Have you ever had a discussion with a bunch of econ-nerds about endogenous money? Did you find yourself quietly trying to disappear into the woodwork as you didn't have the slightest clue what they were talking about?
Fret not. I've been there. And the purpose of today's post is to ensure the next time the topic comes up, you won't recoil in horror (although you probably will still want to excuse yourself because, after all, you're talking to econ-nerds).
Endogenous money seems exotic. In my mind, it sounds vaguely like something practiced in the late 1970's in NYC by the first members of the punk movement.
But it's not. Endogenous money is the theory that the economy's supply of money is determined endogenously - from inside economic forces - as opposed to the authority of a Central Bank.
Why does this even matter?
It might not seem important, but there are profound investment ramifications to which of these camps is correct.
If you are a traditionalist, then you believe a Central Bank engaging in quantitative easing will cause inflation. Expanding the amount of reserves in the economy directly affects the money supply and will therefore cause prices to increase. Endogenous money theorists believe the supply of money is not determined by the Central Bank but rather by outside factors, so therefore quantitative easing does not cause inflation.
I know this seems counter to everything we have been taught. Think back to the famous open letter to Ben Bernanke in November of 2010 warning against his quantitative program. Loads of really smart people signed that letter. Yet if they believed in endogenous money, they probably would have skipped endorsing that message.
It's not just modern money guys who have embraced this idea of endogenous money. One of the best papers out there regarding this topic is published by the Bank of England - "Money Creation in the Modern Economy".
The article does an excellent job of outlining the differences between these two schools of thought:
In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.
Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.
Monetary policy acts as the ultimate limit on money creation. The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans.
In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing’ (QE). QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.
QE initially increases the amount of bank deposits those companies hold (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy.
As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism. This article explains how, just as in normal times, these reserves cannot be multiplied into more loans and deposits and how these reserves do not represent ‘free money’ for banks
The best part of this article is the "two misconceptions about money creation" section:
The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.
In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.
In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.
I have my own way of thinking about endogenous money. It might not be technically correct, but I have found it helps me understand the issues.
Let's take Jamie Dimon - the head of JP Morgan. He runs the largest bank in the world and is plugged into the financial pulse of the global economy. Do you really believe that Jamie determines the quantity of loans his firm underwrites by looking at the reserves on his balance sheet?
Can you imagine Jamie saying, "hey I see that Bernanke just plopped a whole bunch of reserves into the system. Finally, we can make all those loans we have been dying to do..." Not likely.
Sure, JP Morgan technically needs reserves but when Ben Bernanke engaged in quantitative easing and ballooned the amount of reserves in the financial system, it did not mean Jamie was any more likely to make a loan.
The amount of loans Jamie underwrites is determined by the demand for loans, JP Morgan's balance sheet and their outlook for the economy. It has nothing to do with the amount of reserves in the system. Banks need to guard against loans going bad and therefore need equity to lend against. Their goal is to ensure they have adequate capital to withstand a series of bad loans.
At the end of the day it comes down to this - banks are not reserve restrained, they are capital restrained. Now I know some of the STIR (short-term-interest-rate) traders will argue there are times when reserves matter (such as with the recent repo crisis). However, those are technical front-end trading issues.
The whole theory of endogenous money is way more complicated than I have made it. I am by no means an expert. The only thing I would like to leave you with is the thought that when someone tells you inflation will run out of control because of the Fed's balance sheet expansion, think through the logic of their argument. Does it affect the real economy? I would argue a lot less than most believe.
Thanks for reading,
PS: On a side note, I differ from my purist modern money brethren in that I believe changes in reserves have an effect on financial asset prices. But that's not the point I would like to make today.