Money, Credit and Central Banks in PKE Marc Lavoie
Outline of the chapter on PKE money • 1. The main claims of the post-Keynesian views on money, credit and finance • 2. PK monetary theory in historical perspective • 3. The horizontalist and structuralist controversies • 4. New developments in monetary policy implementation • 5. Monetary policy implementation in the aftermath of the subprime financial crisis • 6. Implications for public finance theory and for open-economy monetary economics • 7. The integration of PK monetary economics into PK macroeconomics
Part I Preliminaries
Endogenous money supply: A PK claim now accepted by many schools • Post-Keynesians • Neo-Austrians • New Keynesians • (New consensus authors), Woodford, Taylor, Roemer, Meyer • (New Paradigm Keynesians, focus on credit) Stiglitz, Greenwald, Bernanke • Real business cycle theorists • Barro, McCallum • Goodhart
Cambridge proverbs • The Cambridgian hare: « Economic ideas move in circles: stand in one place long enough, and you will see discarded ideas come round again. » (A.B. Cramp 1970) • Most of modern monetary controversies can be brought back to the 1844 Currency school (Ricardo) and Banking school (Thomas Tooke) debates. • The Radcliffe commission view (1959), endorsed by Kaldor and Kahn, which was considered dépassé in the 1970s and 1980s, is now back into fashion.
Part III The Structuralist vs Horizontalist PK controversies
“A storm in a tea cup” (Moore 2001) ? • The first exponents of money endogeneity were mainly “horizontalists”: Robinson, Kahn, Le Bourva, Kaldor, Moore, and the French “circuitists”. • The main “structuralist” critics were Le Héron, Dow, Wray, Howells, Pollin, and Palley, many of which got their inspiration from Minsky. • As Fontana (2003) puts it, “structuralists took over where the accommodationists had stopped”.They brought some clarifications and provided new details. For instance, they insisted that spreads between interest rates could quickly vary, due to assessed default risks or changes in liquidity confidence. Sometimes, however, they constructed a “horizontal strawman” in an attempt to highlight the originality of their contributions. • To a large extent, the controversy has petered out, for reasons that will soon be given (although Rochon has rekinkled some excitement by editing a forthcoming book on the topic!).
The horizontalist claims • 1. The supply curve of money (or high powered money) can best be represented as a flat curve, at a given interest rate. The short-term interest rate can be viewed as exogenous, under the control of the central bank, within a reasonable range. • 2. There can never be an excess supply of money. • 3. The supply curve of credit can best be represented as flat curves, at a given interest rate (or rather at a set of interest rates). • 4. Central banks cannot exert quantity constraints on the reserves of banks.
The structuralist points (in italics points that I believe were off the mark) • 1a. What about the reaction function of the central bank? [Chick 1977, Rousseas 1986, Palley 1991, Musella and Panico 1995] • 1b. Long-term and other market-determined rates “cause” the overnight rate [Pollin 1991] • 2. If loans create deposits, how do we know that households wish to hold these deposits? [Howells 1995] • 3a. What about credit rationing (shape of credit supply curve)? [Dow2 1989] • 3b. What about borrower’s risk? [Minsky 1975, Dow and Earl 1982] • 3c. and lender’s risk (liquidity preference of banks)? [Dow2, Wray 1989, Chick and Dow, Bibow 2009] • 4a. What about financial innovation, with changes in the velocity of money and liability management, which are the main sources of money endogeneity [Pollin 1991, Palley 1994] • 4b. Surely the central bank does not always “accommodate” and hence exerts quantity constraints on bank reserves [Pollin 1991]
The horizontalist answers I • 1. On the horizontal supply of HPM: • New operating procedures, based on a target overnight rate, show clearly that central banks control the overnight rate and can set it at will, notwithstanding what “markets” think; • Of course, if, in general, higher economic activity is accompanied by higher inflation rates, then, through the central bank reaction function, higher interest rates are likely to accompany higher economic activity, and thus the supply of money or HPM will appear to be upward-sloping through time.
Horizontalist answers II • 2. On the impossibility of excess money: • The main argument is the “reflux principle”. • The stock-flow consistent models of Godley have shown that, despite the presence of an apparently independent money demand function and the presence of a supply of money function based on the supply of loans, flow-of-funds accounting is such that deposits must equate loans despite no such condition being inserted into the model. • In more sophisticated models, changes in liquidity preference by households will induce changes in relative interest rates; but this was never denied by Horizontalists.
Horizontalist answers III • 3. On the horizontal supply of credit: • It has been shown by Wolfson (1996) that there is no incompatibility between credit rationing and horizontalism. It was never denied that banks could modify their lending norms. • It is now clearly established that higher economic activity does not necessarily entail higher debt ratio for firms (contradicting the essence of Minsky’s financial fragility hypothesis). This is now recognized by Wray, a student of Minsky. • But of course, as firms move from one risk class to another, they will trigger higher interest rates. • Recent events have clearly shown that interest rate spreads rise in times of crisis, or when the economy is brought down, not when the economy is quickly expanding.
