01 February 2009

The roving cavaliers of credit

The latest Steve Keen post is essential reading. Some quotes:

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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.

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The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

We are therefore not in a “fractional reserve banking system”, but in a credit-money one, where the dynamics of money and debt are vastly different to those assumed by Bernanke and neoclassical economics in general.

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The money multiplier model implies that, whatever banks might want to do, they are constrained from so doing by a money creation process that they do not control.

However, in the real world, they do control the creation of credit. Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt ... that willingness directly relates to the perceived possibilities for profitable investment—and since these are limited, so also is the uptake of debt.

But in the real world—and in my models of Minsky’s Financial Instability Hypothesis—there is an additional reason why the public will take on debt: the perception of possibilities for private gain from leveraged speculation on asset prices.

4 comments:

alan von altendorf said...

Bron,

Completely totally brilliant. I'm going to quote you with a backlink. Should be required reading in every uni and newspaper office. Simple and clear as a bell.

silveraxis said...

The central bankers realize that mandated reserve ratios are largely irrelevant as they are only short term liquidity measures and not long term solvency measures. That is why reserves are required only on MZM money. The money multiplier matters only as a limiting factor and even then it is a minor one at that. As such, the chicken or egg question is academic.

The real issue is regulatory capital, which is actually outside the Fed's control. Banks cannot simply inflate their balance sheets by equal debits (loans) and credits (deposits) as is being suggested for the simple reason they must set aside capital along the way. Such capital, unlike reserves, cannot be borrowed but must either be raised or earned. It can also be reduced through losses. This fully explains why banks are not lending today even though plenty of people still want to borrow.

In essence the Fed and Treasury have solved the bank and credit liquidity problems for the most part but they have not addressed the capital problems. Geithner's "bad bank" proposal does nothing in this regard as it is a liquidity, not capital, measure. The only possible solutions to the capital problem are to recapitalize banks that suffer massive losses or to guarantee the banks against such losses in the first place.

goldnoob said...

Hi Bron,

Related to the whole fractional reserve banking thing, do we australians have a similar setup with our central bank as the americans do with the fed - the government swapping bonds/debt for money? And does the RBA pass on earnings to external entities? I'm having difficulty making sense of conflicting information on the topic. If you issue your own currency like Guernsey does it seems that you can't be a member of several international clubs.

Bron said...

I'm sure the actual mechanism in Australia must be buried in the RBA website somewhere - I've never bothered to look.