This article first appeared in the Newsletter of the Royal Economic Society in 2017. It is republished here with thanks.
Imperial College London
Michael Joffe has argued the merits of an ‘evidence-based economics’ in these pages before. Here he provides an example of good practice.
In recent years, a sound understanding has emerged in relation to money1 — specifically, how it is created and destroyed in a modern economy such as the UK and the USA.2 The understanding is based on a careful description of the actual behaviour of commercial banks, central banks and other participants, with special attention paid to the actually-occurring causal processes. The account is also supported by statistical analysis.
This makes it a prime example of good practice in ‘evidence-based economics’: the effort to construct economic theory from systematic observation of the world, rather than e.g. from axioms. The idea is to combine evidence with good explanations, thereby generating reliable knowledge in the form of empirically-based causal theories.3
How money creation and destruction works
Money is anything that is widely accepted as payment, especially by the government for tax payment. This means that it involves a social relationship, and a degree of trust. Of the different types of private sector assets, the most liquid ones — banknotes and current accounts (commercial bank money) — are unequivocally money, whereas less liquid forms such as time deposits can be considered as ‘near money’. By far the most important type of money in the modern economy is commercial bank money, in the form of digital records. In Britain nowadays, it constitutes 97 percent of all money. The question is, how are these bank deposits created?
There are two major common misconceptions in the economics literature. One is that banks act simply as intermediaries, lending out the deposits that savers place with them — giving a primary causal role to households’ saving decisions. The other is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — base money. This is then ‘multiplied up’ to produce a much larger amount of broad money — the ‘money multiplier’ idea which is commonly found in textbooks. Here the primary causal role is given to the central bank.
In fact, money is created when commercial banks make loans, and destroyed when the loans are repaid.4 The main causal impulse is located here, and depends on households’ and businesses’ demand for loans, together with banks’ perceptions of the risk-adjusted prospect of profit. Thus, money is generated as a side effect of bank lending.
This operation of demand and supply is not simple and symmetrical. The most important features of money creation depend on banks, whereas repayment — and therefore money destruction — depends on borrowers. In money creation, banks ration credit based on their confidence that the loan will be repaid, and confidence in the solvency of other banks and in the system as a whole. They also decide where to allocate money: their incentives favour lending to borrowers with collateral, which in practice means existing assets rather than productive investment, or consumption. The historical evidence shows that bank lending for productive purposes declined in the UK following deregulation: broad money expanded much faster than GDP.5 The rationale for deregulation was based on the erroneous assumption that banks do not perform any unique function, and are merely financial intermediaries.
The Basel regulations accentuate this tendency: risk weighting is 100 per cent for existing assets (because of the possibility of repossession), and 35 per cent for business investment. The latter therefore has to be three times as profitable, in terms of capital requirements, to be worthwhile. And limited liability of companies increases banks’ risks — in such conditions, they prefer to use the entrepreneur’s house as collateral instead. Banks’ preference for lending to borrowers with collateral has major implications for the economy. Capital is allocated mainly to existing assets, primarily real estate and the financial sector itself rather than the productive economy. There are two major consequences. The resulting asset price inflation has led to an ever-present tendency to bubbles and crashes, plus an inter-generational imbalance in home ownership; and, potential real-economy investors have been deprived of credit.
The ability of banks to initiate loans is subject to a degree of constraint. On the liquidity side, they need enough central bank reserves to ensure that payments can be made to other banks; and they need enough of their demand deposits in the form of cash to allow customers access to cash at all times. These are currently quite weak constraints, as banks can borrow from other banks on the interbank market and from the central bank. There is also a solvency constraint: each bank needs enough capital to be able to cover the situation where customers default on their loans. In addition, banks’ behaviour is constrained by prudential regulation, and influenced by the interest rate which is set by the central bank.
There are other widespread misconceptions. (1) that the interest rate is the sole determinant when a bank makes a loan — actually it is just one factor, albeit an important one (less so for business than for mortgage lending). (2) that the government has direct involvement in money creation. (3) that capital adequacy requirements affect money creation, and therefore have an effect on bubbles — in a boom the risk estimates are lower, optimism leads to more loans so that more money is created, leading to increased bank profits and thus more own capital; in the aggregate, because banks lend to each other, they do not bump up against capital limits.
Government borrowing by issuing bonds does not alter the quantity of money. And government spending does not displace that of the financial sector. The important question is the composition of spending — which is more productive, not who spends it. Private investment can go to existing assets, to mergers and acquisitions with asset stripping, or abroad; and productive investment is less likely in a recession. Government spending can be on housing or infrastructure, e.g. transport, and often involves redistribution and hence an increase in velocity. Also, direction to productive uses, not real estate, finance or consumption, implies less inflation (except when there is no spare capacity in the economy).
So: money is a social relationship backed by the state – the state determines the unit of account, and guarantees future exchange by (i) acceptability as tax payment, (ii) taxpayer-backed insurance of bank deposits, (iii) an implicit guarantee to bail out banks in trouble. All money is credit, but not all credit is money.
