“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 mon­th’s Debt­watch is ded­i­cat­ed to analysing how these Cav­a­liers actu­al­ly “make” mon­ey and debt—something they think they under­stand, but in real­i­ty, they don’t. A sound mod­el of how mon­ey and debt are cre­at­ed makes it obvi­ous that we should nev­er have fall­en for the insane notion that the finan­cial sys­tem should be self-reg­u­lat­ing. All that did was give the Cav­a­liers a licence to run amok, with the con­se­quences we are now expe­ri­enc­ing yet again—150 years after Marx described the cri­sis that led him to write Das Kap­i­tal.

The conventional model: the “Money Multiplier”

Every macro­eco­nom­ics text­book has an expla­na­tion of how cred­it mon­ey is cre­at­ed by the sys­tem of frac­tion­al bank­ing that goes some­thing like this:

Banks are required to retain a cer­tain per­cent­age of any deposit as a reserve, known as the “reserve require­ment”; for sim­plic­i­ty, let’s say this frac­tion is 10%.

When cus­tomer Sue deposits say 100 new­ly print­ed gov­ern­ment $10 notes at her bank, it is then oblig­ed to hang on to ten of them—or $100—but it is allowed to lend out the rest.

The bank then lends $900 to its cus­tomer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its cus­tomer Kim.

Kim then deposits this $810 in her bank. It keeps $81 of the deposit, and lends the remain­ing $729 to its cus­tomer Kevin.

And on this iter­a­tive process goes.

Over time, a total of $10,000 in mon­ey is created—consisting of the orig­i­nal $1,000 injec­tion of gov­ern­ment mon­ey plus $9,000 in cred­it money—as well as $9,000 in total debts. The fol­low­ing table illus­trates this, on the assump­tion that the time lag between a bank receiv­ing a new deposit, mak­ing a loan, and the recip­i­ent of the loan deposit­ing them in oth­er banks is a mere one week.

This mod­el of how banks cre­ate cred­it is sim­ple, easy to under­stand (this ver­sion omits the fact that the pub­lic holds some of the cash in its own pock­ets rather than deposit­ing it all in the banks; this detail is eas­i­ly catered for and is part of the stan­dard mod­el taught to econ­o­mists),… and com­plete­ly inad­e­quate as an expla­na­tion of the actu­al data on mon­ey and debt.

The Data versus the Money Multiplier Model

Two hypothe­ses about the nature of mon­ey can be derived from the mon­ey mul­ti­pli­er mod­el:

1. The cre­ation of cred­it mon­ey should hap­pen after the cre­ation of gov­ern­ment mon­ey. In the mod­el, the bank­ing sys­tem can’t cre­ate cred­it until it receives new deposits from the pub­lic (that in turn orig­i­nate from the gov­ern­ment) and there­fore finds itself with excess reserves that it can lend out. Since the lend­ing, deposit­ing and relend­ing process takes time, there should be a sub­stan­tial time lag between an injec­tion of new gov­ern­ment-cre­at­ed mon­ey and the growth of cred­it mon­ey.

2. The amount of mon­ey in the econ­o­my should exceed the amount of debt, with the dif­fer­ence rep­re­sent­ing the gov­ern­men­t’s ini­tial cre­ation of mon­ey. In the exam­ple above, the total of all bank deposits tapers towards $10,000, the total of loans con­verges to $9,000, and the dif­fer­ence is $1,000, which is the amount of ini­tial gov­ern­ment mon­ey inject­ed into the sys­tem. There­fore the ratio of Debt to Mon­ey should be less than one, and close to (1‑Reserve Ratio): in the exam­ple above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1.

Both these hypothe­ses are strong­ly con­tra­dict­ed by the data.

Test­ing the first hypoth­e­sis takes some sophis­ti­cat­ed data analy­sis, which was done by two lead­ing neo­clas­si­cal econ­o­mists in 1990.[3] If the hypoth­e­sis were true, changes in M0 should pre­cede changes in M2. The time pat­tern of the data should look like the graph below: an ini­tial injec­tion of gov­ern­ment “fiat” mon­ey, fol­lowed by a grad­ual cre­ation of a much larg­er amount of cred­it mon­ey:

Their empir­i­cal con­clu­sion was just the oppo­site: rather than fiat mon­ey being cre­at­ed first and cred­it mon­ey fol­low­ing with a lag, the sequence was reversed: cred­it mon­ey was cre­at­ed first, and fiat mon­ey was then cre­at­ed about a year lat­er:

“There is no evi­dence that either the mon­e­tary base or M1 leads the cycle, although some econ­o­mists still believe this mon­e­tary myth. Both the mon­e­tary base and M1 series are gen­er­al­ly pro­cycli­cal and, if any­thing, the mon­e­tary base lags the cycle slight­ly. (p. 11)

