Mainstream economists are professional trolls.

By this, I don’t mean that mainstream economists work in troll farms and are being paid by Putin—though it would be better for humanity if they were: they’d do far less damage. I mean that, almost to a person, they behave as trolls when debating critics of economics, and when discussing issues that, to their mindset, can only be solved by economic theory. They ridicule their opponents rather than engaging with them, because, like trolls, they are smugly confident that their critics couldn’t possibly be right.

Philip N Cohen (@familyunequal) used this insight to come up with the perfect collective name for a group of economists: A “smug” of Economists:

They are smug because they believe that mainstream, “Neoclassical” economics is an accurate model of the real world, and therefore anyone who criticises it must be wrong.

This smugness would merely be infuriating if they were just trolls, with nasty attitudes but no real power. But in fact, they do have power: though they’ll frequently complain that politicians don’t listen to them enough, the majority of advisors to politicians are economists, and most decisions taken by politicians follow mainstream economic advice. Their smugness therefore leads them to dismiss sound criticism, and that locks in bad policy based on either bad theory, or bad work by other Neoclassical economists.

I experienced two instances of their smugness last week on (where else?) Twitter, via the Londoner Tim Worstall (@worstall) on climate change, and an anonymous New Zealander “Econgrad” (@Econgrad5143), on the role of money in economics.

Worstall trolled Peter Kalmus for saying that “I don’t know how more parents aren’t climate activists“, with the claim that all we need is a carbon tax, citing both Lord Stern and “Nobel Prize” winner Nordhaus as examples of “actual science”.

Worstall probably neither knew nor cared that Peter Kalmus in fact is a climate scientist (see https://en.wikipedia.org/wiki/Peter_Kalmus_(climate_scientist)). But he also clearly does not know that Nicholas Stern is a critic of Nordhaus’s work on climate change. In fact, in a recent open-access paper “A Time for Action on Climate Change and a Time for Change in Economics“, Stern directly rejects Worstall’s advice:

the suggestion that ‘theory says’ that the carbon price is the most effective route is simply wrong and involves a number of mistakes. (Stern 2022)

I tried to alert Worstall to the fact that Nordhaus’s work is dangerously misleading, and he rejected my warning because, hey, I’m a known critic of Neoclassical economics:

So a critic must be wrong, because he’s a critic? Well, here is Lord Nicholas Stern on precisely the same point:

a recent version of the DICE model estimates losses of 8.5% of current GDP at a global temperature rise of 6°C. If this were plausible, there would be little cause for concern about climate change because 6°C of warming will not be reached, even with bad luck, probably for over 100 years, by which point, with a modest amount of economic growth, losing less than 10 percentage points of GDP would be of minor significance in relation to GDP which had more than doubled (at say an underlying growth rate of 1% per annum).

But a 6°C temperature rise would likely be deeply dangerous, indeed existential for hundreds of millions, or billions, of people. It could be a world that could support a far lower population, and we could see deaths on a huge scale, migration of billions of people, and severe conflicts around the world, as large areas, many densely populated currently, became more or less uninhabitable as a result of submersion, desertification, storm surge and extreme weather events, or because the heat was so intense for extended periods that humans could not survive outdoors. It is profoundly implausible that numbers around 10% of GDP offer a sensible description of the kind of disruption and catastrophe that 6°C of warming could cause. (Stern 2022. Emphasis added)

My paper “The appallingly bad neoclassical economics of climate change” (Keen 2020), which Worstall claims to have skimmed, explains how Nordhaus generated these profoundly implausible numbers, and ironically, Neoclassical economics itself was not guilty. In fact, other Neoclassical economists, such as Robert Pindyck, have noted that the function in Nordhaus’s DICE model that purports to show the relationship between global warming and GDP “is made up out of thin air. It isn’t based on any economic (or other) theory or any data” (Pindyck 2017, pp. 103-104).

Ignorant of all this, and with the confidence of a troll, Worstall regularly attacks climate scientists, and dismisses warnings about the dangers of climate change:

Our beefs will quite probably be well and truly be cooked by global warming, thanks in part to the smug trolls of Neoclassical economics, and the appallingly bad work that they witlessly defend.

Keen, Steve. 2020. ‘The appallingly bad neoclassical economics of climate change’, Globalizations: 1-29.

Pindyck, Robert S. 2017. ‘The Use and Misuse of Models for Climate Policy’, Review of Environmental Economics and Policy, 11: 100-14.

Stern, Nicholas. 2022. ‘A Time for Action on Climate Change and a Time for Change in Economics’, The Economic Journal, 132: 1259-89.

 

As I say in the first video in this short series, “come for the clickbait, stay for the education”. No, this post is not money-making advice: it’s telling you how money is actually made, by both banks and the government, using my Minsky software.

Firstly, here are the videos. If you’re a visual learner, you may prefer them to this post:

https://www.youtube.com/watch?v=4tXW1hnqifo

https://www.youtube.com/watch?v=QcwPGLgYrwQ

https://www.youtube.com/watch?v=-of4i2vp77o

https://www.youtube.com/watch?v=nw5ePEyxoOU

A Pure Credit Economy

I start with a model of a pure credit economy—one in which there is no government. Though such a thing has never existed, it’s approximately the situation of 19^th century America, when government debt never exceeded 26% of GDP (even during the Civil War), the government normally ran a balanced budget or a surplus, and government spending was normally under 10% of GDP—see Figure 1.

Figure 1: Private & Public Debt and money creation since 1830

A bank must have positive equity: the value of its (short-term) assets much exceed the value of its (short term) liabilities. If you take a bank which has just been established, it will have assets, but no liabilities, and hence positive equity equal to its Assets. This initial position is shown in Figure 1. This bank’s assets are listed as “Reserves”, it has no liabilities, so its Equity starts equal to its Assets.

Figure 2: A bank must start with, and maintain, positive equity

A bank creates money by issuing loans. It simply adds the amount Credit dollars per year to its depositors, and recording that much additional debt for them as well. This is shown in Figure 2—and notice that Reserves play no role at all.

Figure 3: Creating Loans and Deposits simultaneously

This applies at the aggregate level as well as at the individual bank, so I now consider the aggregate, economic level. Borrowers pay interest on outstanding debt, and banks purchase goods and services from the non-banks. That gives us Figure 4.

Figure 4: Interest payments and bank spending

This is enough to start modelling a pure credit economy in Minsky. Minsky uses flowcharts to define mathematical relationships. The most obvious one here is that Interest equals Loans times the rate of interest. With an initial level of loans of $550 billion in Figure 4, and an interest rate of 5 percent per year, Interest payments start at $27.5 billion—see Figure 5.

Figure 5: Defining the flow “Interest”

I relate spending by banks to the amount of money they hold—their short-term equity—using the engineering concept of a “time constant”. This basically asks the question “how many years could banks spend without any inflows into their accounts?” This will be a substantial time period, compared to (for example) how long workers could survive without getting any income. I set the time constant for banks to 2 years in Figure 6, so that with initial equity of $150 billion, they will spend $75 billion in the first year.

Figure 6: Spending by banks related to bank short-term equity by a time constant

Now I need to define Credit. There are many ways to do this—I could, for example, argue that banks have a target Loans to Equity ratio, and lend till they reach it. But for simplicity, I model credit as a percentage of GDP—see Figure 7.

Figure 7: Credit as a percentage of GDP

Now I have to define nominal GDP, and again for simplicity I model it as being caused by the turnover of money—a simple “velocity of money” model.

Money is the sum of the Liabilities plus short-term Equity of the banking sector—see Figure 8.

Figure 8: Money as the sum of Deposits plus short term bank equity

The Velocity of Money times Money defines GDP—see Figure 9.

Figure 9: Money times Velocity determines nominal GDP

With those definitions, I can model what happens to nominal GDP as credit rises and falls. Positive credit increases both the money supply and GDP; negative credit causes the money supply and GDP to fall.

