I see three statements repeated by Modern Monetary Theory proponents, almost like mantras:
1. Money is endogenous
2. Banks don’t loan out reserves
3. There is no money multiplier
All three of these statements are either false, misleading, or meaningless, depending on how you define terms.
1. Endogeneity: Everyone has their reasons
When economists say a variable is endogenous, they mean it is explained by other variables in the model. Endogeneity is not an intrinsic characteristic of a variable, in the way that an apple is red or water contains hydrogen and oxygen atoms. Rather we find it convenient to regard variables as endogenous for the purposes of a certain analysis. Thus one should never say, “You’re wrong; money is endogenous”, rather you might want to claim that, “For the purpose of your analysis, it is more useful to regard money as endogenous.”
Monetarists often view the monetary base as being determined exogenously by the central bank, that is, at the bank’s discretion. At the same time, they understand that if the central bank is pegging some other variable, say exchange rates or interest rates, then the central bank has no discretion to adjust the money supply independently. They might still believe that changes in the money supply under that regime are very impactful, but there is no policy discretion for the quantity of base money. Base money is endogenous.
Keynesians often regard the monetary base as being endogenous during a period of interest rate targeting, although with the advent of IOER the central bank can target the base and the interest rate independently. In Singapore, the central bank targets the exchange rate, and regards both interest rates and the monetary base as endogenous.
Things change if the central bank stops pegging interest rates at a constant level and instead targets them at a level that is frequently changed. While in that case the base can still be viewed as endogenous for the period when rates are fixed, it’s equally accurate to argue that the central bank adjusts its target interest rate in such a way as to allow desired changes in the base. Thus a central bank intending to do an expansionary monetary policy might cut the interest rate target in order to increase the monetary base. In that sense, they still do have some control over the money supply. The money supply can be viewed as exogenous over a period of months.
All of this nuance is lost in MMT descriptions of monetary policy. Interest rates are viewed as exogenous and the base as endogenous. Any alternative approach is viewed as unthinkable.
To an omniscient God, everything in the universe in endogenous. Everyone has their reasons. Claiming that something is “exogenous” is equivalent to claiming that we don’t fully understand the process by which it is determined. Thus interest rates might look exogenous to one economist, while another sees them as being determined by the central bank’s 2% inflation target. Indeed, the entire “Taylor Rule” literature can be described as an attempt to model interest rates endogenously.
2. It’s a simultaneous system
When a bank makes a loan, it typically gives the borrower a bank account equal to the value of the loan. If the borrower withdraws the money and spends it on a new house, the seller typically takes the funds and deposits them in another bank. That’s the sense in which MMTers argue that banks don’t loan out reserves; the money often stays within the banking system. The exception would be a case where the borrower withdrew the borrowed funds as cash.
My problem with the MMT analysis is that it often seems too rigid, with claims that the banking system has no way to get rid of reserves that it does not wish to hold. That’s true of the monetary base as a whole (cash plus reserves), which is determined by the Fed. But it is not true of bank reserves in isolation. There are two ways for banks to expel undesired excess reserves, a microeconomic approach and a macro approach.
The micro approach is to lower the interest rate paid on bank deposits and/or add service charges of various sorts. This encourages the public to hold a larger share of its money as cash and a smaller share as bank deposits. On the other hand, it’s not clear that this process would constitute “lending out reserves”.
The macro approach better describes what economists mean by lending out reserves. Assume the economy is booming and people are borrowing more from banks. Continue to assume a fixed quantity of base money. If the borrowed money comes back to banks as increased deposits, then banks can make even more loans and create even more deposits. Over time, this will increase the aggregate level of both deposits and loans, putting upward pressure on NGDP.
In the 106 years after the Fed was created at the end of 1913, the currency stock grew by 516-fold, (not 516%, it’s actually 516 times as large.) NGDP was up 549-fold. The currency to GDP ratio does move around over time as tax rates and interest rates change, but clearly the demand for currency is at least somewhat related to the nominal size of the economy. When NGDP grows, currency demand will usually rise. Thus, in aggregate, a banking system that makes lots more loans will gradually lose reserves as NGDP rises, holding the overall monetary base constant.
