Few debates are as central to the heterodox-mainstream divide as endogenous and exogenous money theories. Neoclassical economists side with the exogenous ‘money multiplier’ idea, which says the banks receive reserves from the central bank, which they then lend out. Endogenous money proponents – generally post-Keynesian – side with another story, which says that banks create loans ‘out of nothing’ first, then the central bank more or less passively accommodates their demand for reserves.
In a final bid to demonstrate to economists that there is a difference between the two theories (and that theirs is wrong), I’m going to go through the age old scientific method known as ‘falsification,’ analysing each prediction of endogenous and exogenous money, and asking whether or not it corroborates with the data.
#1: exogenous money predicts reserves, or base money, would move first, followed by broader, credit based measures of the money supply as this was ‘lent out.’ Endogenous money predicts reserves would move last.
The relevant data was, ironically, put forward most conclusively by none other than the Real Business Cycle theorists Kydland and Prescott:
There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.
By some measures the broader money supply moves many months before the monetary base. This is in keeping with the endogenous theory of money.
#2: exogenous money predicts that the central bank can control the quantity of base money at will. Endogenous money predicts it must play the role of passive accommodation, otherwise the economy will implode.
As John Kenneth Galbraith put it, “Milton Friedman’s misfortune is that his economic policies have been tried.” Monetarism was tried in the early 1980s: in the UK, the US and Chile. But the central banks consistently undershot their money targets and interest rates went wild. The policy certainly succeeded in increasing unemployment and therefore taming inflation, but the attempt to control the money base failed completely. Again, this is evidence in favour of endogenous money.
#3: exogenous money predicts that reserves factor into bank’s lending decisions; endogenous money predicts that they do not, and decisions about reserves are taken after loans are made.
Anyone from the real world – bankers, lawyers, accountants – will tell you banks do not consider reserves when lending. They use double entry bookkeeping to simultaneously create an asset (your loan) and a liability (your deposit, in which the loan is ‘stored.’) The books are balanced; if they need reserves they will borrow them from other banks or, failing that, the central bank.
That the central bank could say no means some might interpret endogenous money as a policy issue, but it isn’t – as I explained in my previous post, it reflects the reality of capitalism: banks must make lending decisions based on endogenous activity, and the central bank must accommodate this. If it does not, the credit markets will simply not work, and credit crunches will ensue.
#4: exogenous money predicts that only the distribution, not the level of private debt matters
In the exogenous story, banks act as intermediaries between savers and borrowers. Money is deposited; the bank lends this out. It does this until it either does not want to lend out for whatever reason, or until it hits the limit of how few reserves it can hold. Private debt simply represents a distribution from one person to another; the level alone should not have much macroeconomic impact.
In the endogenous story, banks create purchasing power out of nothing by crediting their customer’s accounts. This implies that an increase in private debt will add to nominal aggregate demand, and hence that private debt expansion will precede nominal growth, and also be correlated with other economic variables:*
We might expect some correlation between economic activity and private debt in the neoclassical model. But a correlation as robust as this, with private debt moving first, strongly supports the endogenous money theory.
#5: exogenous money predicts that increases in the money base will have an impact on bank’s lending and other economic indicators (with some qualifiers). Endogenous money predicts this will be minimal (though reserves may ‘oil the wheels’ of the system somewhat).
Ben Bernanke’s unprecedented doubling of the monetary base obviously did not lead to a massive surge in lending. Neoclassical economists do have some explanations for this, namely that the ‘money multiplier’ collapsed – in other words, banks do not want to lend out the reserves, or there is a lack of demand. This is believable, but really it’s just a tautology – if reserves will increase lending except when they won’t, economists have told us nothing. We do not have a scientific proposition.
Overall I’ll put this one down as ambiguous, but its certainly not a falsification of endogenous money.
I’ve always sided with endogenous money because it is supported by the evidence. If anyone can offer me contrary evidence about the above or other relevant hypotheses, I’ll be happy to listen. But economist-y special pleading about how, even though exogenous money is wrong, the economy behaves as if it is right, or about how I’m not allowed to refute ‘centuries of theory,’ is simply not enough when the evidence is this strong.
*If you are wondering what the ‘credit accelerator’ is, it is the change in the change in debt (acceleration), which is what matters when you do the basic calculations. For more, see here.