The dif­fer­ence in the behav­ior of M1 and M2 sug­gests that the dif­fer­ence of these aggre­gates (M2 minus M1) should be con­sid­ered… The dif­fer­ence of M2 — M1 leads the cycle by even more than M2, with the lead being about three quar­ters.” (p. 12)

Thus rather than cred­it mon­ey being cre­at­ed with a lag after gov­ern­ment mon­ey, the data shows that cred­it mon­ey is cre­at­ed first, up to a year before there are changes in base mon­ey. This con­tra­dicts the mon­ey mul­ti­pli­er mod­el of how cred­it and debt are cre­at­ed: rather than fiat mon­ey being need­ed to “seed” the cred­it cre­ation process, cred­it is cre­at­ed first and then after that, base mon­ey changes.

It does­n’t take sophis­ti­cat­ed sta­tis­tics to show that the sec­ond pre­dic­tion is wrong—all you have to do is look at the ratio of pri­vate debt to mon­ey. The the­o­ret­i­cal pre­dic­tion has nev­er been right—rather than the mon­ey stock exceed­ing debt, debt has always exceed­ed the mon­ey supply—and the degree of diver­gence has grown over time.(there are atten­u­at­ing fac­tors that might affect the prediction—the pub­lic hoard­ing cash should make the ratio less than shown here, while non-banks would make it larger—but the gap between pre­dic­tion and real­i­ty is just too large for the the­o­ry to be tak­en seri­ous­ly).

Aca­d­e­m­ic eco­nom­ics respond­ed to these empir­i­cal chal­lenges to its accept­ed the­o­ry in the time-hon­oured way: it ignored them.

Well, the so-called “main­stream” did—the school of thought known as “Neo­clas­si­cal eco­nom­ics”. A rival school of thought, known as Post Key­ne­sian eco­nom­ics, took these prob­lems seri­ous­ly, and devel­oped a dif­fer­ent the­o­ry of how mon­ey is cre­at­ed that is more con­sis­tent with the data.

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 a firm access­es its line of cred­it to, for exam­ple, buy a new piece of machin­ery, then its debt to the bank ris­es by the price of the machine, and the deposit account of the machine’s man­u­fac­tur­er ris­es by the same amount. If the bank that issued the line of cred­it was already at its own lim­it in terms of its reserve require­ments, then it will bor­row that amount, either from the Fed­er­al Reserve or from oth­er sources.

If the entire bank­ing sys­tem is at its reserve require­ment lim­it, then the Fed­er­al Reserve has three choic­es:

refuse to issue new reserves and cause a cred­it crunch;

cre­ate new reserves; or

relax the reserve ratio.

Since the main role of the Fed­er­al Reserve is to try to ensure the smooth func­tion­ing of the cred­it sys­tem, option one is out—so it either adds Base Mon­ey to the sys­tem, or relax­es the reserve require­ments, or both.

Thus cau­sa­tion in mon­ey cre­ation runs in the oppo­site direc­tion to that of the mon­ey mul­ti­pli­er mod­el: the cred­it mon­ey dog wags the fiat mon­ey tail. Both the actu­al lev­el of mon­ey in the sys­tem, and the com­po­nent of it that is cre­at­ed by the gov­ern­ment, are con­trolled by the com­mer­cial sys­tem itself, and not by the Fed­er­al Reserve.

Cen­tral Banks around the world learnt this les­son the hard way in the 1970s and 1980s when they attempt­ed to con­trol the mon­ey sup­ply, fol­low­ing neo­clas­si­cal econ­o­mist Mil­ton Fried­man’s the­o­ry of “mon­e­tarism” that blamed infla­tion on increas­es in the mon­ey sup­ply. Fried­man argued that Cen­tral Banks should keep the reserve require­ment con­stant, and increase Base Mon­ey at about 5% per annum; this would, he assert­ed cause infla­tion to fall as peo­ple’s expec­ta­tions adjust­ed, with only a minor (if any) impact on real eco­nom­ic activ­i­ty.

Though infla­tion was ulti­mate­ly sup­pressed by a severe reces­sion, the mon­e­tarist exper­i­ment over­all was an abject fail­ure. Cen­tral Banks would set tar­gets for the growth in the mon­ey sup­ply and miss them completely—the mon­ey sup­ply would grow two to three times faster than the tar­gets they set.