As is often the case, Paul Krugman expressed this idea more elegantly than I can:
When we ask, “Are interest rates determined by the supply and demand of loanable funds, or are they determined by the tradeoff between liquidity and return?”, the correct answer is “Yes” — it’s a simultaneous system.
Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.
Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.
MMTers have a bad habit of assuming that mainstream economists are clueless, just because we use a different framework.
3. There are a million money multipliers
Krugman’s explanation also helps us to understand the confusion over money multipliers. Injecting more money into the economy sets in motion forces that boost the nominal quantity of just about everything, not just bank loans and bank deposits. An exogenous and permanent doubling of the monetary base will double the nominal value of every single asset class, from one carat collectable diamonds to Tesla common stock to inventories of soybeans to houses in Orange County to rare stamps. And it will also double the monetary aggregates. That’s because money is neutral in the long run, so doubling the money supply leaves all real values unchanged in the long run.
So the money multiplier for any asset class is merely the nominal stock of that asset dividend by the monetary base. No serious economist believes the M1 or M2 money multiplier is a constant, and indeed textbooks usually explain it this way:
mm = (1 + C/D)/(C/D + ER/D + RR/D)
It’s one plus the ratio of cash and bank deposits divided by the cash ratio plus the excess reserve ratio plus the required reserve ratio. Then economists model the money multiplier by describing the factors that cause these three ratios to change over time. In my view, the money multiplier model is pretty useless, as I don’t view M1 and M2 aggregates as being important. Your mileage may vary. But there’s nothing “wrong” with the model; the question is whether it’s useful or not.
The one money multiplier that does matter is NGDP/Base. Unfortunately, both IOER and the recent zero interest rate episodes have made that multiplier more unstable. I favor a monetary policy where the NGDP multiplier (aka “velocity”) would be more stable. No more IOER and fast enough expected NGDP growth to assure positive interest rates.
4. Beware of “realism” and the fallacy of composition
Sometimes you’ll encounter an economist who is very proud that he or she understands how the financial system works in the “real world”. And obviously that knowledge can be useful for certain purposes. But the banker’s eye view often misses what’s most important in macroeconomics, the general equilibrium connections that Krugman alluded to in his “simultaneous system” remark.
If the Fed gave me a check in exchange for an equal quantity of T-bonds, I’d be no richer than before, no more likely to go out and buy a new car. And if I took that check and deposited it in a bank, that bank might be no more likely to make a business loan. They could simply buy a bond, or lend the reserves to another bank. But as everyone tries to get rid of the base money they don’t want, subtle changes begin to occur in a wide range of asset prices, which will eventually push NGDP higher. If wages are sticky then the extra NGDP will lead more people to go out and buy cars.
Just not me, not the person who first got the new Fed-created money.
READER COMMENTS
JP
Nov 29 2020 at 5:33pm
In the paragraph beginning with “Monetarists often view,” did you mean to write “Base money is endogenous” or “Base money is exogenous?” If the former, I don’t understand the paragraph given the context of the discussion.
Scott Sumner
Nov 29 2020 at 8:52pm
JP, The last word in the paragraph should be endogenous. But keep in mind that no longer holds if the interest rate target moves around over time.
Mike Sproul
Nov 29 2020 at 7:32pm
“But as everyone tries to get rid of the base money they don’t want, subtle changes begin to occur in a wide range of asset prices, which will eventually push NGDP higher. ”
The three most important answers to this are
The Law of Reflux
The Law of Reflux
the Law of Reflux
Scott Sumner
Nov 29 2020 at 9:01pm
Of course no one is obligated to take federal reserve notes that they don’t wish to hold. In the old days, bank notes had to be redeemed for real money.
Mike Sproul
Nov 30 2020 at 1:19pm
Unwanted FRN’s can reflux to the Fed through several channels: The gold channel (now closed), the bond channel, the loan channel, etc. Closing one of those channels is ineffective s long as other channels stay open.
This means that unwanted FRN’s do not accumulate in public hands, and there is no force pushing NGDP higher.
Scott Sumner
Dec 1 2020 at 2:20pm
I should have said base money, as currency can be exchanged for bank reserves.
Market Fiscalist
Nov 29 2020 at 8:43pm
I thought this was an excellent article and I have enjoyed and learned from your series of posts on MMT.
