by Andreas Hoffmann

George Selgin has a much-discussed post over at Alt-M. I agree with most of it. However, I am puzzled by the following statement:

Austrian accounts of the money-creation process often exaggerate the ability of fractional reserve banks to create money “out of thin air,” even while sticking to a fixed reserve ratio, by looking at only one part of the bank money creation process. […] Actually, it isn’t, for the simple reason that, more often than not, a deposit made at one bank involves a corresponding withdrawal of funds from another bank, as when the deposited sum takes the form of a check.

Now, “exaggerate” leaves room for interpretation. And obviously, deposits are often transferred from one bank to another. But the endogenous money view cannot be so easily dismissed.

Ever since Nicholas Kaldor, Post-Keynesians emphasize the endogenous nature of money creation. Recently, the Bank of England, BIS economists and even New Keynesians like David Romer (by replacing the vertical-sloping LM curve with a Taylor rule, and acknowledging the importance of the interest rate target) suggest that money creation is (mostly) endogenous.

In contrast to the exogenous money view you still find in most intro textbooks, endogenous money creation is typically described as follows:

A bank grants a loan to a customer. The bank balance sheet lengthens. There is an extra asset (the bank loan) and an extra bank liability (the deposit at the bank). When the debtor withdraws the deposits for use, the bank is in need of additional financing. The bank might find financing from other banks. If not, there is always the central bank. To prevent interest rates from rising, the central bank will accommodate the needs of the bank. There is no need to attract a deposit before granting a loan!

While Post-Keynesians tend to suggest that this process is fully endogenous, central banks, Romer et al., and some Austrians view the amount of money created as somehow constrained by monetary policy. I’d say the latter is probably more correct as central banks may increase rates to stem a rise in money growth. BIS economists recommend leaning against the wind policies. During crisis periods, however, central banks really accommodate any rise in money demand. The Post-Keynesian view is closer to reality then.

Now, the issue is to know what to make of it. The “Vollgeld” guys (as I see them) are suspicious of banks (typically left-wing). They want to put money creation exclusively in the hands of central banks. The Post-Keynesians tend to prefer regulation to limit lending. The BIS believes in tightening regulation as well. I am not sure what the Austrian view would be in this regard.

I like Hayek’s view:

“So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them. And even if it is a mistake — as the recurrence of crises would demonstrate —to suppose that we can, in this way, overcome all obstacles standing in the way of progress, it is at least conceivable that the non-economic factors of progress, such as technical and commercial knowledge, are thereby benefited in a way which we should be reluctant to forgo.” See Hayek (MT&TC, pp. 189–190).