Figure 10: A pure credit economy

Did you notice anything unconventional in the above explanation? Reserves, which play a pivotal role in the mainstream model of bank lending, played no role at all here. As I explain in “The Dead Parrot of Mainstream economics”, banks can’t “lend from Reserves” (you can read this post on Substack or Patreon). Instead, Reserves play a crucial role in the next aspect of money creation: government deficits.

A Pure Fiat Economy

A pure fiat money economy is as much of an abstraction as a pure credit economy, but it lets us isolate the key factors in money creation by governments. This is shown in Figure 11: when a government spends more than it gets back in taxation, it adds Fiat dollars per year to Deposit accounts. That is creating money, just as bank lending creates money, but with one critical difference: the bank asset that is created along with Deposits is Reserves, rather than Loans.

Figure 11: The absolute basics of government money creation

Reserves, which played no role in the model of a pure credit economy, play a central role here. As is well known—even by Neoclassical economists—Reserves are a liability of the Central Bank. Therefore, we have to include the Central Bank to properly model government money creation, and this shows that the increase in Reserves is caused by a transfer of funds from the Treasury’s accounts at the Central Bank, as shown in Figure 12.

Figure 12: The Central Bank’s main Liabilities are Reserves and the Treasury’s Deposit account

Finally, we need to look at the Treasury’s books: where does it get the funds? Figure 13 shows the source: the Treasury doesn’t “get” the funds from anywhere: it simply creates them by going into negative equity.

Figure 13: Treasury creates the funds by going into negative equity

I know lots of people will have a “that’s not right” response to this, and in sense that’s partially correct: it’s not right, it’s also “might”. The whole idea of a fiat currency is that the power controlling a nation, the government, can declare that its liabilities are to be used as the form of money in the domain it controls. It therefore needs to create those liabilities, and a deficit—spending more than it takes back in taxation—is the means by which it does that.

Furthermore, its liabilities become the asset of the non-governmental sectors, which is easily seen by looking at the economy from the private sector’s point of view—see Figure 14. The negative equity of the government creates the identical positive equity for the private sector. Therefore, rather than being a “bug” of the system, it is a critically important feature: negative equity for the government is a pre-requisite for the existence of a fiat currency.

Figure 14: The private sector’s positive equity is created by the government’s negative equity

The full picture of government money creation by fiat is shown in Figure 15, and it makes it obvious that the negative equity for the government is the positive equity for the private sector. I’ve set all accounts to zero so that I can show in the next figure that the government can, effectively, create a monetary economy from nothing: whereas the banking sector needs to have positive equity to function, a government can hypothetically start from zero and establish a monetary economy.

Figure 15: The 4 primary sectors of a fiat economy

In Figure 16, I have the government creating $10 (billion) of fiat money per year, by spending $10 billion more than it takes back in taxes. Over 30 years, it creates negative equity for itself of $300 billion, and identical positive equity for the private sector.

Figure 16: Fiat creation of $10 (billion) a year creates money and positive equity for the private sector

I’ve deliberately omitted government bonds until now, because I want to emphasise the fundamental point that, whereas a bank creates money by expanding its assets and liabilities equally, a government creates money by creating negative equity for itself, and identical positive equity for the non-government sector. Bonds play no role in that. But if a government doesn’t issue bonds, then it wears its negative equity on its account at the Central Bank: notice that the Treasury’s account at the Central Bank goes into overdraft. Most governments have passed laws to prevent this: they require the Treasury to maintain a positive balance in its account at the Central Bank.

Figure 17 shows this legislatively required situation from the point of view of the banking sector: government spending in excess of taxation creates Fiat money; the government issues bonds equivalent to the amount of Fait money created, plus interest on outstanding bonds; and the Central Bank, in its “Open Market Operations” with private banks, can also purchase bonds as assets for itself on the secondary market (since the same laws also normally ban the Central Bank from buying bonds directly from the Treasury).

Figure 17: Bond sales, interest on bonds and Central Bank bond purchases

This only substantive difference this makes to the situation without bond sales is that, as well as Fiat creating money for the private non-bank sector, interest on bonds owned by the banks creates money (and positive equity) for the banking sector. In addition, because the sale of bonds is required by law to match the excess of government spending over taxation plus the interest paid on bonds owned by the banks, the Treasury’s account at the Central Bank does not go into overdraft.

To model this in Minsky, I made bond sales equal to the sum of Fiat plus interest on existing bonds, and had the Central Bank purchase bonds equivalent to the interest on bonds—see Figure 18

Figure 18: Modelling the requirement to sell bonds in Minsky

Figure 19 models this with Fiat creation (otherwise misleadingly known as the government deficit) of $10 (billion) per year and a 3% rate of interest on bonds. The outcome is that this creates a growing economy, and generates positive equity for both the private non-banking sector and the banking sector.

Figure 19: A Fiat Currency “lifting itself by its own bootstraps”

Fiat creates money for the non-bank private sector; interest on bonds creates money for the banking sector; and the turnover of money creates GDP. Far from the servicing of government debt being a burden on future generations, as Neoclassical economists claim, the payment of interest on government bonds finances the banking sector while the excess of government spending over taxation creates money and positive equity for the non-bank private sector.

The real world is a mixed fiat-credit system of course, and Minsky can model the two together—which I’ve done in posts before and will doubtless do again. Once you understand this system, the Neoclassical obsession with reducing government debt can be seen for what it is: it is an attitude born of ignorance of the actual system of money creation, and it results in policies that make capitalism malfunction even more so than it would do without their intervention.

In my previous post “It’s not a Deficit, it’s a Fiat” (which, like this post, is open access on Patreon and Substack), I showed that the so-called “Deficit” is actually government creation of “Fiat” money. If you haven’t read that post yet, read it now and come back to this one later.

In that post, I rejected the use of the word “Deficit” to describe government spending in excess of taxation, because mainstream economists have made it a pejorative word. Rather like the Pigs in Animal Farm, they declare that “Deficit BAD! Surplus GOOD”, when a deficit for one party in a financial system necessarily requires an identical surplus for another. What a government “deficit” actually does is create “Fiat” money for the non-government sectors of the economy, and from now on I’m going to use that word—Fiat—to describe the gap between government spending and taxation.

This post starts where that one ended, with the full 4-sector accounting of how the government, when it spends more than it collects in taxes, creates money for the private sector—as shown in Figure 1 here. The key point is that negative entry for Fiat in the Treasury’s Assets causes an identical positive entry in the private sector’s Assets: this is how a government creates Fiat money.

Figure 1: The basics of how a government creates Fiat money

What Figure 1 lacks is an explanation of government “debt”—which is another misnomer, since it doesn’t involve borrowing from banks at all, but rather banks swapping one Asset (Reserves) for another (Treasury Bonds, or TBonds for short).

I’m going to show why by starting with an operation which, in most countries in the world, is illegal: the Central Bank buying bonds directly from the Treasury. This operation is illegal for the same reason that smoking marijuana is illegal in most countries in the world, while drinking alcohol is not. It’s not because the former is more dangerous than the latter, but because legislators followed conventional wisdom rather than scientific research, and banned the safer drug while making the more dangerous one legal.

If the government doesn’t sell bonds, then what will happen is obvious from Figure 1: a sustained Fiat (“Deficit” for those who still haven’t got the memo) will drive the CRF (the “Consolidated Revenue Fund”, the Treasury’s account at the Central Bank) into overdraft. Without bond sales, there’s only one entry in the CRF account, and it’s negative.

On the other hand, if the Treasury sells bonds to the Central Bank, as shown in Figure 2, then there is a positive entry in the CRF—the proceeds of bond sales—as well as a negative. The CRF can then remain positive. In fact, if bond sales precisely equal Fiat, then the CRF will remain constant.

