Mainstream monetary theory — neat, plausible, and utterly wrong

22 June, 2017 at 16:21 | Posted in Economics | 10 Comments

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.

garbageOne 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 …

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10 Comments

  1. Yes. Insanely stupid.
    .
    One problem I see as an obstacle going forward is that a profession peopled predominantly with those so lacking good taste and judgment as to accept this nonsense in textbooks is incapable of the discrimination necessary to do better. Economics is trapped in a Dunning-Krueger hell of its own making.

    • What are you talking about here? The mainstream or MMT? The text is confusing enough already. The headline gets dissed in the text but it does quote Mankiw, a supporter of the mainstream. The mainstream is filled with nonsense. Steve Keen goes into details if anyone is interested.

      MMT is quite simply a description of the economic reality of today. So it cannot possibly be said to be “utterly wrong” Any more than the Constitution is wrong, for the Constitution is the source of the currency and the laws that manage it. They all come from thin air and thus so does the dollar.

  2. Very nice article. The MMT folks have been saying this for quite a while now. Bruce Wilder might be right about why mainstream economists won’t accept this reality but instead continue to teach their textbook stories. I think once you realize that banks don’t function primarily as intermediators, you are led to the conclusion that the loanable funds theory just isn’t right either. And that poses fundamental problems for New Keynesians, so they just ignore it, and continue on as if we were living under a strict gold standard.

  3. ” At a deep fundamental level the supply of money is endogenous.”

    Is it?

    This is the opinion of Prof. R.A. Werner:

    He agrees that the demand for credit is “very large (perhaps infinite)”. Werner, Richard (2005), ‘New Paradigm in Macroeconomics’, Basingstoke: Palgrave Macmillan P195.
    However: “We conclude that the likeliest assumption concerning the determination of the credit market is that it is supply-determined.” {Following Stiglitz and Weiss: Credit rationing in markets with imperfect information, American Economic Review, vol 71, no 3, pp. 393-410}. Werner, Richard (2005), ‘New Paradigm in Macroeconomics’, Basingstoke: Palgrave Macmillan P197

    • ” At a deep fundamental level the supply of money is endogenous.”

      Is it?

      The answer to your question is- Yes.

      How can something that costs nothing to create be limited by the supply of it? Governments will always create money whenever they decide they really need to, such as in a war. Banks will create money whenever they think it will be profitable, only limited by the government and the eventuality that their created money will be converted into government money which they will be obligated to hand over.

      The supply of money in a fiat monetary system is limited only by the monetary policies the government wishes to implement at that time. Most governments are interested in allowing growth in their economies, since it tends to keep people happier than the alternative. Therefore, they will allow the money supply to adapt to the needs of the economy whenever they realize or decide it is in their interest to do so. Of course, they may be idiots and not realize this, or their interests may not be the same as the majority of their citizens at times, and both of these situations often occur.

      • Not quite right, Jerry. Those governments which are MONETARY SOVEREIGN are free to do whatever they choose regarding their currency, but they can only create it in response to debt. They can’t just “print” it without a specific reason. Banks too have to have loan requests before they create the credit entries and translate them into the currency.
        But no problem with your contention the government can alter what happens to the currency. As both the constitution, and its laws including the creation of the national currency, political decisions etc all come from thin air. Government has decided to be stupid and tie spending down to a debt limit. It is an utterly useless device, resulting from extreme ignorance and malfeasance from politicians compounded by the toxic doctrines from mainstream economics.

        • Partly true but partly false. I would point out that the decision to limit the country’s options by using a different currency is a policy choice in and of itself. A truly sovereign country such as France could decide to leave their monetary arrangement just as they decided to join it. That is also a policy choice. There might be consequences and costs, but they could re-establish their own currency whenever they decided to. That is the nature of being a sovereign government- it means you make your own decisions until someone else comes and invades your country.

          And any truly sovereign country with their own currency can create more of it at whatever point the government decides to. That’s not even debatable. The US Fed had no problems creating trillions of dollars when it wanted to for QE and if Congress told it to create more money for whatever purpose, well it would just have to do so. The money might not be able to purchase anything, but that is a different argument.

          • So what was true and what was false? Splitting straws now.

  4. Ejhr, what is true is that banks need customers that want to borrow if they are to create ‘money’. What is false is that a sovereign government can only “create it in response to debt”, which even though I don’t know what that means, I know is false. National governments can do pretty much what they want to within their borders- both fortunately, and unfortunately. At least for some period of time. And definitely with their currency. In my opinion. And in fact. 🙂

    • It’s not my theory, Jerry. It’s MMT. Modern Monetary Theory. or better; Modern Monetary Mechanics. [people confuse theory with hypothesis, and MMT is not hypothetical, just factual] I’ve never seen it explained, but it is a tenet of MMT that the government can ONLY create money in response to debt. I would guess it’s just not necessary.
      After all it never needs to borrow or save its own currency, since it can buy any and every debt ad hoc. What the idea there is of borrowing from the banks is just because that’s what the banks want and is of course a major beef Ellen has with banking. The politicians are slaves to the banks, corrupted by donations.


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