Horizontalist answers IV • 4. On quantity restraints on bank reserves: • There is no incompatibility between horizontalism and bank innovations or liability management. • New central bank operating procedures clearly show what was hidden before: central banks passively try to provide the reserves being demanded by the banking system. • The «unconventional» operating procedures introduced during the subprime financial crisis have shown that central banks could impose excess reserves while keeping the overnight rate at its target level.
Conclusion • The original horizontalist depiction, that of Kaldor and Moore, is still the most appropriate. • But Structuralists have helped to fill in many details. • As Wray (2006) concludes: • «There cannot be any automatic and necessary impact of spending on interest rates because loans and deposits can and normally do increase as spending rises. The overnight rate will change only if and when the central bank decides to allow it to do so. Short-term loan and deposit retail rates can be taken as a somewhat variable mark-up and mark-down from the overnight rate.»
Part IV New developments in monetary policy implementation by central banks
New operating procedures and horizontalism • Central banks have new operating procedures, although they are not that much different from what they used to be. They bring central banks closer to the « overdraft economy», and further away from the «asset-based econonomy» as defined by Hicks. • The procedures of some central banks are more transparent (than they were and than those of other central banks), so the horizontalist story is more obvious: Canada, Australia, Sweden • The procedures of other central banks are less transparent; but when interpreted in light of horizontalism, we can see that their operational logic is identical to that of the more transparent central banks (like the Fed, until 2008, or Brazil, see Carvalho de Rezende IJPE 2009).
The new operating procedures put in place in Canada and other such countries are fully compatible with the PK monetary theory • Central banks set a target overnight rate, and a band around it • Commercial banks can borrow as much as they can at the discount rate • There are no compulsory reserves and no free reserves (zero net settlement balances) • The target rate is (nearly) achieved every day • Central banks only pursue defensive operations, trying to achieve zero net balances. • When there are tensions, as during the recent subprime financial crisis, they try their best to supply the extra amount of balances demanded by direct clearers (mainly banks)
Post-Keynesians Based on a microeconomic justification Tied to the inner functioning of the clearing and settlement system Linked to the day-by-day, hour-per-hour, operations of central banks New Consensus Based on the 1970 Poole article A macroeconomic justification If the IS curve is the most unstable, use monetary targeting If the LM curve is unstable (money demand is unstable), use interest rate targets Two different justifications for the current interest rate procedures ?
The microeconomic justification for interest rate targeting • Central bank interventions are essentially « defensive ». Their purpose is to compensate the flows of payments between the central bank and the banking sector. • These flows arise from: a) collected taxes and government expenditures; b) interventions on foreign exchange markets; c) purchases or sales of government securities, or repurchase of securities arrriving at maturity; d) provision of banknotes to private banks by the central bank. • Without these defensive interventions, bank reserves or clearing balances would fluctuate enormously from day to day, or even within an hour. The overnight rate would fluctuate wildly.
Authors who support the microeconomic explanation • Several central bank economists • Bindseil 2004 ECB, Clinton 1991 BofC, Lombra 1974 and Whitesell 2003 Fed • Some post-Keynesian authors • Eichner 1985, Mosler 1997-98, Wray 1998 and neo-chartalists in general • Institutionalists • Fullwiler 2003 et 2006
This was understood a long time ago by some PK economists • “The Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system” (Eichner, 1987, p. 849). • “Fed actions with regards to quantities of reserves are necessarily defensive. The only discretion the Fed has is in interest rate determination” Wray (1998, p. 115).
There is no relationship between open market operations and bank reserves • “No matter what additional variables were included in the estimated equation, or how the equation was specified (e.g., first differences, growth rates, etc.), it proved impossible to obtain an R2 greater than zero when regressing the change in the commercial banking system’s nonborrowed reserves against the change in the Federal Reserve System’s holdings of government securities ....”(Eichner, 1985, pp. 100, 111).
Principles of central banking (Fullwiler 2009) • 1: The daily operations of central banks are mostly about the payments system, not reserve requirements. • 2: The operating target of central banks is necessarily an interest rate target. The money multiplier framework is inapplicable and untenable in practice • 3: The central bank accommodates banks’ demand for reserve balances while offsetting changes to its balance sheet inconsistent with such accommodation. • 4: Reserve requirements have to do with interest rate targeting, not money supply targeting. • 5: Potential deviations in the overnight rate rate from the target rate are set by the central bank collateralized lending rate and the rate of interest on reserves. • 6: Implementing a new target interest rate does not require any open-market operation (the so-called liquidity effect). • 7: The central bank operations, overall, are about “price,” not “quantity”.
Conclusion: The Cambridgian hare! • « Today’s views and practice on monetary policy implementation and in particular on the choice of the operational target have returned to what economists considered adequate 100 years ago, namely to target short-term interest rates » Ulrich Bindseil 2004, ECB, formerly from the Bundesbank