than in the domestic private sector which is deleveraging. In the end that is ultimately either overseas, government sector or reserves at the CB.
The banks can supply in an unlimited fashion but don’t because of fear of losses and also because of the application of various constraints on lending such as capital adequacy, cost of capital, reluctance to dilute existing shareholders etc. That fear of loss is diminished as periods without losses lengthen and is increased when losses are high and asset values have fallen. So banks control supply too in some ways, but not completely.
Being able to create unlimited amounts of money does not equate to total control of supply (and demand).
“private oligopoly of banks who compete for business”
Don’t oligopolies avoid competition?
“banks rule the monetary roost”
What do you mean by that? Banks index their IOUs to central bank money, so surely the central bank has some part in ruling the roost since it sets the value of the unit.
Apart from that I do agree… Keynes tended to always assume a fixed money supply.
JP Koning, I hope to see Cullen’s responses to your questions. My thoughts: regarding oligopolies, perhaps Cullen means that the banks are obviously private, privileged (they have charters to create money as good as US bank notes, and we don’t), politically influential (try putting a banker in jail!), and many have TBTF status, and perhaps, most importantly, the Federal Reserve system was designed with their interests in mind, even if it does also impose some limitations on their behavior. If every citizen’s birthright were to have a banking charter, and to be able to keep his accounts with the Federal Reserve and have an implicit guarantee of being bailed out then it would no longer be an oligopoly (however it might be a mess!). After all, what is a bank other than a guy with a charter and a ledger (upscale banks have spreadsheets). Seriously… what else do you really need?
“banks rule the monetary roost”: I think this refers to the banks as the main agents of money creation in our system. But also I think this gets back to the main purpose of the Fed: To act as a central payment clearing house and to make sure the system runs smoothly. Part of making the system run smoothly (and to prevent bank runs) is to ensure that reserves are there when needed. Think of the chaos that would ensue if customers found messages on the screens of every ATM in town saying: “Sorry! Out of cash, the Fed has decided to limit supply!” Hahahaha! Or perhaps have your check bounce, not because you didn’t have “funds” in your deposit, but because the Fed refused to honor an overdraft of your bank’s reserve account to pay the other bank (even though those funds would only need to be temporarily created by the Fed).
Of course the Fed can set the overnight rate and do lots of other things (QE, Monetary Policy, etc). Also, along w/ other agencies, it can act as a regulator, but we’ve seen what that amounts to in recent decades! Hahahaha!
Oligopolists still have to compete to sell their goods and services. They just do so in coordination with their fellow market rulers. Maybe oligopoly isn’t the exact right word, but it’s pretty damn close to what modern banking amounts to.
I’d say that the Fed only loosely controls the money supply. Bank lending is influenced by the benchmark rate, but it is merely one variable in the process and less influential than most presume. I think of the central bank as supporting the banking system and not dominating over it. The Fed is designed primarily to facilitate and support private banking. Not to steer it or control it.
Cullen, I think you’ve answered my question (the one above JP Koning’s) with this sentence:
“Bank lending is influenced by the benchmark rate, but it is merely one variable in the process and less influential than most presume.”
I think that Rowe and Glasner would disagree as to the degree of influence. I’m with you here… I see influence, but nothing approaching control.
Tom + Cullen,
There are many monetary phenomena so the term “ruling the monetary roost” is perhaps a little too confining since it implies only a single monetary phenomenon over which institutions might rule. Yes, private banks are responsible for creating money. But if the Fed chooses to change the medium of account and targets 100% year-over-year increase in, say, the S&P, then surely it is “ruling” something.
But I am probably splitting hairs by now. Keynes used the term “ruling the roost” so you are probably parroting him here for stylistic purposes more than anything.
Hi JP,
I agree. But I also think it’s important not to drift into the world of theoretical overreach. The Fed is a bank much like any other bank. It can create money from thin air. But there are legal constraints to its ability. In the USA, the Fed is not legally allowed to purchase stocks on the secondary market. But, in theory, the Fed could buy up everything as Scott Sumner often states. The Fed could also become a lender to the private sector at 0% which would be straight money printing. Of course, it doesn’t do these things. That’s in large part because the Fed is designed to facilitate the existence of private banking. The Fed has to be careful not to overstep its legal boundaries here or it begins to drift into the realm of hurting the very entities it exists to support.
Cullen
Isnt a zero % loan still a loan? Its not money printing technically. Just cuz I dont pay back interest, the fact that I have to pay back the principle makes it different than a helicopter drop. No?
Well, in my mind, banks are the money printers. The govt is a money redistributor. The fed is a bank. It makes loans and buys securities that already exist. That’s why I use that example. If the govt wanted to print money the US Tsy could just start firing off money into people’s accounts with total disregard for balances in the TGA account, but that’s obviously not what it’s designed to do. But THAT would be pure money printing in the cleanest sense.
JP Koning, is there a difference between “medium of account” and “unit of account?” I’m just trying to decipher that sentence.
Tom, boy have I got the thing for you.
JP, Thanks!
The first quote concerns cash, which is the purview of the monetary authority. Anybody else creating cash is a counterfeiter!
The second and third quotes are ambiguous as to whether the new money is being supplied directly by the monetary authority or being brought into being (by others) through its actions.
At worst, not proven; at best, innocent as charged.
S = I?