"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Monday, January 10, 2011

How is Money Created? A Look Back at Economist Steve Keen's "The Roving Cavaliers of Credit."

Back in January 2009, Australian Economist Steve Keen (one of the few economists that predicted the crisis) wrote an essay on his blog describing the theory of endogenous (created from within) money creation.  Many readers of this blog may already be aware of this topic from Mish Shedlock's blog, but I think it is necessary that we occasionally look back at such non-orthodox economic views to "recalibrate" our analysis.  It is easy to occasionally fall into the trap of gold standard thinking because our main stream media and politicians often treat economics this way.  I also post this for those that are not aware of this alternative view of money creation.

I don't agree with everything that Steve Keen has written, but I also believe that his views should be made more public.

Here are a few portions of his essay:

Talk about centralisation! The credit system, which has its focus in the so-called national banks and the big money-lenders and usurers surrounding them, constitutes enormous centralisation, and gives this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner— and this gang knows nothing about production and has nothing to do with it.” [1]
Ten years ago, a quote from Marx would have one deemed a socialist, and dismissed from polite debate. Today, such a quote can (and did, along with Charlie’s photo) appear in a feature in the Sydney Morning Herald—and not a few people would have been nodding their heads at how Marx got it right on bankers.F
He got it wrong on some other issues,[2] but his analysis of money and credit, and how the credit system can bring an otherwise well-functioning market economy to its knees, was spot on. His observations on the financial crisis of 1857 still ring true today:
“A high rate of interest can also indicate, as it did in 1857, that the country is undermined by the roving cavaliers of credit who can afford to pay a high interest because they pay it out of other people’s pockets (whereby, however, they help to determine the rate of interest for all), and meanwhile they live in grand style on anticipated profits.
Simultaneously, precisely this can incidentally provide a very profitable business for manufacturers and others. Returns become wholly deceptive as a result of the loan system…”[1]
One and a half centuries after Marx falsely predicted the demise of capitalism, the people most likely to bring it about are not working class revolutionaries, but the “Roving Cavaliers of Credit”, against whom Marx quite justly railed.
...This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,
“In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]
Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.
...If neoclassical theory was correct, this increase in the money supply would cause a bout of inflation, which would end bring the current deflationary period to a halt, and we could all go back to “business as usual”. That is clearly what Bernanke is banking on:
“The conclusion that deflation is always reversible under a fiat money systemfollows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days.
What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.
By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…
If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.” [8]
However, from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:
1. Banks won’t create more credit money as a result of the injections of Base Money. Instead, inactive reserves will rise;
2. Creating more credit money requires a matching increase in debt—even if the money multiplier model were correct, what would the odds be of the private sector taking on an additional US$7 trillion in debt in addition to the current US$42 trillion it already owes?;
3. Deflation will continue because the motive force behind it will still be there—distress selling by retailers and wholesalers who are desperately trying to avoid going bankrupt; and
4. The macroeconomic process of deleveraging will reduce real demand no matter what is done, as Microsoft CEO Steve Ballmer recently noted:  “We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy”.[9]
The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed—so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.
Measured on this scale, Bernanke’s increase in Base Money goes from being heroic to trivial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broadest measure of the money stock—the M3 series that the Fed some years ago decided to discontinue.
...With a sensible model of how money is endogenously created by the financial system, it is possible to concur that a decline in money contributed to the severity of the Great Depression, but not to blame that on the Federal Reserve not properly exercising its effectively impotent powers of fiat money creation. Instead, the decline was due to the normal operations of a credit money system during a financial crisis that its own reckless lending has caused—the Cavaliers are cowards who rush into a battle they are winning, and retreat at haste in defeat.
However, with his belief in Friedman’s analysis, Bernanke did blame his 1930 predecessors for causing the Great Depression. In his paean to Milton Friedman on the occasion of his 90th birthday, Bernanke made the following remark:
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” [18]
In fact, thanks to Milton Friedman and neoclassical economics in general, the Fed ignored the run up of debt that has caused this crisis, and every rescue engineered by the Fed simply increased the height of the precipice from which the eventual fall into Depression would occur.
Having failed to understand the mechanism of money creation in a credit money world, and failed to understand how that mechanism goes into reverse during a financial crisis, neoclassical economics may end up doing what by accident what Marx failed to achieve by deliberate action, and bring capitalism to its knees.
Neoclassical economics—and especially that derived from Milton Friedman’s pen—is mad, bad, and dangerous to know.
The full essay can be found HERE.