Figure 2: Treasury Bond sales to the Central Bank

Which situation is better: no bond sales and the CRF going into overdraft, as in Figure 1, or bond sales and the CRF remaining positive, as in Figure 2? Personally, I prefer Figure 2, since then the CRF, which is the Treasury’s deposit account at the Central Bank, remains positive, like deposit accounts in private banks. It would feel strange that a crucial deposit account in the overall financial system is negative while all others are positive, which is the case for Figure 1.

But that’s all that is involved here: it’s just a feeling. Practically, there is no significant difference between Figure 1 and Figure 2: in both cases, the government creates money for the private sector by going into negative equity itself, to a level that is precisely equal to the positive equity it creates for the private sector. This is simply how a fiat currency works.

Unfortunately, stupid laws mean that neither Figure 1 nor Figure 2 is legal. Instead, just like a stoner is forced by stupid laws to buy his dope from a dealer, the Central Bank is forced by stupid laws to buy Treasury Bonds from Private Banks. What actually happens in practice is shown in Figure 3: the Treasury sells to Primary Dealers, and the Central Bank buys off the Dealers.

Figure 3: Treasury sells to (Primary) Dealers, the Central Bank buys off Dealers

“Primary Dealers” is a very apt label for private banks, given that they function like drug dealers selling to drug consumers today. They only have a market because stupid laws enable their trade.

The end result of this process is, potentially, equivalent to the direct sale of Bonds by the Treasury to the Central Bank—if the Central Bank bought all the Bonds sold to the private banks. It certainly has no impact on the core fact that the government creates Fiat money by spending more than it gets back in taxation, which in turn increases private sector bank deposit accounts by precisely the same amount.

I haven’t shown interest payments yet for two reasons. Firstly, I’m making the false assumption that the Central Bank buys all the bonds. This is something it’s entirely capable of doing, but normally it doesn’t. Secondly, in most countries, the Treasury is not required to pay interest on bonds held by the Central Bank—and in countries where it is so required, the Treasury receives most of that back, because technically the Treasury owns the Central Bank.

Removing this assumption means that the Treasury has to pay interest on the bonds owned by the private banks—and that gets us to Figure 4, which is the real-world situation (minus one detail of the real world, that private banks sell a lot of the bonds they buy to NBFIs: non-bank financial institutions).

Figure 4: Interest payments on bonds create net worth for the banks

This changes the situation shown in Figure 1 in one important respect: as well as the Fiat creating money for the private non-bank sector, interest payments on bonds create money for the banking sector.

The reason that I describe the sale of bonds to banks as a gift is that, because of this sale, the Government pays the banks an income stream which it could easily avoid by having the Central Bank buy all the bonds issued by the Treasury.

Why should the government bestow this gift on the banks? One good reason is that the interest payments compensate the private banks for the costs they incur by running the economy’s payments system. Without interest on government-created money, the banks would have to profit solely from their dealings with the non-bank public: from charging interest on private debt, fees on depositors, etc. They do that anyway of course, but the higher the income banks make directly from the government, the less is the pressure on them to entice the non-bank public into debt.

The UK provides a striking example of how the erroneous obsession with reducing government debt—which, to labour the point, reduces the amount of Fiat-based money in the economy—encouraged banks to create private debt to compensate for the fall in their income from the government. Prior to 1980, private debt in the UK was normally below 70% of GDP, and stable. After then, it more than trebled—and this started at a time of high and rising official and private interest rates.

Figure 5: UK Private debt took off when government debt fell & banks were allowed to lend for house purchases

Two causal factors can be identified: the decline in private sector holdings of government bonds relative to GDP, and Thatcher’s decision to allow banks to lend for house purchases (before Thatcher, building societies had an effective monopoly on mortgage issuance in the UK). The former reduced the income of banks substantially, the latter opened up a market for private debt that banks took full advantage of—setting off a house price bubble in the process.

If we had people in charge of the monetary system who actually understood how money works, then private debt, not government debt, would be kept low, the Deficit Fiat would be kept at a level commensurate with the needs of the private sector for money for commerce and savings, and the finance sector would be kept in check.

Instead, with the anti-government debt obsession, we have inadequate government spending on vital services, inadequate amounts of Fiat money in circulation, and the Dealers rather than the authorities, are in charge of the joint. The “War on Deficits Fiat” has been about as successful as the “War on Drugs”.

The prominent Australian mainstream economist Chris Richardson recently celebrated the fact that the Australian government is now in surplus:

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His “temporary” and “permanent” comment was in relation to this earlier tweet: tax revenues are up but that’s temporary; there’s too much spending, and that’s permanent.

Yes, this is “stunningly strong” news for the government’s finances, seen in isolation. Figure 1 shows this situation. If the government spends more than it gets back in taxation, then it runs a deficit. The deficit reduces the amount of money in the Treasury’s deposit account at the Central Bank—the “Consolidated Revenue Fund”. This means that the government, which already has more liabilities than assets—and is therefore in negative equity—is pushed even further into negative equity. That has to be bad, right?

Figure 1: A deficit pushes the government further into negative equity! BAD BAD BAD!!!

Sure, if you take a partial view of the financial system, and look just at the government’s accounts in isolation. But that sort of thinking is something that economists, in other circumstances, deride as “partial” analysis. What you really need to do, to truly understand a system, is do a general analysis—and that means looking at the entire system. In the case of government deficits, that means looking at the accounts for the Central Bank, the private banks, and the non-bank private sector, as well as for the Treasury.

The “Consolidated Revenue Fund” (CRF), which is the Treasury’s asset, is the Treasury’s deposit account at the Central Bank: it is a liability of the Central Bank, just as your deposit account at a private bank is your asset and the private bank’s liability.

The private banks also have accounts at the Central Bank, which economists call Reserve accounts. When the government runs a deficit, the CRF falls and the Reserve accounts of the private banks rise. This is a necessary step in how the government’s spending and taxation affect the private sector’s bank accounts. This transfer of funds from the Treasury’s Consolidated Revenue Fund to the Reserve accounts of the private banks is shown in Figure 2—where I’ve replaced the wordy “Consolidated Revenue Fund” with its abbreviation CRF.

Figure 2: The Deficit transfers funds from Treasury’s CRF to the Reserve accounts of private banks

The increase in Reserves caused by the Deficit enables the private banks to increase the non-bank private sector’s deposit accounts—which is what a deficit does. A deficit occurs when the government spends more on the private sector than it takes back from the private sector in taxes. A deficit therefore increases the money supply, by increasing the private sector’s bank accounts. This is shown in Figure 3.

Figure 3: The Deficit increases bank Reserves and the private sector’s Deposit accounts

Finally, the Deficit increases the private non-bank sector’s net worth: the increase in the value of the private sector’s Deposit accounts doesn’t come with any offsetting increase in the private sector’s liabilities, so the net worth of the private sector rises. This is shown in Figure 4.

Figure 4:The Deficit increases the private sector’s Assets without changing its Liabilities, so the net worth of the private sector rises

So, what is a negative for net worth of the government—when it runs a deficit—is a positive for the private sector. When the government decreases its net worth by running a deficit, it increases the net worth of the private sector by precisely as much. A deficit for the government is a surplus for the private sector.

What is Richardson really celebrating, because the government is now running a surplus? He’s celebrating the government reducing the financial resources of the private sector. He’s celebrating the government reducing the money supply. Somehow, this is supposed to make the economy work better.

I deliberately haven’t considered the government debt issues in this post, because I want to focus on the core point that a government Surplus, while it increases the net worth of the government, necessarily reduces the net worth of the private sector. I’ll cover the government debt issue in my next post, but I hope this one points out something ridiculous in celebrating the government running a Surplus: you are also celebrating the private sector being forced to run a matching Deficit.