Ulti­mate­ly, Cen­tral Banks aban­doned mon­e­tary tar­get­ting, and moved on to the mod­ern approach of tar­get­ting the overnight inter­est rate as a way to con­trol infla­tion.[6] Sev­er­al Cen­tral Banks—including Aus­trali­a’s RBA—completely aban­doned the set­ting of reserve require­ments. Others—such as Amer­i­ca’s Fed­er­al Reserve—maintained them, but had such loop­holes in them that they became basi­cal­ly irrel­e­vant. Thus the US Fed­er­al Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by indi­vid­u­als; banks have no reserve require­ment at all for deposits by com­pa­nies.[7]

How­ev­er, neo­clas­si­cal eco­nom­ic the­o­ry nev­er caught up with either the data, or the actu­al prac­tices of Cen­tral Banks—and Ben Bernanke, a lead­ing neo­clas­si­cal the­o­reti­cian, and unabashed fan of Mil­ton Fried­man, is now in con­trol of the Fed­er­al Reserve. He is there­fore try­ing to resolve the finan­cial cri­sis and pre­vent defla­tion in a neo­clas­si­cal man­ner: by increas­ing the Base Mon­ey sup­ply.

Give Bernanke cred­it for try­ing here: the rate at which he is increas­ing Base Mon­ey is unprece­dent­ed. Base Mon­ey dou­bled between 1994 and 2008; Bernanke has dou­bled it again in just the last 4 months.

If the mon­ey mul­ti­pli­er mod­el of mon­ey cre­ation were cor­rect, then ulti­mate­ly this would lead to a dra­mat­ic growth in the mon­ey sup­ply as an addi­tion­al US$7 tril­lion of cred­it mon­ey was grad­u­al­ly cre­at­ed.

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 sys­tem fol­lows 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.

Bernanke’s expan­sion of M0 in the last four months of 2008 has mere­ly reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quar­ter­ly whole mon­ey stock data is month­ly, so the fall in the ratio is more than shown here giv­en the lag in report­ing of debt).

To make a seri­ous dent in debt lev­els, and thus enable the increase in base mon­ey to affect the aggre­gate mon­ey stock and hence cause infla­tion, Bernanke would need to not mere­ly dou­ble M0, but to increase it by a fac­tor of, say, 25 from pre-inter­ven­tion lev­els. That US$20 tril­lion truck­load of green­backs might enable Amer­i­cans to repay, say, one quar­ter of out­stand­ing debt with one half—thus reduc­ing the debt to GDP ratio about 200% (rough­ly what it was dur­ing the Dot­Com bub­ble and, coin­ci­den­tal­ly, 1931)—and get back to some seri­ous infla­tion­ary spend­ing with the oth­er (of course, in the con­text of a seri­ous­ly depre­ci­at­ing cur­ren­cy). But with any­thing less than that, his attempts to reflate the Amer­i­can econ­o­my will sink in the ocean of debt cre­at­ed by Amer­i­ca’s mod­ern-day “Rov­ing Cav­a­liers of Cred­it”.

How to be a “Cavalier of Credit”

Note Bernanke’s assump­tion (high­light­ed above) in his argu­ment that print­ing mon­ey would always ulti­mate­ly cause infla­tion: “under a fiat mon­ey sys­tem”. 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.[10]

Call­ing our cur­rent finan­cial sys­tem a “fiat mon­ey” or “frac­tion­al reserve bank­ing sys­tem” is akin to the blind man who clas­si­fied an ele­phant as a snake, because he felt its trunk. We live in a cred­it mon­ey sys­tem with a fiat mon­ey sub­sys­tem that has some inde­pen­dence, but cer­tain­ly does­n’t rule the mon­e­tary roost—far from it.

The best place to start to analyse the mon­e­tary sys­tem is there­fore to con­sid­er a mod­el of a pure cred­it economy—a toy econ­o­my in which there is no gov­ern­ment sec­tor and no Cen­tral Bank whatsoever—and see how that mod­el behaves.

The first issue in such a sys­tem is how does one become a bank?—or a “cav­a­lier of cred­it” in Marx’s won­der­ful­ly evoca­tive phrase? The answer was pro­vid­ed by the Ital­ian non-ortho­dox econ­o­mist Augus­to Graziani: a bank is a third par­ty to all trans­ac­tions, whose account-keep­ing between buy­er and sell­er is regard­ed as final­ly set­tling all claims between them.

Huh? What does that mean? To explain it, I’ll com­pare it with the man­ner in which we’ve been mis­led to think­ing about the mar­ket econ­o­my by neo­clas­si­cal eco­nom­ics.

It has delud­ed us into think­ing of a mar­ket econ­o­my as being fun­da­men­tal­ly a sys­tem of barter. Every trans­ac­tion is seen as being two sided, and involv­ing two com­modi­ties: Farmer Maria wants to sell pigs and buy cop­per pipe; Plumber Joe wants to sell cop­per pipe and buy pigs.

