Technical Notes for ‘Banking Buffoonery’

This is an appendix to our earlier post, “Banking Buffoonery, Modeling Mysticism and Why Krugman Should Be Sweatin’ Bullets.” We discuss the Bank of England report and IS-LM model in more detail, using a Q&A format.

I don’t get the problem with standard monetary theories – can you explain it differently?

Think of it this way:

A professor of medicine, who’s never actually worked as a doctor, watches people come and go from a hospital but fails to recognize that the number entering isn’t the same as the number departing.  He mistakenly concludes that the labor and delivery unit must be a type of adoption agency. The professor then writes a textbook stating that babies must first enter the hospital with their natural parents before they can go home with their new parents. In other words, labor and delivery units are said to be mere intermediaries that have nothing to do with either labor or delivery.

Students are also taught that population growth results from hospital authorities’ staffing decisions. The number of local pregnancies has nothing to do with these decisions, for pregnancies aren’t even mentioned in the professor’s textbook. Rather, the professor claims that a centrally-planned control factor “multiplies up” through the adoption process to determine the overall supply of people.

Substitute “bank lending department” for “labor and delivery unit”, “money supply” for “supply of people”, and our ridiculous scenario isn’t that different to how monetary theory is taught by many economists. Economics really went that far astray.

Has anyone else commented on IS-LM after the BoE report?

We googled “Bank of England IS-LM” to see if anyone had covered our topic. We only found a defense of IS-LM, on blog Pieria, and it didn’t mention the report except to include a reference at the end. This was surprising, especially as one of Pieria’s bloggers (not the author of the defense) had previously admitted to being “more and more embarrassed at having to teach the IS-LM model.” In any case, we’ll defend our IS-LM rejection against the IS-LM defense.

There are two main pieces to Pieria’s post, although the first isn’t especially controversial.  The author, Frances Coppola, suggests that the IS curve is still valid when you take the “view” that money is endogenous (created by banks when they lend). Traditionally, IS-LMers insist that lending follows savings, and therefore, there’s no such thing as endogenous money. Every act of lending is said to match a pre-existing saver with a borrower. But Coppola argues that you can lose this restriction when drawing an IS curve, which you surely can for it’s only a matter of definition.

But we would state the argument differently. We’d say that not only can you redefine the IS curve to allow for the “view” that bank lending creates money, but you shouldn’t draw the curve at all until you recognize that its shape is determined mostly by such lending. Other forms of credit creation, such as a pension fund buying a corporate bond, merely transfer purchasing power from savers to borrowers. Only bank lending creates purchasing power without prior savings, injecting additional spending directly into the economy. (Borrowing from lenders outside the U.S. is a third category, and one that corresponds loosely with bank lending, but we covered that in our last post and will ignore it here.)

IS-LMers such as Paul Krugman don’t see the difference, leading them to draw an IS curve based on factors such as relative propensities to consume of savers and borrowers. This is speculative, sloppy (it mixes immediate and potential delayed effects) and leaves out the most important variables.

The second piece to the IS-LM defense is where the wheels fall off. Coppola proposes correcting the LM curve for endogenous money by narrowing the definition of money to the monetary base (currency plus bank reserves held at the central bank), but fails to acknowledge that currency and reserves are no less endogenous than bank deposits. Currency is endogenous because banks generally request more of it as lending increases, in order to meet greater demand from customers. Reserves are endogenous because minimum requirements are linked mathematically to newly-created deposits (although some countries have done away with reserve requirements altogether).

Now, central banks could hypothetically establish (exogenous) targets for the monetary base and stymie requests for currency and reserves. But we know that they don’t. In any case, the IS-LM model’s core premise of independent markets for money and credit would still be invalid.

What’s more, regardless of the central bank’s attitude towards the monetary base, it’s hard if not impossible to believe in a meaningful “liquidity preference” link to interest rates, which is the crux of the LM curve. At least, not for currency holdings, which don’t play the role they once did. The idea had some merit long ago, when currency was backed by (or minted from) precious metals, bank runs were commonplace, and people hoarded cash. But today, we see that:

  • Currency notes aren’t linked to anything of value
  • Standard legal tender coins have negligible intrinsic values
  • Coins minted from precious metals (e.g. American Eagles) have negligible legal tender face values
  • The amount of currency in circulation is virtually irrelevant economically
  • The amount of currency in circulation is certainly irrelevant to interest rates.

When was the last time you waited for higher rates before pulling a stack of $100 bills out from under your mattress? Monetary base IS-LMers believe that this is what you do.

If no-one else is making the connection from the BoE report to IS-LM, what makes you think it’ll have any effect?

Well, we admit that we may overestimate some economists’ ability to adjust to reality. That said, we don’t expect anyone to come out and say they were wrong. This just doesn’t happen.

More realistically, IS-LMers should become more fearful of the “endogenous money crowd.” As in the link above, these troublesome endogenous money folks are usually seen as holding an opposing “view” of how money is created. Some economists have been happy to claim the opposing “view” is wrong. We doubt they’ll get away with that anymore. For example, Krugman is unlikely to want a repeat of the 2012 exchange excerpted in the main article. As much as he was embarrassed by more knowledgeable bloggers and commenters at that time, it’ll be even worse when they can pelt him with a barrage of Bank of England links.

Others economists, such as Coppola in the Pieria post, propose somehow reconciling IS-LM with endogenous money. This defense may persist for awhile, but it relies on illogical arguments that should eventually be recognized as such (at least, in a sane world).

The real swing vote, though, gets back to the positioning of endogenous money as a “view”. Many economists are willing to concede that IS-LM falls apart when you take this “view”, even as they accept both sides of the debate. (Why make enemies when you can find a way to agree with everyone?) This is the piece we expect to change, now that people are paying more attention to banking and authorities such as the BoE are weighing in. It’ll become impossible to claim that there are two opposing “views” – as opposed to a single reality – and retain any credibility.

So, by saying that banks inject money directly into the economy, you’re claiming that money creation is unlimited and banks are evil, right?

No, we’re not saying either of those things, contrary to what some pundits may like you to believe. Our key points are that bank lending is riskier than other forms of credit creation, because it stimulates spending without prior savings, and that one of the major deficiencies of orthodox theory is the failure to recognize this. We also agree with a variety of heterodox economists that bank lending is a huge part of the business cycle. For more on this, see “3 Underappreciated Indicators to Guide You Through a Debt-Saturated Economy.” Moreover, decades of increasing leverage continue to pose risks for the future, as discussed in “Is This What a Credit Bubble Looks Like”.

But are you saying there’s no reason to limit government deficits, since banks can negate crowding out effects by creating money?

We’re not saying that, either. Although it’s true that bank lending can prevent government deficits from crowding out private spending, this has little to do with the reasons for limiting deficits and debt. For a thorough response to this nonsensical interpretation of the BoE’s report, we recommend Detlev Schlichter’s posts here and here. For our views and research on government debt, see “Fonzi or Ponzi? One Theory on the Limits to Government Debt” or “Why The Next Global Crisis Will Be Unlike Any In The Last 200 Years,”

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