Publications

One thing’s for sure: The financial crisis has dealt a deadly blow to what was until recently considered the state-of-the-art of monetary policy. Just compare the 1992 edition of Modern Money Mechanics, published by the Federal Bank of Chicago, with the articles and videos published this month by the Bank of England (BoE).

The former publication explains that a bank’s excess reserves can be used to make loans, that prudent bankers “will not lend more than their excess reserves,” and that there is a “deposit expansion and contraction associated with a given change in bank reserves,” a.k.a. the money multiplier. Ultimately, “the total amount of reserves is controlled by the Federal Reserve.”

In stark contrast to what was considered common knowledge twenty years ago, the BoE now considers the multiplier a mistaken belief. For the Bank of England, a “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.” Contrary to a widespread view, “neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available.” The BoE further explains: “Loans create deposits, not the other way around”; and bank reserves do not provide incentives for banks to lend “as the money multiplier mechanism would suggest.”

The many professionals in the banking and finance industry who often have trouble with the way academics teach and discuss money and monetary policy will find the new view much closer to their operational experience. The few economists who have long rejected the “state-of-the-art” in their models, and refused to teach it in their classrooms, will feel vindicated. Those lagging behind had better adapt quickly to a changing paradigm, re-write their lecture notes, and avoid describing the stance of monetary policy with the position of a money supply function. For example, the Khan Academy’s course in banking includes several lectures based on the notion of the money multiplier. To serve its users well, the Khan Academy should largely revise those lectures or at least explain that they apply to a monetary system based on gold or some other fixed-rate system.

The views expressed in the BoE publication do not come out of the blue. Several studies have recently challenged the notion of the money multiplier. The fact that this is now stated by a central bank marks good progress in the understanding of monetary operations, especially in light of conventional wisdom having inspired a number of erroneous interpretations during the banking and financial crisis.

It is also a blow to the “Monetarist Keynesian” approach that continues to inspire mainstream macroeconomic models. In a video that is part of a 1980 series called “Free to Choose,” Milton Friedman explains the money multiplier in a fixed-rate monetary system (the gold standard) and argues that the same principle holds in the contemporary U.S. banking system. Friedman concludes that the Great Depression was caused by the U.S. Fed doing a very poor job, forcing the money multiplier to work its way downwards and effectively destroying the money supply. A former graduate student at MIT who had studied Friedman’s view of the Great Depression—named Ben Bernanke—has seemingly dealt with the 2007-08 crisis with one idea in mind: prevent the money supply contraction that caused the Great Depression. This was the theoretical foundation of Helicopter Ben’s QEs.

For the Bank of England, now, there are two common misconceptions about Quantitative Easing: “that QE involves giving banks ‘free money’; and that the key aim of QE is to increase bank lending by providing more reserves to the banking system, as might be described by the money multiplier theory.” The BoE also explains how the amount of central bank money (banknotes and bank reserves) is fixed by the demand of its users and not by the central bank “as it is sometimes described in some economics textbooks.”

And yet, more progress is desirable, and I would not mark the BoE paper with an A.

For all those economists who feel they have been ahead of the curve on this matter, the Bank of England should make an additional effort, especially on two remaining issues.

1. Why money is valuable to its holders

In its account of money and monetary policy, the BoE asks the question: What makes an inconvertible piece of paper valuable? The BoE explains that money is an IOU issued by a single (monopolist) supplier rather than by a variety of individuals. Although a twenty-pound note is no longer convertible into gold, it is “worth twenty pounds precisely because everybody believes it will be accepted as a means of payment both today and in the future… And for everyone to believe that, it is important that money maintains its value over time and is difficult to counterfeit. It’s the central bank’s job to ensure that that is the case.”

Economists have always had a hard time proving how confidence alone could suffice. Money historians dealing with “token money” (not redeemable in gold or silver) and those economists who are aware of the political foundation of money or who have read or heard Warren Mosler have a different answer. It is inaccurate to describe paper currency as an “unredeemable” asset whose value depends on users’ confidence. Paper money gives its holder a credit that is redeemable in a very concrete way, and it is so redeemed every time holders of money use currency to pay their liabilities to the government: taxes, sanctions, and fines. In fact, the national currency is the only means available for making such payments.

The BoE remains silent on this point. Acknowledgement of this fact would entail accepting that the payment of taxes is made possible by government spending and not the other way around. It is tax payers, not governments, that can go broke!

2. How powerful is monetary policy

On this point, the BoE publication does not break much with the past, at the risk of making statements that clash with the rest of the paper.

The BoE makes two accurate statements regarding central bank money (banknotes and bank reserves):

1) it is not chosen or fixed by the central bank;

2) it does not multiply up into loans and bank deposits.

This would seem to imply that a central bank does not control the money supply. More accurately, as the ECB states on its website, “by virtue of its monopoly, a central bank is able to manage the liquidity situation in the money market and influence money market interest rates.”

To the reader’s surprise, however, the BoE concludes that the central bank can:

“influence the amount of money in the economy. It does so in normal times by setting monetary policy — through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation. This in turn affects the prices and quantities of a range of assets in the economy, including money.”

For the BoE, changing interest rates is a powerful means to influence bank lending and thus the money supply and the overall economy. This view that interest rates trigger an effective “transmission mechanism” is one of the Great Faults in monetary management committed during the Great Recession.

There are various channels through which interest rates influence demand, output, and the price level, yet none is empirically strong, and some work in different directions. Bank lending is primarily pro-cyclical, as a famous quote attributed to Mark Twain explains effectively (“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”), and the Global Crisis proved central banks to be powerless in trying to reverse this course. The reality is that the level of interest rates affects the economy mildly and in an ambiguous way. To state that monetary policy is powerful is an unsubstantiated claim.