Mon­ey sim­ply elim­i­nates the prob­lem that it’s very hard for Plumber Joe to find Farmer Maria. Instead, they each sell their com­mod­i­ty for mon­ey, and then exchange that mon­ey for the com­mod­i­ty they real­ly want. The pic­ture appears more complicated—there are two mar­kets intro­duced as well, with Farmer Maria sell­ing pigs to the pig mar­ket in return for mon­ey, Plumber Joe doing the same thing in the cop­per mar­ket, and then armed with mon­ey from their sales, they go across to the oth­er mar­ket and buy what they want. But it is still a lot eas­i­er than a plumber going out to try to find a pig farmer who wants cop­per pipes.

In this mod­el of the econ­o­my, mon­ey is use­ful in that it replaces a very dif­fi­cult search process with a sys­tem of mar­kets. But fun­da­men­tal­ly the sys­tem is no dif­fer­ent to the barter mod­el above: mon­ey is just a con­ve­nient “numeraire”, and any­thing at all could be used—even cop­per pipe or pigs—so long as all mar­kets agreed to accept it. Gold tends to be the numeraire of choice because it does­n’t degrade, and paper mon­ey mere­ly replaces gold as a more con­ve­nient form of numeraire.

Impor­tant­ly, in this mod­el, mon­ey is an asset to its hold­er, but a lia­bil­i­ty to no-one. There is mon­ey, but no debt. The frac­tion­al bank­ing mod­el that is tacked onto this vision of bar­ter­ing adds yet anoth­er mar­ket where depos­i­tors (savers) sup­ply mon­ey at a price (the rate of inter­est), and lenders buy mon­ey for that price, and the inter­ac­tion between sup­ply and demand sets the price. Debt now exists, but in the mod­el world total debt is less than the amount of mon­ey.

If this mar­ket pro­duces too much mon­ey (which it can do in a frac­tion­al bank­ing sys­tem because the gov­ern­ment deter­mines the sup­ply of base mon­ey and the reserve require­ment) then there can be infla­tion of the mon­ey prices of com­modi­ties. Equal­ly if the mon­ey mar­ket sud­den­ly con­tracts, then there can be defla­tion. It’s fair­ly easy to sit­u­ate Bernanke’s dra­mat­ic increase in Base Mon­ey with­in this view of the world.

If only it were the world in which we live. Instead, we live in a cred­it econ­o­my, in which intrin­si­cal­ly use­less pieces of paper—or even sim­ple trans­fers of elec­tron­ic records of numbers—are hap­pi­ly accept­ed in return for real, hard com­modi­ties. This in itself is not incom­pat­i­ble with a frac­tion­al bank­ing mod­el, but the empir­i­cal data tells us that cred­it mon­ey is cre­at­ed inde­pen­dent­ly of fiat mon­ey: cred­it mon­ey rules the roost. So our fun­da­men­tal under­stand­ing of a mon­e­tary econ­o­my should pro­ceed from a mod­el in which cred­it is intrin­sic, and gov­ern­ment mon­ey is tacked on later—and not the oth­er way round.

Our start­ing point for analysing the econ­o­my should there­fore be a “pure cred­it” econ­o­my, in which there are pri­vate­ly issued bank notes, but no gov­ern­ment sec­tor and no fiat mon­ey. Yet this has to be an econ­o­my in which intrin­si­cal­ly use­less items are accept­ed as pay­ment for intrin­si­cal­ly use­ful ones—you can’t eat a bank note, but you can eat a pig.

So how can that be done with­out cor­rupt­ing the entire sys­tem. Some­one has to have the right to pro­duce the bank notes; how can this sys­tem be the basis of exchange, with­out the per­son who has that right abus­ing it?

Graziani (and oth­ers in the “Cir­cuitist” tra­di­tion) rea­soned that this would only be pos­si­ble if the pro­duc­er of bank notes—or the keep­er of the elec­tron­ic records of money—could not sim­ply print them when­ev­er he/she want­ed a com­mod­i­ty, and go and buy that com­mod­i­ty with them. But at the same time, peo­ple involved in ordi­nary com­merce had to accept the trans­fer of these intrin­si­cal­ly use­less things in return for com­modi­ties.

“There­fore for a sys­tem of cred­it mon­ey to work, three con­di­tions had to be ful­filled:

In order for mon­ey to exist, three basic con­di­tions must be met:

a) mon­ey has to be a token cur­ren­cy (oth­er­wise it would give rise to barter and not to mon­e­tary exchanges);

b) mon­ey has to be accept­ed as a means of final set­tle­ment of the trans­ac­tion (oth­er­wise it would be cred­it and not mon­ey);

c) mon­ey must not grant priv­i­leges of seignor­age to any agent mak­ing a pay­ment.” [11]

In Grazian­i’s words, “The only way to sat­is­fy those three con­di­tions is …:

“to have pay­ments made by means of promis­es of a third agent, the typ­i­cal third agent being nowa­days. When an agent makes a pay­ment by means of a cheque, he sat­is­fies his part­ner by the promise of the bank to pay the amount due.