I have a question on ‘Thus, in aggregate, a banking system that makes lots more loans will gradually lose reserves as NGDP rises, holding the overall monetary base constant.’
In a system with no central bank and a fixed base money and assuming demand to hold money remained constant then if the demand for loans increased the only way I can see that this demand could be accommodated is if interest rates rise to encourage greater deposits within the banking system – this might cause NGDP to rise but I do not see how this is consistent with banking system losing reserves.
In a system with a central bank and interest rate targeting if the demand for loans increased then the CB (to maintain its target) would have to increase base money / reserves so that banks could accommodate the increased demand for loans at the current targeted rate. In this case NGDP would almost certainly increase but base money (held both as reserves and as currency) would both increase as well
So I guess I am curious on the details of how banks can lose reserves as demand for loans increases.
Scott Sumner
Nov 29 2020 at 8:58pm
I was considering a case where banks preferred to hold fewer reserves. As I understand it, the MMTers contend that the banking system as a whole can’t get rid of unwanted reserves. But if the banks prefer to hold fewer reserves, then banks would not see a need to attract deposits via higher interest rates on deposits.
But I do see how that’s confusing, there are so many moving parts.
Market Fiscalist
Nov 29 2020 at 10:32pm
Oh, OK.
But why would a bank (under normal circumstances) ever want to reduce its reserves ? A bank might prefer to hold less reserves against its current loans if the demand to hold money had increased , but wouldn’t it really prefer in this situation to make more loans at a lower interest rate (if this increased profits) and keep its reserves rather than reducing them?
But I get your point. Its complicated. And MMT chooses a limited set of options to make it seem easy.
Jerry Brown
Nov 30 2020 at 4:30am
You might keep in mind that MMT was founded to some extent by a banker named Warren Mosler. MMT descriptions of how banking works also seem to be generally fairly accurate. And much more accurate than what economists like Paul Krugman describe when they actually try to explain their own ideas about how banking works.
Scott is correct when he says MMT contends that the banking system as a whole cannot get rid of unwanted reserves. The ‘unwanted’ part is confusing because reserves are always an asset for any bank- and banks want assets even if they are not their most profitable assets.
Market Fiscalist
Nov 30 2020 at 9:43am
Scott gave an example of how banks could expel reserves from the banking system by increasing loans, driving up NGDP, and thus causing people to hold more base money outside the banking system.
Having thought about it a bit I think what he probably means is that if they find they have excess reservists (for example they find a way to optimize the use of reserves, or simply volatility in the system has dropped so they need to keep less reserves against their current lending) then this will start the process of increased lending that in turn increases NGDP and that ultimately leads to more ‘reserves’ being held outside the banking system.
Scott Sumner
Nov 30 2020 at 12:50pm
Banks can also get rid of reserves simply by cutting the interest rate on deposits, encouraging people to hold more cash. I can’t even imagine how the MMTers could claim that banks can’t get rid of reserves.
You ask why would banks ever want to reduce reserve holdings? Suppose reserves earn 0% and T-bills earn 5%. Then reserves are less profitable than T-bills. That’s basically Krugman’s point.
Market Fiscalist
Nov 30 2020 at 3:28pm
‘You ask why would banks ever want to reduce reserve holdings?’
I really meant why would they want to reduce reserve holdings by inducing the public to take reserves out of the banking system rather than using them for profit making activities like making loans or buying t-bill (or other bonds), as this is how banks make profits . But perhaps there are times when there are so few profitable lending opportunities and the interest rate on T-bills and other bonds is so low that banks best strategy will be to lower rates to discourage deposits.
Scott Sumner
Dec 1 2020 at 2:21pm
Both can be true. They can exchange reserves for T-bills and also cut the interest rate on deposits to prevent the cash from flowing back in.
Ilya
Nov 29 2020 at 11:51pm
Everything you write here reminds me of Selgin’s description of the banking system in The Theory of Free Banking.
Jerry Brown
Nov 30 2020 at 4:02am
“MMTers have a bad habit of assuming that mainstream economists are clueless, just because we use a different framework.” Then ‘mainstream economists have a bad habit of assuming that MMTers are clueless’ would be an equally fair observation. Wouldn’t it? I mean you straight out wrote very recently that we have no understanding of even basic monetary theory.