Finally, though Richardson’s celebration of a government surplus is typical of the flawed, partial analysis that mainstream economists do when they attempt to analyse the monetary system, it’s also, I think, a product of the pejorative nature of the words “Deficit” and “Surplus”.

A Deficit is BAD! A Surplus is GOOD!

Really? Not when you take a systemic, rather than a partial, look at the financial system. Then a Deficit for one sector is a necessary consequence of a Surplus for another sector: you can’t have one without the other.

Frankly, I’m so sick of this flawed partial thinking that I refuse to use the words “Deficit” and “Surplus”. I will instead use the word “Fiat” to describe a government “Deficit”, because what this so-called Deficit does is actually create “Fiat” money, while a government Surplus destroys Fiat money.

In my next post, I’ll complete the “debt” side of this model. In the meantime, I’ll await an explanation from Richardson of why it’s a good idea for the government to destroy Fiat money.

Figure 5: It’s not a Deficit, it’s a Fiat

Only the good ideas die young

The Post-Keynesian Economist Victoria Chick—Vicki to her friends—died earlier this year, and was celebrated today by the interment of her ashes in her beloved home of Hamstead, and a tribute to her at University College London, her academic home for over half a century.

With Vicki’s death, most of her generation—who were prominent critics of conventional economics in the 1960s and 1970s—is no more. I’ve attended several funerals now for scholars like Vicki, who opposed the Neoclassical mainstream in economics, only to see that mainstream outlive them.

Though it’s both hard and weird to acknowledge it, I’m now one of today’s elders of non-mainstream economics. I cracked 70 last month, friends like Marc Lavoie are close behind, and we’re watching a new generation of rebels take our place. The thought that made Vicki’s farewell both poignant and chilling for me was, will the Neoclassical mainstream of economics still be dominant when my day of internment arrives?

Unfortunately, I believe so. The fact that Neoclassical economics is still dominant today, when it has been empirically and logically contradicted for over a century, proves that Max Planck’s adage that “Science advances one funeral at a time” does not apply to economics.

If funerals alone could have killed it, it would have died in the decades after the Great Depression—the economic event which, more than any other, showed that there was something seriously wrong with the mainstream vision of capitalism as a self-adjusting system that, left to its own devices, will achieve a state of welfare-maximizing equilibrium.

Instead, Neoclassicals developed a twisted tale in which the Great Depression was caused, not by capitalism itself, but by the government. Specifically, they blamed the Federal Reserve for tightening monetary policy. Milton Friedman was the first to make this case, arguing, as Ben Bernanke put it, that:

Federal Reserve policy turned contractionary in 1928, in an attempt to curb stock market speculation… the main lines of causation [of the Great Depression] ran from monetary contraction—the result of poor policy-making and continuing crisis in the banking system—to declining prices and output. (Bernanke 2000)

Bernanke echoed this explanation in an obsequious speech he made at Milton Friedman’s 90^th birthday function in 2002:

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.

Bollocks. The real cause of the Great Depression was the collapse of a private debt bubble that the economics mainstream completely ignored. The Roaring Twenties roared because of a private-debt-fuelled Ponzi scheme that began in real estate and ended up in the Stock Market. The party came to an end when credit flipped from almost 10% of GDP in 1928 to almost minus 10% in 1933—see Figure 1.

Figure 1: Credit collapsing from almost 10% of GDP to almost minus 10% is what caused The Great Depression

With their fallacious argument that bad monetary policy caused the Great Depression, this particular anomaly—from the point of view of mainstream economics—was dealt with. To this day, even after the “Great Recession” gave us a repeat performance (see Figure 2) the mainstream still hasn’t considered the argument that the private banking system, and not the Federal Reserve, caused the Great Depression.

Figure 2: Credit collapsing from over 15% of GDP to almost minus 5% is what caused The Great Recession

All other anomalies have been treated the same way: either ignored, or explained away by an alternative scapegoat that doesn’t challenge the mainstream view of capitalism as a self-regulating system.

This isn’t done because Neoclassical economists are paid shrills or apologists for capitalism, but because the Neoclassical model describes a utopia and, for whatever reason, humans seem to yearn for utopias. The Neoclassical model is a utopia because it asserts that people earn what they deserve—their “marginal product”—while also getting what they want from the system—they “maximize their utility” subject to their budget constraints. Even when the real world departs wildly from this textbook vision, the desire to believe overwhelms the desire to understand.

Funnily enough, this isn’t all that far removed from how actual scientists behave, as Max Planck—the discoverer of quantum mechanics—himself lamented. He remarked in his autobiography that:

It is one of the most painful experiences of my entire scientific life that I have but seldom—in fact, I might say, never—succeeded in gaining universal recognition for a new result, the truth of which I could demonstrate by a conclusive, albeit only theoretical proof. (Planck 1949, p. 22)

The difference between science and economics comes down, not to the behaviour of people, but to the nature of the anomalies that disturb the existing paradigm. Planck overturned 19^th century physics with the discovery that the only way to explain the radiation emitted by a “black body” was to accept that energy was not continuous, as in Maxwell’s theory, but that it came in discrete packets he called “quanta”.

Though Planck was correct, science made the move from Maxwellian physics to quantum mechanics, not because physicists were better people than economists (though in the main, they are), but because scientific anomalies don’t go away, whereas economic ones do.

Planck’s contemporaries continued to teach Maxwell’s theories and resist Planck’s paradigm. As time went on, these Maxwellian professors ultimately retired or died, and had to be replaced—and their replacements were students who were wedded, not to the old failed Maxwellian paradigm, but to the new paradigm of quantum mechanics. As Planck put it:

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it. (Planck 1949, pp. 23-4)

Scientific revolutions occur in sciences because the anomaly that undermines the dominant theory doesn’t go away. But in economics, the anomaly passes with time: no student can reproduce the Great Depression and then check whether the mainstream rationalization or a radical new explanation makes more sense of the event.

A minority of students can’t accept the old way of thinking—which is where rebels like Vicki, and myself, and today’s members of Rethinking Economics come from. But another minority also exists that finds the libertarian message of the Neoclassical mainstream seductive, and it is they—rather than the rebels—who form the next generation of Professors.

So Neoclassical economics has outlived Veblen, and Sraffa, and Keynes, and now Chick and Harcourt. Someday in the future, it will outlive me, and Kelton, and Lavoie.

The only alternative I can see is far less pleasant: that rather than Neoclassical economics outliving its critics, it may in fact kill capitalism first.

Farewell then Vicky. I’m no believer in the afterlife, but if there is one, I’m sure you’re discussing your works and downing a pint now with your fellow departed economic rebels (Chick 1991, 1997; Chick 1998; Krugman et al. 1998; Chick 2001; Chick and Dow 2001; Chick and Dow 2002, 2005; Chick 2008; Chick and Dow 2012; Chick and Tily 2014).

References

Bernanke, Ben S. 2000. Essays on the Great Depression (Princeton University Press: Princeton).

Chick, V. 1991. ‘Hicks and Keynes on liquidity preference: a methodological approach’, Review of Political Economy, 3: 309-19.

———. 1997. ‘Some reflections on financial fragility in banking and finance’, Journal of Economic Issues , 31 (2) pp. 535-541. (1997).

Chick, Victoria. 1998. ‘On Knowing One’s Place: the Role of Formalism in Economics’, The Economic journal (London), 108: 1859-69.

———. 2001. ‘Cassandra as optimist.’ in Riccardo Bellofiore and Piero Ferri (eds.), Financial Keynesianism And Market Instability: The Economic Legacy of Hyman Minsky (Edward Elgar Publishing: Cheltenham).

———. 2008. ‘Could the crisis at Northern Rock have been predicted?: An evolutionary approach’, Contributions to political economy, 27: 115-24.

Chick, Victoria, and Sheila Dow. 2002. ‘Monetary Policy with Endogenous Money and Liquidity Preference: A Nondualistic Treatment’, Journal of Post Keynesian Economics, 24: 587-607.