Once the pay­ment is made, no debt and cred­it rela­tion­ships are left between the two agents. But one of them is now a cred­i­tor of the bank, while the sec­ond is a debtor of the same bank. This insures that, in spite of mak­ing final pay­ments by means of paper mon­ey, agents are not grant­ed any kind of priv­i­lege.

For this to be true, any mon­e­tary pay­ment must there­fore be a tri­an­gu­lar trans­ac­tion, involv­ing at least three agents, the pay­er, the pay­ee, and the bank.” ( p. 3).

Thus in a cred­it econ­o­my, all trans­ac­tions are involve one com­mod­i­ty, and three par­ties: a sell­er, a buy­er, and a bank whose trans­fer of mon­ey from the buy­er’s account to the sell­er’s is accept­ed by them as final­is­ing the sale of the com­mod­i­ty. So the actu­al pat­tern in any trans­ac­tion in a cred­it mon­ey econ­o­my is as shown below:

This makes banks and mon­ey an essen­tial fea­ture of a cred­it econ­o­my, not some­thing that can be ini­tial­ly ignored and incor­po­rat­ed lat­er, as neo­clas­si­cal eco­nom­ics has attempt­ed to do (unsuc­cess­ful­ly; one of the hard­est things for a neo­clas­si­cal math­e­mat­i­cal mod­eller is to explain why mon­ey exists, apart from the search advan­tages not­ed above. Gen­er­al­ly there­fore their mod­els omit money—and debt—completely).

It also defines what a bank is: it is a third par­ty whose record-keep­ing is trust­ed by all par­ties as record­ing the trans­fers of cred­it mon­ey that effect sales of com­modi­ties. The bank makes a legit­i­mate liv­ing by lend­ing mon­ey to oth­er agents—thus simul­ta­ne­ous­ly cre­at­ing loans and deposits—and charg­ing a high­er rate of inter­est on loans than on deposits.

Thus in a fun­da­men­tal way, a bank is a bank because it is trust­ed. Of course, as we know from our cur­rent bit­ter expe­ri­ence, banks can dam­age that trust; but it remains the well­spring from which their exis­tence aris­es.

This mod­el helped dis­tin­guish the real­is­tic mod­el of endoge­nous mon­ey from the unre­al­is­tic neo­clas­si­cal vision of a barter econ­o­my. It also makes it pos­si­ble to explain what a cred­it crunch is, and why it has such a dev­as­tat­ing impact upon eco­nom­ic activ­i­ty.

First, the basics: how does a pure cred­it econ­o­my work, and how is mon­ey cre­at­ed in one? (The rest of this post nec­es­sar­i­ly gets tech­ni­cal and is there for those who want detailed back­ground. It reports new research into the dynam­ics of a cred­it econ­o­my. There’s noth­ing here any­where near as poet­ic as Marx’s “Cav­a­liers of Cred­it”, but I hope it explains how a cred­it econ­o­my works, and how it can go bad­ly wrong in a “cred­it crunch”)

How the Cavaliers “Make Money”

Sev­er­al economists—notably Wick­sell and Keynes—envisaged a “pure cred­it econ­o­my”. Keynes imag­ined a world in which “invest­ment is pro­ceed­ing at a steady rate”, in which case:

“the finance (or the com­mit­ments to finance) required can be sup­plied from a revolv­ing fund of a more or less con­stant amount, one entre­pre­neur hav­ing his finance replen­ished for the pur­pose of a pro­ject­ed invest­ment as anoth­er exhausts his on pay­ing for his com­plet­ed invest­ment.” [12]

This is the start­ing point to under­stand­ing a pure cred­it economy—and there­fore to under­stand­ing our cur­rent econ­o­my and why it’s in a bind. Con­sid­er an econ­o­my with three sec­tors: firms that pro­duce goods, banks that charge and pay inter­est, and house­holds that sup­ply work­ers. Firms are the only enti­ties that bor­row, and the bank­ing sec­tor gave loans at some stage in the past to start pro­duc­tion. Firms hired work­ers with this mon­ey (and bought inputs from each oth­er), enabling pro­duc­tion, and ulti­mate­ly the econ­o­my set­tled down to a con­stant turnover of mon­ey and goods (as yet there is no tech­no­log­i­cal change, pop­u­la­tion growth, or wage bar­gain­ing).