I have read your blogs for many years now and commented many times and yet I have never assumed you were clueless even if I disagreed with something. I think you are wrong sometimes about some things- but never assumed you were ‘clueless’. I would not bother reading you if I did.
And yes, every night before we go to sleep, people who think MMT might explain some things have to do the mantra- money is endogenous, loans create deposits, banks don’t loan reserves, the money multiplier theory is wrong, monetary policy doesn’t work, our gurus are the best, et cetera. It is actually very calming when I remember to do it. Come on already.
Scott Sumner
Nov 30 2020 at 12:59pm
It’s one thing for a group to have a different point of view, and another not to be able to explain that point of view in a intelligible manner. I don’t agree with people like Krugman and Woodford on monetary economics, but I can read and understand their arguments. MMTers claim Keynes as an inspiration, but even Keynesians don’t seem to be able to understand their model.
Both here and at MoneyIllusion I’ve asked a number of questions about MMT, and no one has been able to give me a clear answer to some very basic questions.
I also believe that MMTers made a big mistake in defining terms such as “saving” in such an unusual way. It makes communication even more difficult, and communication is hard enough as it is.
Njnnja
Nov 30 2020 at 8:07am
The “concrete steps” for the micro approach to lending out bank reserves is that the relationship between net interest rates credited to depositors and deposit balances works because people are comparison shopping with fixed income markets. So when someone isn’t getting enough yield in their bank deposit, they get it from somewhere else, ultimately by lending to some corporate like Microsoft (by buying bonds). So even if the bank isn’t lending reserves via its credit department, they are controlling the aggregate supply of money loaned.
Alan Goldhammer
Nov 30 2020 at 8:26am
I thought this was a very good exposition except for one statement about the value of ‘rare stamps’ increasing as the monetary base increases. From personal experience I think this is not correct. I tried to sell my stamp collection last year and it was hard worth much at all. There are increasingly fewer stamp collectors and most stores that deal in stamps are no longer around. Perhaps Scott’s definition of ‘rare stamp’ pertains to very rare issues such as the upside down airmail stamp that was a misprint, but I don’t have one of those.
Scott Sumner
Nov 30 2020 at 1:03pm
You misunderstood my argument. Obviously the relative prices of all sorts of assets change all the time, but that’s a completely separate question from the nominal value of those assets.
Suppose the real value of a stamp collection falls by 80%, from $1000 to $200. If during the same period the price level doubles, then the nominal value will fall from $1000 to $400. That doesn’t mean that money creation isn’t causing the value of stamps to double relative to their value if there had been no money creation.
Alan Goldhammer
Nov 30 2020 at 7:11pm
Scott – I do understand your argument but think you have not accounted for collectibles falling out of favor. As long as something is valued by a significant number of people, it’s core value will hold up. Once the number of people interested in that item(s) decreases, the value decreases as the market is contracting. That’s what is happening to stamps right now as well as paintings by certain artists that once commanded a high price and no longer do. It is just a small nit and I agree with everything else you wrote.
Scott Sumner
Dec 1 2020 at 2:23pm
Again, I did account for collectables falling out of favor, that’s what I meant with my example of the real price of stamps falling by 80%.
Brian Albrecht
Nov 30 2020 at 8:55am
Or, and you say this elsewhere in the piece so well, it is simply that you don’t care about the process for the particular question. To make progress on topic X, I (and most economists) find it helpful to explicitly think of Y as exogenous.
I run into trouble reading MMTers because I cannot disentangle what they are assuming is exogenous. You’ve done better at deciphering it.
Scott Sumner
Nov 30 2020 at 1:04pm
Thanks Brian. Your way of putting it is more accurate.
James
Nov 30 2020 at 1:16pm
From the point of view of a policy skeptic, you guys (MMT, NGDP targeters, Keynesians, etc) are more alike than different. All of you guys seem to believe:
(1) Variables like output, inflation, and unemployment are imperfect but generally useful indicators of welfare.
(2) Monetary and/or fiscal policy can affect welfare and those indicator variables in predictable ways.