———. 2005. ‘The Meaning of Open Systems’, Journal of Economic Methodology, 12: 363-81.

Chick, Victoria, and Sheila C. Dow. 2001. ‘Formalism, logic and reality: a Keynesian analysis’, Cambridge Journal of Economics, 25: 705-21.

———. 2012. ‘On causes and outcomes of the European crisis: Ideas, institutions, and reality’, Contributions to political economy, 31: 51-66.

Chick, Victoria, and Geoff Tily. 2014. ‘Whatever happened to Keynes’s monetary theory?’, Cambridge Journal of Economics, 38: 681-99.

Krugman, P., E. R. Weintraub, R. E. Backhouse, and V. Chick. 1998. ‘Formalism in economics’, The Economic journal (London), 108: 1829-69.

Planck, Max. 1949. Scientific Autobiography and Other Papers (Philosophical Library; Williams & Norgate: London).

 

For those that are too young to remember, the legendary English comedy show Monty Python had a famous sketch about a disgruntled customer of a pet shop, who realised he had been sold a dead Parrot. The shopkeeper steadfastly refused to admit that the Parrot was dead:

CUSTOMER: I wish to complain about this parrot what I purchased not half an hour ago from this very boutique.
SHOPKEEPER: Oh yes, the, uh, the Norwegian Blue … What’s, uh … What’s wrong with it?
CUSTOMER: I’ll tell you what’s wrong with it, my lad. ‘E’s dead, that’s what’s wrong with it!
SHOPKEEPER: No, no, ‘e’s uh, … he’s resting.
CUSTOMER: Look, my lad, I know a dead parrot when I see one, and I’m looking at one right now.
SHOPKEEPER: No no, he’s not dead, he’s, he’s restin’! …

Why has this sketch come to mind for me? Because Gregory Mankiw, the author of one of the world’s most popular economics textbooks, has just shown that this fictional shopkeeper has nothing on Mankiw and his mainstream economics colleagues, when it comes to pretending that something which is dead is actually alive and well.

The Dead Parrot in question is the “Money Multiplier”: the theory that banks create money by lending out reserves. It’s also called “Fractional Reserve Banking”.

The 6^th edition of Mankiw’s Macroeconomics textbook (there’s now a 9^th edition, but I’m not about to waste money buying a dead parrot) explains the Money Multiplier by starting with “an imaginary economy” in which the money supply is initially $100 in cash. Then the population deposits all that cash in “First National Bank”. The money supply now consists of $100 in bank deposits, while all the cash is in the vault of First National Bank. Next First National Bank decides to make loans, so it lends out $90 in cash. The money supply now consists of $100 in demand deposits and $90 in cash. Mankiw declares that:

The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money. (Mankiw 2012, p. 333)

The process then repeats, with the loan recipients depositing their $90 in cash in another bank, which also hangs on to 10% of the cash ($9) and lends out the rest ($81), also in cash. Mankiw explains that:

The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created… The amount of money the banking system generates with each dollar of reserves is called the money multiplier…

The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. In our example, R = 1/10, so the money multiplier is 10. (Mankiw 2012, p. 334)

There are numerous problems with this as a model of bank money creation, not the least of which is that it only works if all loans are in cash (a point that Mankiw at least notes). Though that may have happened in the 19^th century Wild West, today, banks make loans by increasing a customer’s deposit account, and recording precisely the same sum as a debt of the customer to the bank. No cash is involved, nor are bank reserves “lent out”.

Non-mainstream economists like me and my contemporaries and predecessors have been trying to kill this false theory for decades—see these references for a sample of the anti-Money-Multiplier literature (Moore 1979, 1983; Dymski 1988; Graziani 1989; Minsky, Nell, and Semmler 1991; Minsky 1993; Keen 1995; Dow 1997; Werner 1997; Rochon 1999; Palley 2002; Fontana and Realfonzo 2005; Carney 2012; Fullwiler 2013; Werner 2014; Schumpeter 1934; Holmes 1969).

But we’re used to being ignored. Mainstream economists reject our papers when we submit them to their journals, and they never read our journals or books. We were resigned to being right, but not taken seriously at the same time.

Then in 2014, a miracle occurred: the Bank of England published a paper that supported our realistic analysis, and rubbished the mainstream myths. Entitled “Money creation in the modern economy“, it began with the declaration that:

Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. (McLeay, Radia, and Thomas 2014, p. 14. Emphasis added)

It took direct aim at textbook writers like Mankiw with the statement that:

The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.” (McLeay, Radia, and Thomas 2014, p. 14. Emphasis added)

I remember how much this paper excited me when it first came out: surely the textbook writers couldn’t ignore the Bank of England? I felt the same thrill in 2017 when the Bundesbank came out with a very compatible paper, in which it declared that:

It suffices to look at the creation of (book) money as a set of straightforward accounting entries to grasp that money and credit are created as the result of complex interactions between banks, non-banks and the central bank. And a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal. (Deutsche Bundesbank 2017, p. 13. Emphasis added)

We monetary rebels now had two central banks on our side, opposing the textbook writers, and over time many other Central Banks also joined the fray. Surely now, textbook writers would be forced to change their tune?

Well bollocks to that, as Mankiw’s post on April 5^th of this year showed. Entitled “The Importance of Teaching Fractional Reserve Banking“, it was written as if these Central Bank refutations of the Money Multiplier model hadn’t been written. I certainly doubt that Mankiw has read them.

In his post, Mankiw recounted a conversation with a fellow mainstream economist who “does not teach the students about money creation under fractional reserve banking”—and not because it’s a fallacy, but because he believes it’s “an unnecessary technicality”. Mankiw then defended the false theory on the basis that it explains how “a lower interest rate on reserves increases bank lending and expands the money supply by increasing the money multiplier”, and that it’s necessary to teach “the traditional pedagogy about how banks influence the money supply … if students are to understand the economics of inflation”.

“The traditional pedagogy”, as Mankiw puts it, is no more necessary for students of economics to learn than it is necessary for students of astronomy to learn Ptolemy’s Earth-centric view of the cosmos before they can understand the Copernican system. It’s a fallacy, it belongs in the garbage bin of science, and its continued presence in mainstream economics textbooks is a major reason why mainstream economists don’t understand money, or inflation, or the causes of financial crises.

I’d long ago given up on persuading the mainstream to see reason on this any many other issues, but this ludicrous blog post by Mankiw, and the Twitter conversation initiation by Jason Furman that alerted me to it, was a real “aha moment” for me: why bother trying to reason with these people? They get hit in the face by a wet fish dose of reality, the wet fish is wielded by someone they normally listen to, and yet they continue on regardless with their fantasies.

Figure 1: The tweet that alerted me to Mankiw’s blog post, and my acerbic reply

There’s just no point talking with them: they won’t listen to anything that disturbs their paradigm in any way. But they obviously dominate the training of economists: it’s as if the academic astronomy departments were still teaching students to believe in crystalline spheres, equants and epicycles, while Elon Musk and friends were using Newton’s and Einstein’s math to shoot for the stars.

So, what to do? By sheer happenstance, I have started teaching my alternative approach to economics in an online course for which I’m charging US$500. The main reason to charge for it is that most of the money goes to a marketing firm that is motivated by the money to reach a far larger audience than I could ever hope to reach by teaching my ideas for free here on Substack and Patreon. Their early marketing methods were annoying—and I apologise for that—but they’re learning about my audience, and improving their messaging over time.

I give ten lectures over ten weeks, which at $50 a lecture is pretty good value. It’s certainly better for your brain (and your pocket!) than paying for a degree in economics that teaches you the fantasies that Mankiw and other mainstreamers peddle. If you’d like to experience these lectures (with a money-back guarantee if you ask for a refund within the first 30 days), click on this link:

https://start.profstevekeen.me/products/email-am-rebel-economist

Tell them Greg sent you.