There are four types of accounts: Firms’ Loans, Firms’ Deposits, Banks’ Deposits, and House­holds Deposits. These finan­cial flows are described by the fol­low­ing table. I’m eschew­ing math­e­mat­i­cal sym­bols and just using let­ters here to avoid the “MEGO” effect (“My Eyes Glaze Over”)—if you want to check out the equa­tions, see this paper:

1. Inter­est accrues on the out­stand­ing loans.

2. Firms pay inter­est on the loans. This is how the banks make mon­ey, and it involves a trans­fer of mon­ey from the firms deposit accounts to the banks. The banks then have to acknowl­edge this pay­ment of inter­est by record­ing it against the out­stand­ing debt firms owe them.

3. Banks pay inter­est to firms on the bal­ances in their deposit accounts. This involves a trans­fer from Bank Deposit accounts to Firms; this is a cost of busi­ness to banks, but they make mon­ey this way because (a) the rate of inter­est on loans is high­er than that on deposits and (b) as is shown lat­er, the vol­ume of loans out­stand­ing exceeds the deposits that banks have to pay inter­est on;

4. Firms pay wages to work­ers; this is a trans­fer from the firms deposits to the house­holds.

5. Banks pay inter­est to house­holds on the bal­ances in their deposit accounts.

6. Banks and house­holds pay mon­ey to firms in order to pur­chase some of the out­put from fac­to­ries for con­sump­tion and inter­me­di­ate goods.

This finan­cial activ­i­ty allows pro­duc­tion to take place:

1. Work­ers are hired and paid a wage;

2. They pro­duce out­put in fac­to­ries at a con­stant lev­el of pro­duc­tiv­i­ty;

3. The out­put is then sold to oth­er firms, banks and house­holds;

4. The price lev­el is set so that in equi­lib­ri­um the flow of demand equals the flow of out­put

The graphs below show the out­come of a sim­u­la­tion of this sys­tem, which show that a pure cred­it econ­o­my can work: firms can bor­row mon­ey, make a prof­it and pay it back, and a sin­gle “revolv­ing fund of finance”, as Keynes put it, can main­tain a set lev­el of eco­nom­ic activ­i­ty. [13]

These sta­ble accounts sup­port a flow of eco­nom­ic activ­i­ty in time, giv­ing firms, house­holds and banks steady incomes:

Out­put and employ­ment also tick over at a con­stant lev­el:

That’s the absolute­ly basic pic­ture; to get clos­er to our cur­rent real­i­ty, a lot more needs to be added. The next mod­el includes, in addi­tion to the basic sys­tem shown above:

1. Repay­ment of debt, which involves a trans­fer from the Firms’ deposit account to an account that was­n’t shown in the pre­vi­ous mod­el that records Banks unlent reserves; this trans­fer of mon­ey has to be acknowl­edged by the banks by a match­ing reduc­tion in the record­ed lev­el of debt;

2. Relend­ing from unlent reserves. This involves a trans­fer of mon­ey, against which an equiv­a­lent increase in debt is record­ed;

3. The exten­sion of new loans to the firm sec­tor by the banks. The firms sec­tor’s deposits are increased, and simul­ta­ne­ous­ly the record­ed lev­el of debt is increased by the same amount.

4. Invest­ment of part of bank prof­its by a trans­fer from the bank­ing sec­tor’s deposit accounts to the unlent reserves.

5. Vari­able wages, grow­ing labour pro­duc­tiv­i­ty and a grow­ing pop­u­la­tion.

The finan­cial table for this sys­tem is:

As with the pre­vi­ous mod­el, this toy econ­o­my “works”—it is pos­si­ble for firms to bor­row mon­ey, make a prof­it, and repay their debt.

With the addi­tion­al ele­ments of debt repay­ment and the cre­ation of new mon­ey, this mod­el also lets us see what hap­pens to bank income when these para­me­ters change.

Though in some ways the answers are obvi­ous, it lets us see why banks are tru­ly cav­a­lier with cred­it. The con­clu­sions are that bank income is big­ger:

If the rate of mon­ey cre­ation is high­er (this is by far the most impor­tant fac­tor);

If the rate of cir­cu­la­tion of unlent reserves is high­er; and

If the rate of debt repay­ment is lower—which is why, in “nor­mal” finan­cial cir­cum­stances, banks are quite hap­py not to have debt repaid.

In some ways these con­clu­sions are unre­mark­able: banks make mon­ey by extend­ing debt, and the more they cre­ate, the more they are like­ly to earn. But this is a rev­o­lu­tion­ary con­clu­sion when com­pared to stan­dard think­ing about banks and debt, because 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. In the mod­el econ­o­my shown here, 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.

That clear­ly is what has hap­pened in the world’s recent eco­nom­ic his­to­ry, as it hap­pened pre­vi­ous­ly in the runup to the Great Depres­sion and numer­ous finan­cial crises before­hand. In its after­math, we are now expe­ri­enc­ing a “cred­it crunch”—a sud­den rever­sal with the cav­a­liers going from being will­ing to lend to vir­tu­al­ly any­one with a pulse, to refus­ing cred­it even to those with sol­id finan­cial his­to­ries.

