Advocates of Reason: 19 November 2012

Man has only one tool to fight error: reason.

Ludwig von Mises

1. Edward Harrison, “Endogenous Money and Fully Reserved Banking.” The idea of “endogenous banking” is circulating the blogosphere with more presence than ever, especially after the Krugman–Keen debate (where the end result is that few heterodox economists realized that “orthodox” banking theory acknowledges that the money supply is partially decided endogenously). I have a few quibbles on Harrison’s post.

First, all production requires savings, whether funded by fiduciary media (credit) or fully backed money substitute. The availability of inputs real goods requires that these be saved, not consumed. Credit only complicates the distribution of real goods (the Mises–Hayek cycle theory is built on this insight). If credit leads to higher productivity it’s not because it allows for production without as much saving, it’s because it makes financial intermediation more efficient (less savings left unused). That credit allows for loans without savings isn’t a good thing, and in a free banking system the ability for banks to extend credit would be severely constrained.

Second, Harrison writes that bank reserves are irrelevant, because credit demand is endogenously determined; this is true, but  generally since demand for credit is practically limitless, reserves provide banks with the capital to lend. I don’t find it convincing to interpret the causality from loan origination to reserve provision (that is, banks lend and then the central banks provides the necessary reserves). Rather, individual banks will borrow from the Fed (at the overnight rate) as long as they can charge some kind of premium over that rate (that is, as long as they’re making a profit). But, clearly, the availability of cheap-enough reserves is determinant. That in our current world, of depressed demand for credit and underwater balance sheets (especially amongst banks), the Fed’s capital injections haven’t led to more credit expansion is not evidence that reserves are irrelevant in a world of “healthy” borrowing and lending activity.

As much as I sympathize with the notion of “endogenous money,” I don’t think the post Keynesian theory of banking accurately captures the actual process of credit expansion.

2. Raghuram Rajan, “Is Finance Too Competitive?” As you read through it, you might find ancillary points disagreeable. But, the main message is spot on: banking should be competitive, and those which do poorly should face the full brunt of their losses. Finance is a crucial sector for any economy, and the freer and more competitive it is, the better. Unfortunately, Rajan doesn’t explicitly extend his thoughts on financial competition to money itself; a competitive market in money issuance would reduce the likelihood of debilitating financial crises caused by monetary distortions.

3. Susan Corke and David J. Kramer, “Russians Are Afraid and for Good Reason.” This is an interesting piece on the status of civil rights in Russia. According to the authors, Putin’s government seeks to impose a repressive legal system which, in ways, mirrors that of the early Soviet Union, but in a more subtle way some Russians, however, haven’t been fooled.

4. Robert Wenzel, “Immigration Patterns in the Eurozone.” Southern Europe’s struggling economies have pushed workers to migrate south to north,

5. Liz Alderman, “Privatizing Greece, Slowly but Not Surely.” As the Greek government sells off assets to raise revenue, it finds that some of the land it owns has been, essentially, occupied. The whole process reveals multiple dimensions of the inefficiency of Greece’s government.

  • Beefcake the Mighty

    Your second point against Harrison is actually a very good one. The MMT’ers confuse what may be true for an individual bank (that they can issue loans first and later seek out necessary reserves) with what is true for the banking system as a whole. For the latter clearly the existence of reserves is a prerequisite for credit expansion by individual banks. There was an excellent Libertarian Papers essay about a year ago on deflation (by some Indian guy, I can’t remember the name) on this issue.

  • Woj

    Regarding Harrison’s post, I’m a bit confused by your first comment. You mention that ” all production requires savings” then agree “That credit allows for loans without savings.” Could you clarify?

    As for the second point, the central bank always provides enough reserves (either through OMOs or the discount window) for the entire banking system to meet its requirements. Banks can also borrow/lend reserves to each other through the inter-bank market. Since the discount window entails an excess fee for banks, it marks the known upper bound at which reserves can always be obtained. Under normal, pre-2008, circumstances the Fed would adjust the total number of reserves in the banking system through OMOs to ensure it met its target interest rate. Now that the banking system has substantial excess reserves, the Fed uses IOER policy to set the interest rate and adjusts the amount of reserves to increase liquidity, shorten asset maturities in the private sector and alter expectations.

    • Woj

      Also, it might be helpful to consider monetary systems such as Canada’s where no reserve requirement exists yet there is a practicing central bank and private credit markets.

    • wrothbard

      Imagine that company A produces cogs.
      Imagine that company B produces machines by employing cogs.

      Imagine that B needs a shipment of 500 cogs. In order to get ahold of these cogs, they get a loan and purchase 500 cogs from company A. In this case, the credit from the bank allows them to purchase the cogs quickly, rather than waiting for sales or investments to raise the money necessary to purchase the cogs.

      Now imagine that B needs a shipment of 500 cogs. They get a loan from a bank, but then discover that company A has already sold or scrapped or consumed in some other way all their cogs. Because A did not ‘save’ their cogs company B is not able to produce their machines, no matter how large a loan they get from the bank.

      In other words, a company needs capital to engage in production, and this capital comes from the accumulation of saved (non-consumed) goods.

      • Woj

        Thanks for outlining that argument…in a convincing manner. I was caught up in thinking about saving through a loan-able funds type model rather than simply non-consumed goods.

      • JCatalan

        Thanks for the clarifying example, “wrothbard.” Woj, I also have in mind things like forced saving, where consumer good production is sacrificed for more intermediate production even while consumer demand hasn’t fallen (intertemporal misallocation).

    • JCatalan


      My point is that the central bank is a major factor in deciding the limit to credit expansion. Demand for credit may be endogenous, but the supply of credit is partially determined exogenously. A truly endogenous model of banking would be something like free banking.

      • Woj

        I agree with you that the central bank attempts to limit credit expansion through altering interest rates, expectations and regulation (e.g. capital reqs). Further, it could end the discount window and limit reserves, while letting the interest rate float (e.g. Volcker).

        Separately, I would agree that “the supply of credit is partially determined exogenously” in the sense that the Treasury/Congress increase the money supply through deficit spending.

        This may be a semantic issue, but “exogenous” money often refers to the ability of the central bank to control M (separate from the interest rate) through reserves and the money multiplier. I don’t think central banks can currently limit the potential supply of credit, which makes the actual money supply largely endogenous (one could probably argue nothing it determined entirely endogenously).

  • Roman P.

    3. Bullshit. There is no unrest over the new laws, not more than usual, at least. New regulations are tolerable and workable with, and that’s that for most of the population. The authors are fundamentally misunderstanding the true nature of the Russian society, which is not some Orwellian totalitarism, but rather an anarchy (in Hobbsian sense). Laws don’t play as much role as you think.

    • JCatalan

      Fair enough. I took a class once on Russian government, but we didn’t really go into the minutiae of current policy.