Carney, John. 2012. “What Really Constrains Bank Lending.” In NetNet, edited by John Carney. New York: CNBC.

Deutsche Bundesbank. 2017. ‘The role of banks, non- banks and the central bank in the money creation process’, Deutsche Bundesbank Monthly Report, April 2017: 13-33.

Dow, Sheila C. 1997. ‘Endogenous Money.’ in G. C. Harcourt and P.A. Riach (eds.), A “second edition” of The general theory (Routledge: London).

Dymski, Gary A. 1988. ‘A Keynesian Theory of Bank Behavior’, Journal of Post Keynesian Economics, 10: 499-526.

Fontana, Giuseppe, and Riccardo Realfonzo (ed.)^(eds.). 2005. The Monetary Theory of Production: Tradition and Perspectives (Palgrave Macmillan: Basingstoke).

Fullwiler, Scott T. 2013. ‘An endogenous money perspective on the post-crisis monetary policy debate’, Review of Keynesian Economics, 1: 171–94.

Graziani, Augusto. 1989. ‘The Theory of the Monetary Circuit’, Thames Papers in Political Economy, Spring: 1-26.

Holmes, Alan R. 1969. “Operational Constraints on the Stabilization of Money Supply Growth.” In Controlling Monetary Aggregates, edited by Frank E. Morris, 65-77. Nantucket Island: The Federal Reserve Bank of Boston.

Keen, Steve. 1995. ‘Finance and Economic Breakdown: Modeling Minsky’s ‘Financial Instability Hypothesis.”, Journal of Post Keynesian Economics, 17: 607-35.

Mankiw, N. Gregory. 2012. Principles of Macroeconomics, 6th edition (South-Western, Cengage Learning: Mason).

McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, 2014 Q1: 14-27.

Minsky, Hyman P. 1993. ‘On the Non-neutrality of Money’, Federal Reserve Bank of New York Quarterly Review, 18: 77-82.

Minsky, Hyman P., Edward J. Nell, and Willi Semmler. 1991. ‘The Endogeneity of Money.’ in, Nicholas Kaldor and mainstream economics: Confrontation or convergence? (St. Martin’s Press: New York).

Moore, Basil J. 1979. ‘The Endogenous Money Supply’, Journal of Post Keynesian Economics, 2: 49-70.

———. 1983. ‘Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply’, Journal of Post Keynesian Economics, 5: 537-56.

Palley, Thomas I. 2002. ‘Endogenous Money: What It Is and Why It Matters’, Metroeconomica, 53: 152-80.

Rochon, Louis-Philippe. 1999. ‘The Creation and Circulation of Endogenous Money: A Circuit Dynamique Approach’, Journal of Economic Issues, 33: 1-21.

Schumpeter, Joseph Alois. 1934. The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle (Harvard University Press: Cambridge, Massachusetts).

Werner, R. 1997. ‘Towards a new monetary paradigm: a quantity theorem of disaggregated credit, with evidence from Japan’, Kredit und Kapital, 30: 276-309.

Werner, Richard A. 2014. ‘Can banks individually create money out of nothing? — The theories and the empirical evidence’, International Review of Financial Analysis, 36: 1-19.

 

Professor Steve Keen, Distinguished Research Fellow, Institute for Strategy, Resilience and Security, University College London.

One of the great ironies of economics is that, while the public regards economists as experts on money, the issue of how money is created is still not settled within economics.

In 2014, the Bank of England published a landmark paper explicitly rejecting the textbook model of money creation, stating that:

Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits…

The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank ‘multiplied up’ into more loans and deposits. (McLeay, Radia, and Thomas 2014, p. 14)

Several other Central Banks published related papers, notably the Bundesbank in 2017, which stated that:

It suffices to look at the creation of (book) money as a set of straightforward accounting entries to grasp that money and credit are created as the result of complex interactions between banks, non- banks and the central bank. And a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal (Deutsche Bundesbank 2017, p. 17)

And yet, just five years later, the Nobel Prize in Economics was awarded to Bernanke, Diamond and Dybvig for work which, as the “Scientific Background” to the Prize noted, claimed that banks function as “financial intermediaries” which “channel funds from savers to investors, receiving funds from some customers and using the funds to finance others” (Committee for the Prize in Economic Sciences in Memory of Alfred Nobel 2022, p. 4). The document did not cite these Central Bank papers, let alone note the contrary arguments in them.

In this paper, I use double-entry bookkeeping to prove that mainstream economists are wrong about banks and their importance in macroeconomics. Banks are money creators, not “financial intermediaries”, and financial flow analysis shows that bank credit creation has significant macroeconomic effects, contrary to assertions by Bernanke (Bernanke 2000, p. 24) and the Committee for the Nobel Prize in Economics.

Double-Entry Bookkeeping and the invalidity of mainstream economics

Banks are creatures of accounting: they create not goods and services, but financial assets and liabilities. Double-entry bookkeeping is central to both accounting and the operation of actual banks. Yet one striking feature of mainstream economics is the near complete absence of double-entry bookkeeping in its models of banking and money creation. This leads to mainstream economics being replete with concepts and models that contradict double-entry bookkeeping—and which are therefore false as models of the real-world.

The two essentials of double-entry bookkeeping are the classification of all accounts as either Assets or Liabilities—with the gap between the two being the Equity of the entity in question—and the recording of all transactions twice, so that the rule that is maintained for every transaction.

I have developed an Open-Source (i.e., free) software program called Minsky to enable monetary dynamics to be modelled easily (Minsky can be downloaded from the software repository SourceForge at https://sourceforge.net/projects/minsky/). Its key feature is called a Godley Table (named in honour of the non-mainstream economist Wynne Godley). A Godley Table classifies all financial accounts as either Assets or Liabilities, checks that every transaction obeys the rule that , and allows the user to build dynamic, monetary models of the economy that way.

When Neoclassical ideas about money are put into Minsky, they are shown to either contradict the rules of double entry bookkeeping, or to not have the outcome that Neoclassical economists expect. Take, for example, Bernanke and Blinder’s IS/LM-style model of banking (Bernanke and Blinder 1988). in which:

“the supply of deposits (we ignore cash) is equal to bank reserves, R, times the money multiplier” (Bernanke and Blinder 1988, p. 436).

This is standard fare in mainstream economics, and it presumes a simple mechanism between Reserves and the creation of Deposits. But it is easily shown that this mechanism either (1) violates the principles of double-entry bookkeeping, or (2) depends upon the existence of cash, which they ignore.

Before I illustrate this, I will show why the Bundesbank’s comments that “the creation of (book) money” is “as a set of straightforward accounting entries”, and that “a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves” are accurate—unlike mainstream economics. To create a loan, a bank simply adds the same number to its outstanding loans as it does to its Deposits: “Loans create Deposits”. The bank customer gets more money in their account, matched by an identical debt to the bank. Bank Assets—in the form of loans—rise as much as Liabilities—in the form of Deposits—and the key accounting equation is satisfied.

Reserves play no role whatsoever in this process—see Figure 1, which shows Credit dollars being added to the Banks’ Liabilities of Deposits, and Credit dollars also added to Banks’ Assets of Loans. It is, as the Bundesbank says, an extremely straightforward and easy to understand process.