I intro­duce a “cred­it crunch” into this mod­el by chang­ing those same key key finan­cial para­me­ters at the 30 year mark, but decreas­ing them rather than increas­ing them. Firms go from hav­ing a 20 year hori­zon for debt repay­ment to a 6.4 year hori­zon, banks go from increas­ing the mon­ey sup­ply at 10% per annum to 3.2% per annum, while the rate of cir­cu­la­tion of unlent reserves drops by 68%.

There is much more to our cur­rent cri­sis than this—in par­tic­u­lar, this mod­el omits “Ponzi lend­ing” that finances gam­bling on asset prices rather than pro­duc­tive invest­ment, and the result­ing accu­mu­la­tion of debt com­pared to GDP—but this lev­el of change in finan­cial para­me­ters alone is suf­fi­cient to cause a sim­u­lat­ed cri­sis equiv­a­lent to the Great Depres­sion. Its behav­iour repro­duces much of what we’re wit­ness­ing now: there is a sud­den blowout in unlent reserves, and a decline in the nom­i­nal lev­el of debt and in the amount of mon­ey cir­cu­lat­ing in the econ­o­my.

This is the real world phe­nom­e­non that Bernanke is now rail­ing against with his increas­es in Base Mon­ey, and already the wide­spread lament amongst pol­i­cy mak­ers is that banks are not lend­ing out this addi­tion­al mon­ey, but sim­ply build­ing up their reserves.

Tough: in a cred­it econ­o­my, that’s what banks do after a finan­cial crisis—it’s what they did dur­ing the Great Depres­sion. This cred­it-econ­o­my phe­nom­e­non is the real rea­son that the mon­ey sup­ply dropped dur­ing the Depres­sion: it was­n’t due to “bad Fed­er­al Reserve pol­i­cy” as Bernanke him­self has opined, but due to the fact that we live in a cred­it mon­ey world, and not the fiat mon­ey fig­ment of neo­clas­si­cal imag­i­na­tion.

The impact of the sim­u­lat­ed cred­it crunch on my toy econ­o­my’s real vari­ables is sim­i­lar to that of the Great Depres­sion: real out­put slumps severe­ly, as does employ­ment.

The nom­i­nal val­ue of out­put also falls, because prices also fall along with real out­put.

This fall in prices is dri­ven by a switch from a regime of grow­ing demand to one of shrink­ing demand. Rather than there being a con­tin­u­ous slight imbal­ance in demand’s favour, the imbal­ance shifts in favour of supply—and prices con­tin­ue falling even though out­put even­tu­al­ly starts to rise.

The unem­ploy­ment rate explodes rapid­ly from full employ­ment to 25 per­cent of the work­force being out of a job—and then begins a slow recov­ery.

Final­ly, wages behave in a per­verse fash­ion, just as Keynes argued dur­ing the Great Depres­sion: nom­i­nal wages fall, but real wages rise because the fall in prices out­runs the fall in wages.

This com­bi­na­tion of falling prices and falling out­put means that despite the fall in nom­i­nal debts, the ratio of debt to nom­i­nal out­put actu­al­ly rises—again, as hap­pened for the first few years of the Great Depres­sion.

Though this mod­el is still sim­ple com­pared to the econ­o­my in which we live, it’s a lot clos­er to our actu­al econ­o­my than the mod­els devel­oped by con­ven­tion­al “neo­clas­si­cal” econ­o­mists, which ignore mon­ey and debt, and pre­sume that the econ­o­my will always con­verge to a “NAIRU”[14] equi­lib­ri­um after any shock.

It also shows the impor­tance of the nom­i­nal mon­ey stock, some­thing that neo­clas­si­cal econ­o­mists com­plete­ly ignore. To quote Mil­ton Fried­man on this point:

“It is a com­mon­place of mon­e­tary the­o­ry that noth­ing is so unim­por­tant as the quan­ti­ty of mon­ey expressed in terms of the nom­i­nal mon­e­tary unit—dollars, or pounds, or pesos… Let the num­ber of dol­lars in exis­tence be mul­ti­plied by 100; that, too, will have no oth­er essen­tial effect, pro­vid­ed that all oth­er nom­i­nal mag­ni­tudes (prices of goods and ser­vices, and quan­ti­ties of oth­er assets and lia­bil­i­ties that are expressed in nom­i­nal terms) are also mul­ti­plied by 100.” [15]

The mad­ness in Fried­man’s argu­ment is the assump­tion that increas­ing the mon­ey sup­ply by a fac­tor of 100 will also cause “all oth­er nom­i­nal mag­ni­tudes” includ­ing com­mod­i­ty prices and debts to be mul­ti­plied by the same fac­tor.