Implications for evidence-based economics
This body of work is a careful descriptive study showing how a particular sub-system of the economy works. The result is an account of the money supply that has the virtue of being obvious, in the sense that participants (e.g. central bankers) have apparently been aware of it all along.6
It demonstrates a basic contention of evidence-based economics, that good economics can be generated from observations; the difficulty of conducting experiments in many branches of economics is not necessarily a barrier, as is sometimes thought. One objection could be that this is “merely” a description, whereas what is needed is “theory”. This is based on an over-restricted view that equates theory with formal modelling, rather than with an account of the causal processes that corresponds with the real world, as in the natural sciences.7 Admittedly there is no ingenious model here. But there is a debunking of the money multiplier model, of the notion of loanable funds, and of banks as intermediaries. The description replaces false theory with facts. This is crucial. And models could be nested within this broader account — which would allow transparency about what is omitted in the modelling process.8
It is also sometimes said that the generation of evidence is dependent on theory. This is true to an extent, in the sense that one needs a framework to suggest what sorts of things could be relevant. But it need not be a straightjacket. In this case, little prior structure was imposed, allowing the account to emerge from the evidence.
This allowed the notions of loanable funds, banks as mere intermediaries, and the textbook money multiplier model to be exposed as false. It is quite a different criticism of orthodox economic theory from that which is often heard, that its assumptions are unrealistic and/or that its models are over-simplified. Here the charge is that the world works in a different way from that depicted in textbooks — error is quite different from simplification.
The account of money creation and destruction is formulated in the causal language of capacities. Central to it are the capacity of commercial banks to create money by making loans, and the specific capacities of central banks. Flows also have causal effects: commercial banks’ preference for existing assets directs the flow of money into some parts of the economy rather than others, with important consequences for economic activity. Buying power is placed in the hands of real estate and financial traders rather than real-economy businesses.
The primary task is here seen as identifying the causal driving force — rather than quantification or prediction, as is common in economics. Causal direction is emphasized, i.e. that lending has its own dynamic, and is not secondary to saving; also, the provision of reserves by the central bank is responsive to the needs of commercial banks, it does not ‘cause’ commercial-bank lending, or the quantity of such lending. And the account allows for multiple causation, in the sense that there is nothing to stop the description being supplemented with additional causal factors that may be relevant in certain circumstances.
Finally, heterogeneity is important in evidence-based economics. The description of the system of money creation/destruction applies to most countries with an advanced banking system. It may be similar in other places and at other times, but that needs to be established by examining the evidence.9 A comparative perspective might show that there are systematic differences, and these could be informative. More generally, it is dangerous to claim that the same laws apply to all economies, irrespective of place and time. This account has identified capacities and other characteristics of the system, but they are not necessarily immutable. For example, they are likely to depend on institutions which may be different elsewhere, and which can change over time.
Evidence-based economics is concerned with explaining how the economy works. It does not have direct policy implications, but is important to policy in providing the factual basis for decision making. In the present context, a proper understanding of money shows the existence of a range of policy options that are not at present on the agenda. These include measures that could boost both public and private investment in the real economy.
Notes and references:
2. Ryan-Collins J et al. 2011 Where does money come from?, New Economics Foundation; McLeay M et al. 2014 ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin. Q1: 14-27;. Benes J and Kumhof M, 2012, The Chicago Plan revisited. IMF Working Paper No. 12/202. http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf. Carpenter SB & Demiralp S 2010. Money, reserves, and the transmission of monetary policy: does the money multiplier exist? US Federal Reserve Staff Working Paper 2010-41 https://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf. This account was standard in the early twentieth century, and was well understood by Schumpeter and others, but became displaced by other theories — for a historical review see Chick V, 2005, ‘Lost and found. Some history of endogenous money in the twentieth century’, in Fontana G et al (eds.), The monetary theory of production, Palgrave Macmillan.
3. Joffe M. 2014. ‘Can economics be evidence based?’ http://www.res.org.uk/view/art4aApr14Features.html.
6. ‘Virtually every monetary economist believes that the CB [central bank] can control the monetary base … and … the broader monetary aggregates as well. … Almost all those who have worked in a CB believe that this view is totally mistaken; in particular it ignores the implications of several of the crucial institutional features of a modern commercial banking system’. Goodhart CAE, 1994, ‘What should central banks do? What should be their macroeconomic objectives and operations?’ Economic Journal, 104, p.1424.
7. Joffe M, 2017, ‘Causal theories, models and evidence in economics — some reflections from the natural sciences’, Cogent Economics and Finance https://www.cogentoa.com/article/10.1080/23322039.2017.1280983
8. For example, the Bank of England has developed a stock-flow consistent model that fully incorporates the role of credit creation and the financial sector more broadly. See Burgess S et al, 2016, http://www.bankofengland.co.uk/research/Documents/workingpapers/2016/swp614.pdf