Figure 1: The absolute basics of real-world lending: Loans create Deposits

Mainstream economists—including members of the Federal Reserve’s “Federal Open Market Committee” (FOMC) who determine monetary policy, and set interest rates—also believe that their model of banks lending from Reserves is quite simple and straightforward, as these quotes from Ben Bernanke and Charles Plosser (then President of the Federal Reserve Bank of Philadelphia) in 2009—during the depths of the 2008 financial crisis—illustrate:

Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets. (Bernanke 2009, p. 5)

As real rates rise, the opportunity cost of banks holding on to vast excess reserves may lead to a rapid increase in the money multiplier and a conversion of excess reserves into loans or borrowed money. (FOMC 2009, p. 55)

In fact, the “conversion of excess reserves into loans” is virtually impossible: certainly, the simple, direct relationship between Loans and Deposits is does not exist. “Lending from Reserves” means that Reserves go down. Adding money to Deposits means that Deposits go up. Not only does this combination violate the rule that (as Figure 2 shows), it also doesn’t convert Reserves into Loans. Therefore, an attempt to fit the mainstream economic idea that banks lend out Reserves leads to the absurdity that lending reduces bank assets, rather than increasing them, breaks the laws of accounting, and shows Banks giving away Credit for free.

Figure 2: “Lend from Reserves” violates the rules of accounting

To conform to the laws of accounting, “Lending from Reserves” would have to reduce Reserves and increase Loans, as shown in Figure 3. The accounting is now valid, but there is still one weakness: how do borrowers get the money they have borrowed?

Figure 3: “Lend from Reserves” now obeys the rules of accounting–but how do borrowers get the money?

The only way this can make sense is if the loan is in the form of cash, as shown in Figure 4—but recall that, in their model of lending, Bernanke and Blinder ignored cash.

Figure 4: “Lend from Reserves” requires that loans are in the form of cash

Of course, banks generally do not make loans in cash today—instead, they directly add Credit to Deposit accounts, as shown in Figure 1. Reserves play no role in lending, as the Bundesbank stated, and the mainstream attempt to argue that they do generates a caricature of actual bank practice.

The same applies to another aspect of mainstream thinking about banks, that they are “mere intermediaries” that enable savers to lend to borrowers.

Loanable Funds versus Bank Originated Money and Debt

Though Paul Krugman is the main proponent of the “Loanable Funds” model of banking, Bernanke also confirmed that he accepted it when he described it as compatible with the model in (Bernanke and Blinder 1988):

The theory of the bank-lending channel holds that monetary policy works in part by affecting the supply of loans offered by depository institutions. This concept is a cousin of the idea I proposed in my paper on the Great Depression, that the failures of banks during the 1930s destroyed “information capital” and thus reduced the effective supply of credit to borrowers. Alan Blinder and I adapted this general idea to show how, by affecting banks’ loanable funds, monetary policy could influence the supply of intermediated credit (Bernanke and Blinder, 1988).

Loanable Funds sees banks, not as issuers of debt, but as intermediaries that collect funds from savers and lend them out to borrowers. Mainstream economists do not consider that this means (a) that savers, and not banks, would be the actual owners of the debt issued, and (b) that bank deposits could not be demand deposits in this model. Instead, they simply assume that loans redistribute spending power from savers to borrowers, and that repayment of loans does the opposite, as the following quote from Bernanke illustrates in the case of the Great Depression:

The idea of debt-deflation goes back to Irving Fisher … Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. (Bernanke 2000, p. 24. Emphasis added)

The italicized text indicates that Bernanke assumes that a loan causes the spending power of savers (creditors in his language) to fall and that of borrowers (debtors) to rise, while repayment does the opposite. Therefore, in the Loanable Funds model, aggregate spending only varies with changes in the level of debt if Borrowers spend more rapidly than Savers.

Figure 5 sets this model out in Minsky: Savers lend Credit dollars per year to Borrowers (this is negative when debt is repaid); Borrowers pay Interest dollars per year to Savers; Savers pay a Fee to the banks for arranging the loans; Savers spend on Borrowers; Borrowers spend on Savers; and the Banks spend on both Savers and Borrowers.

Figure 5: A simple model of Loanable Funds–but where is the Loan itself?

Even at this point, there is an obvious problem with this model: where is the debt itself? It doesn’t appear here because, in Loanable Funds, the debt (Loans) is an asset of the Savers. To show it, we need to add another table for the Savers: one table is not enough.

Before I add that table, I want to show what the real-world situation, in which banks issue loans, looks like. In this case, Banks lend to Borrowers, Borrowers pay interest to the Banks, and there is no Fee charged on Savers. As Figure 6 shows, Loans do appear in this model, because they are Assets of the Banks: there is no need for an additional table to show them, This illustrates that the real-world practice of banking—which I call “Bank Originated Money and Debt” (BOMD)—is actually simpler than the model of Loanable Funds.

Figure 6: The real-world situation of Banks lending to Borrowers

That said, Figure 7 shows the minimum system needed to model Loanable Funds, since Loans now appear as Assets of the Savers.

Figure 7: Two Godley Tables–one for Banks, the other for Savers, are needed to model Loanable Funds

If this model described reality, then Bernanke would be right that “pure redistributions”—by which he means net lending, which I call Credit here—would “no significant macroeconomic effects” unless there were “implausibly large differences in marginal spending propensities among the groups”. In Figure 8, I build such a model, with Borrowers spending their bank balances 4 times per year, Savers spending 2 times per year, and Banks only 0.1 times per year. I then run it with varying levels of credit: initially 0% of GDP, then 5% so that debt grows, the minus 5% so that it falls, and finally back to zero percent again. There are changes in GDP, but they precisely match changes in the velocity of money.

Figure 8: Loanable Funds with large differences in spending propensities

These are however second-order effects, since there is no change in the amount of money in the economy, and therefore GDP can only grow or fall as much as the velocity of money increases or decreases. In that sense, there’s no great harm done to macroeconomics if banks, and debt, and indeed money are ignored in macroeconomic models—which is the case with Neoclassical macroeconomics.

However, what happens if we model the real-world situation that banks are not intermediaries between Savers and Borrowers, but creators of both debt and money? That is shown in Figure 9, which was created from the model in Figure 8 simply by showing Loans as an Asset of the Banks, rather than Savers, directing Interest payments to the Banks rather than Savers, and deleting the now superfluous Fee.

Figure 9: The real-world of bank originated money and debt

The result is dramatically different, because positive Credit now creates new money, which increases GDP. Similarly, negative Credit destroys money and reduces GDP.

Obviously, from the simulations above, Credit significantly affects macroeconomics in the real-world of Bank Originated Money and Debt (BOMD), but it does not in the Neoclassical fictional world of Loanable Funds.

The Logic of Credit

To understand what lies behind those simulations, I use a device that I call a “Moore Table” (in honour of the great non-mainstream economist Basil Moore) to show that, in the real-world, Credit is part of both Aggregate Demand and Aggregate Income. I abandon the frankly silly Neoclassical categories of “Savers” and “Borrowers”, and consider instead an economy consisting of Households, a Services sector, and a Manufacturing sector, where each sector spends a certain number of dollars per year on the other.

In the first Moore Table shown in Table 1, I omit lending completely, and consider just expenditure financed out of existing money. Households spend A dollars per year on Services and B dollars per year on manufacturing; Services spend C dollars per year on Households, and D dollars per year on Manufacturing; and Manufacturing spends E dollars per year on Households and F dollars per year on Services. The diagonal entries show expenditure; the off-diagonal elements show income, and in the fundamental relation in macroeconomics, aggregate income, which is the negative of the sum of the diagonal elements, is identical to aggregate expenditure, which is the positive sum of the off-diagonal elements.

Table 1: A Moore Table showing expenditure IS income for a 3-sector economy

This leads to Equation 1:

         

In Table 2, I show the Loanable Funds by imagining that the Services sector lends Credit dollars per year to the Households sector, and then Households use this borrowed money to buy more goods from Manufacturing. However, the lending by Services lending comes at the expense of the Service Sector’s spending on Manufacturing (you can’t spend money you’ve lent to someone else). So Services spends (D-Credit) dollar per year on Manufacturing, whereas Households spend (B+Credit) dollars per year on Manufacturing. Lending from the Services Sector to the Household Sector is neither Expenditure nor Income, so the transfer of money can’t be shown horizontally: it is instead shown as a transfer across the diagonal, reducing the expenditure of the lender (Services) and increasing the spending of the borrower (Households). Households pay Interest dollars per year on their outstanding debt to Services, and since this is both an expenditure and an income, it is shown horizontally.