None of you guys:
(1) demonstrate that information about what the treasury or central bank is doing gives you the ability to predict future values of output, inflation and unemployment more accurately than univariate time series models that rely only on lagged values of the dependent variable. Maybe you see how a reasonable person could look at this and infer that if you guys were “in charge” at the Fed, you would not be able to predict the consequences of your actions.
(2) say how you might detect whether changes in these variables correspond to actual changes in welfare or just an increasing gap between these indicators and welfare. As an analogy, SAT score is indicative of preparedness for college but increases in SATs could come from increased preparedness (if it is a result of a smarter cohort of students) or from a decrease in the usefulness of the indicator (if it is a result of replacing high school AP courses with test prep courses).
Scott Sumner
Dec 1 2020 at 2:33pm
There’s certainly a lot of evidence that monetary policy can have predictable effects on variables such as inflation. That’s why we give the Fed a 2% inflation target, and it’s why we don’t give the target to Congress.
I don’t think monetary policy can reduce unemployment in the long run, although bad monetary policy can create recessions.
James
Dec 1 2020 at 5:32pm
“There’s certainly a lot of evidence that monetary policy can have predictable effects on variables such as inflation.”
Please do share.
I’m sure that within the sample used to calibrate a model, measures related to monetary policy help predict inflation. Are you aware of any paper which compares out of sample performance of multiple inflation models and finds that including measures of monetary policy reduces forecast error? By that I mean: calibrate multiple models on data from periods 1 to n; each model generates forecasts for period n+1; record errors for each model; repeat over many values of n; summarize the errors for all models.
I am no expert on current trends in empirical macro but I never encountered a paper from any economist that focused on out of sample forecast accuracy.
Garrett
Nov 30 2020 at 2:38pm
Cullen Roche, who has written about MMT a lot over the years, responded to your posts here.
Dan Culley
Nov 30 2020 at 5:09pm
You unfortunately missed a key point: MMT is itself endogenous. As soon as you have an explanation of it and can explain why it is incorrect, it becomes something else.
Jeff S Eder
Nov 30 2020 at 10:28pm
I am a Canadian and just happened upon this article on a stop over in Denver. I am on my way to Mexico to escape these kinds of conversations among other things. I agree there are many problems with MMTs descriptive analysis https://progressivemoney.ca/the-deficit-myth-revised . However, there were also some problems with Scott Summer’s analysis, to correctly challenge it would require more effort than I am willing to give right now. So, I will just summarize:
1. The majority of money in circulation is the result of privately owned commercial banks creating digital money through the loans process. When a loan is issued simultaneously a deposit is created, that money doesn’t come from anywhere.
2. Banks Can do whatever they want with their reserves as long as they meet their capital requirements.
3. Absolutely, there is no money multiplier as described in macroeconomic textbooks. Again, there are capital adequacy requirement ratios that are supposed to be maintained.
If interested in supporting arguments go to https://progressivemoney.ca/
Scott Sumner
Dec 1 2020 at 2:29pm
It’s clear that you did not understand my post as your first and second points in no way conflict with anything I said. I can’t comment on your third post, as I don’t know which textbooks you are referring to. Mishkin’s Money and Banking text does a good job on the MM.
Money can be defined as base money or broader monetary aggregates. I usually refer to base money in my analysis, which cannot be created by the private banking system
jim carter
Dec 2 2020 at 12:26pm
How does the Federal Reserve embezzle $4 billion DAILY for [covert] owners of the Fed using the auction accounts of Treasury securities which the FRBNY as fiscal agents for the government have exclusive control over ? Ref. 31 CFR 375.3. ;
https://www.spartareport.com/2020/07/the-federal-reserve-for-dummies
Ralph Musgrave
Dec 10 2020 at 6:42am
Scott’s conclusion (his last two paras) is essentially that QE works. It’s news to me that any MMTer disagrees with that, though like many non-MMTers, MMTers argue that QE is not desperately effective when interest rates are low. Thus (if I understand MMT correctly) MMTers tend to favour monetary / fiscal coordination: i.e. having government and central bank simply create new money and spend it, and/or cut taxes. And that’s essentially what governments and central banks have done, big time, over the last five years or so.
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