Misthos here.  Steve Keen's analysis is very compelling, and I agree with most of the points he makes.  He has recently given a presentation of a mathematical model that shows that a credit system can be sustainable.  However, in my view, he neglects the FIRE economy aspects of many Western economies.  That is, he neglects to take into consideration that in the real world credit is often used for consumption, for asset value speculation, and generally, malinvestment.  The drag on the economy of such uses of credit is severe, to which I would think he agrees. 
But there are other factors that are ignored by most economists as well.  What of the geopolitical ramifications of a nation's monetary system?  A monetary system can strongly influence trade arrangements that often result in severe and unsustainable imbalances.  Most economists look at issues piecemeal.  One set  of economists may focus on the domestic ramifications of a certain monetary or fiscal policy, while another set of economists focus on the international ramifications, and the two views are rarely synthesized.
But at the end of the day, money is how we "keep score," so to speak.  Thus it's method of creation determines who has wealth, and why, and who gets to consumes what.  The market too, rightly or wrongly, has a say in how successful a monetary policy or system can be.  Bond vigilantes that can influence a nation's credit can often be irrational, or surprisingly nonexistent.  We live in an extremely complex world where multiple factors can create unimaginable unintended consequences.  The prevailing neo-classical views of economics, as Steve Keen, I believe, has successfully challenged, are the views that affect you and me.  If these views are inherently wrong, what does that mean to our economic future?  How will these issues ultimately be resolved?


Jim Slip said...

Misthos, I quote again from this blog (excellent blog btw, if you're into MMT):


"(G-T) = (S-I) – NX

The left-hand side depicts the public balance as the difference between government spending G and government taxation T. The right-hand side shows the non-government balance, which is the sum of the private and foreign balances where S is saving, I is investment and NX is net exports. With a consolidated private sector including the foreign sector, total private savings has to equal private investment plus the government budget deficit."

My comment:

So it seems to me that the big problem is globalization, or rather de-industrialization of a lot of countries of the West.

By having negative net exports "bleeding" the economy out of net financial assets (that is local currency), there's your source of constant government deficits, but which DON'T create surpluses in the private sector because of the trade/ account deficits.

In other words the government deficits are not big enough to make up for the trade/ account deficits, so there's the source of the leveraging of the private sector, and the building up of the debt bubble.

Dave Narby said...

Hey Misthos,

Like many things in this world, you can either work with human nature, or you can work against it...

IMO, that economists and politicians continually try to work against it is at the heart of most of our problems.

Enjoy your work, please continue!

Misthos said...

Jim - I agree. But when I look at the greater historical trend, going back 40 years to the end of Bretton Woods, a question arises:

Did Fiat money - or rather, the MMT system require that the West de-industrialize, or did the West reach a post industrial age first, and needed an expandable fiat system to maintain a certain level of economic growth? Which resulted in the financialization of most Western economies, i.e. Ponzi/Pyramid economics?

Either way, we have massive trade relationships and surplus/deficit imbalances in the world today. Hence the currency wars of devaluations to increase exports, and devalue old debts.

The EU is doing the opposite of course, with Greece, Ireland, etc... they are essentially putting Greece and Ireland on a "gold standard" right when they have reached outrageous debt levels they can't manage. It's economic suicide. But it's not just those two countries. All EU countries are in violation of Maastricht debt loads to a degree.

Misthos said...

Dave, thanks, and well said - I agree!