What­ev­er might be the impact on prices of increas­ing the mon­ey sup­ply by a fac­tor of 100, the nom­i­nal val­ue of debt would remain con­stant: debt con­tracts don’t give banks the right to increase your out­stand­ing lev­el of debt just because prices have changed. Move­ments in the nom­i­nal prices of goods and ser­vices aren’t per­fect­ly mir­rored by changes in the lev­el of nom­i­nal debts, and this is why nom­i­nal mag­ni­tudes can’t be ignored.

In this mod­el I have devel­oped, mon­ey and its rate of cir­cu­la­tion mat­ter because they deter­mine the lev­el of nom­i­nal and real demand. It is a “New Mon­e­tarism” mod­el, in which mon­ey is cru­cial.

Iron­i­cal­ly, Mil­ton Fried­man argued that mon­ey was cru­cial in his inter­pre­ta­tion of the Great Depression—that the fail­ure of the Fed­er­al Reserve to suf­fi­cient­ly increase the mon­ey sup­ply allowed defla­tion to occur. But he a triv­ial “heli­copter” mod­el of mon­ey cre­ation that saw all mon­ey as orig­i­nat­ing from the oper­a­tions of the Fed­er­al Reserve:

“Let us sup­pose now that one day a heli­copter flies over this com­mu­ni­ty and drops an addi­tion­al $1,000 in bills from the sky, which is, of course, hasti­ly col­lect­ed by mem­bers of the com­mu­ni­ty. Let us sup­pose fur­ther that every­one is con­vinced that this is a unique event which will nev­er be repeat­ed… [16]

When the heli­copter starts drop­ping mon­ey in a steady stream— or, more gen­er­al­ly, when the quan­ti­ty of mon­ey starts unex­pect­ed­ly to rise more rapid­ly— it takes time for peo­ple to catch on to what is hap­pen­ing. Ini­tial­ly, they let actu­al bal­ances exceed long— run desired bal­ances…” (p. 13)

and a triv­ial mod­el of the real econ­o­my that argued that it always tend­ed back to equi­lib­ri­um:

“Let us start with a sta­tion­ary soci­ety in which … (5) The soci­ety, though sta­tion­ary, is not sta­t­ic. Aggre­gates are con­stant, but indi­vid­u­als are sub­ject to uncer­tain­ty and change. Even the aggre­gates may change in a sto­chas­tic way, pro­vid­ed the mean val­ues do not… Let us sup­pose that these con­di­tions have been in exis­tence long enough for the soci­ety to have reached a state of equi­lib­ri­um…” (pp. 2–3)

One nat­ur­al ques­tion to ask about this final sit­u­a­tion is, “ What rais­es the price lev­el, if at all points mar­kets are cleared and real mag­ni­tudes are sta­ble?” The answer is, “ Because every­one con­fi­dent­ly antic­i­pates that prices will rise.” (p. 10)

Using this sim­plis­tic analy­sis, Mil­ton Fried­man claimed that infla­tion was caused by “too many heli­copters” and defla­tion by “too few”, and that the defla­tion that ampli­fied the down­turn in the 1930s could have been pre­vent­ed if only the Fed had sent more heli­copters into the fray:

“dif­fer­ent and fea­si­ble actions by the mon­e­tary author­i­ties could have pre­vent­ed the decline in the mon­ey stock—indeed, pro­duced almost any desired increase in the mon­ey stock. The same actions would also have eased the bank­ing dif­fi­cul­ties appre­cia­bly. Pre­ven­tion or mod­er­a­tion of the decline in the stock of mon­ey, let alone the sub­sti­tu­tion of mon­e­tary expan­sion, would have reduced the con­trac­tion’s sever­i­ty and almost as cer­tain­ly its dura­tion.” [17]

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.

Debtwatch Statistics February 2009

My dis­cus­sion of the most recent month­ly data is abbre­vi­at­ed giv­en the length of this Report, but it now appears that the debt bub­ble has start­ed to burst. Pri­vate debt fell by $A$5 bil­lion in the last month, the first fall since 2003, and the steep­est month­ly fall on record.

As a result, Aus­trali­a’s Debt to GDP ratio has start­ed to fall.

How­ev­er, it might rise once more if defla­tion takes hold. This was the Depres­sion expe­ri­ence when the debt to GDP ratio rose even as nom­i­nal debt lev­els fell. Leav­ing that pos­si­bil­i­ty aside for the moment, it appears that Aus­trali­a’s peak pri­vate debt to GDP ratio occurred in March 2008, with a ratio of 177% of GDP includ­ing busi­ness secu­ri­ties (or 165% exclud­ing busi­ness secu­ri­ties).