Table 2: The Moore Table for Loanable Funds

When you add up expenditure and income in this table, Credit cancels out: for every positive entry for Credit in either Aggregate Demand (the negative of the sum of the diagonal cells) or Aggregate Income (the sum of the off-diagonal cells), there’s an offsetting negative entry that cancels it out. The only effect of lending on this model of the economy is that Interest payments turn up as part of both expenditure and income:

         

Table 3 shows the real-world situation of “Bank Originated Money and Debt”. It’s more complicated than the other tables, because we have to add the Banking Sector to the model, and we have to include the Banking Sector’s Assets—where Credit appears as an increase in the Banking Sector’s loans to the Household Sector—as well as its Liabilities and its Equity. I also add spending by the Banking sector on the other 3 sectors. Table 3 explicitly shows all spending as passing through the Liabilities (Deposit accounts) and Equity sides of the banking sector’s accounts. The Household Sector’s expenditure on Manufacturing includes Credit, as in Loanable Funds, but this credit-financed spending does not come at the expense of any other sector’s expenditure: instead, it comes from the creation of new money via the expansion of the Banking Sector’s Liabilities and Assets.

Table 3: The Moore Table for Bank Originated Money and Debt

The key outcome is that Credit does not cancel out, as it does in Loanable Funds: there is a single entry for Credit in Aggregate Expenditure—it finances part of the Household Sector’s purchases from the Manufacturing Sector—and a single entry in Aggregate Income—where it is part of the Manufacturing Sector’s income:

         

Consequently, in the model shown in Table 3—and in the real world—credit is a substantial source of both Aggregate Demand and Aggregate Income. This is the logical explanation of the difference in behavior between the “Loanable Funds” model shown in Figure 8 and the BOMD model shown in Figure 9. It is also the explanation for the real-world phenomena of debt-deflationary crises like the Great Recession, the Great Depression, and the Panic of 1837. Neoclassical economics, by ignoring banks, debt and money in its macroeconomic models, is ignoring the main factors that drive economic performance, and also cause economic crises.

This is apparent when, using the guidance above, we look at the role of both private debt and credit in the Great Recession.

The Empirics of Credit

Far from Credit having “no significant macroeconomic effects”, as Bernanke asserted, in the real-world Credit is overwhelmingly the factor causing economic fluctuations—and especially severe downturns like the Great Recession. This is because it is by far the most volatile component of aggregate demand—which mainstream Neoclassical economists miss because their false Loanable Funds theory tells them not to even look at data like that plotted in Figure 10.

Figure 10: Private Debt, Credit and Unemployment in the USA 1970-2012

In doing so, they are like the Ptolemaic astronomers that Galileo ridiculed in correspondence with Kelper five centuries ago, for their steadfast refusal to look through Galileo’s telescope. They therefore never saw the moons of Jupiter, whose existence demolished their Earth-centric vision of the Universe:

What is to be done? Shall we side with Democritus or Heraclitus? I think, my Kepler, we will laugh at the extraordinary stupidity of the multitude. What do you say to the leading philosophers of the faculty here, to whom I have offered a thousand times of my own accord to show my studies, but who with the lazy obstinacy of a serpent who has eaten his fill have never consented to look at planets, nor moon, nor telescope? Verily, just as serpents close their ears, so do these men close their eyes to the light of truth. (Gebler 1879, p. 26)

References

• Bernanke, Ben. 2009. “The Federal Reserve’s Balance Sheet: An Update.” In Federal Reserve Board Conference on Key Developments in Monetary Policy. Washington, DC: Board of Governors of the Federal Reserve System.
  
• Bernanke, Ben S. 2000. Essays on the Great Depression (Princeton University Press: Princeton).
  
• Bernanke, Ben S., and Alan S. Blinder. 1988. ‘Credit, Money, and Aggregate Demand’, American Economic Review, 78: 435-39.
  
• Bholat, David, and Robin Darbyshire. 2016. “Accounting in central banks.” In, edited by Bank of England. London.
  
• Carney, John. 2013. “Basics of Banking: Loans Create a Lot More Than Deposits.” In NetNet, edited by John Carney, Brilliant simple example of loan/deposit creation followed by regulatory requirements. Well worth modeling in Minsky. New York: CNBC.
  
• Committee for the Prize in Economic Sciences in Memory of Alfred Nobel, The. 2022. “Financial Intermediation and the Economy.” In. Stockholm: The Royal Swedish Academy of Sciences.
  
• Deutsche Bundesbank. 2017. ‘The role of banks, non- banks and the central bank in the money creation process’, Deutsche Bundesbank Monthly Report, April 2017: 13-33.
  
• FOMC. 2009. “Meeting of the Federal Open Market Committee on December 15–16, 2009.” In.: Federal Reserve.
  
• Gebler, Karl von. 1879. “Galileo Galilei and the Roman Curia.” In. London: C. Kegan Paul & Co.
  
• McLeay, Michael, Amar Radia, and Ryland Thomas. 2014. ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, 2014 Q1: 14-27.
  

 

In “A Simple Solution to the Banking Crisis That No Country Will Implement” (Patreon link; Substack link—both open access), I argued that The Fed could end the current crisis simply by buying all outstanding Treasury Bonds at face value. After that, in future The Fed should either let Treasury run an overdraft on its account at The Fed, or The Fed should purchase Treasury Bonds directly from Treasury.

Neither of these practices are unprecedented: as I noted in that post, The Bank of England let the UK Treasury operate an overdraft during Covid, while The Fed routinely purchased bonds directly from Treasury before The Banking Act of 1935, and occasionally even after that—notably, during WWII.

Kenneth D. Garbade, a Vice-President of the New York Fed, explained the origin of the practice of requiring The Fed to only purchase bonds in the secondary market in “Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks” (Garbade 2014). It’s hard to read his history and not conclude that the current system—which requires Treasury to sell bonds to private banks and “primary dealers”, rather than to The Fed—was based on the rickety pillars of the self-interest of bond traders, and delusional ideas about money held by the mainstream economists who staff The Fed, and misinform our politicians.

The Abstract to Garbade’s paper highlights how Keystone Cops-like—to mix my analogies—the whole kerfuffle over direct Fed purchases of Treasury Bonds was:

1) Why did Congress prohibit direct purchases in 1935 after they had been utilized without incident for eighteen years, 2) why did Congress provide a limited exemption in 1942 instead of simply removing the prohibition, and 3) why did Congress allow the exemption to expire in 1981? (Garbade 2014, Abstract. Emphasis added)

As Garbade noted, direct Fed purchases of Treasury Bonds had not led to the sky falling—nor any other calamity—in the years before the 1935 Act. So why prohibit them then? The best reasons he could find in the literature were that this was done “to prevent excessive government expenditures”. The Federal Reserve Chair from 1934 till 1948, Marriner Eccles, put it this way in 1942:

“The restriction forbidding Federal Reserve banks to buy Government obligations except on the open market was imposed … on the theory that forcing the Government to borrow on the open market would afford a check on excessive public expenditures”. (Garbade 2014, p. 5, quoting Eccles)

Eccles followed up in 1947 with the explicit statement that this theory was erroneous:

Those who inserted this proviso were motivated by the mistaken theory that it would help to prevent deficit financing. According to the theory, Government borrowing should be subject to the “test of the market.”

[T]here was a feeling that [the absence of a prohibition] left the door wide open to the Government to borrow directly from the Federal Reserve bank all that was necessary to finance the Government deficit, and that took off any restraint toward getting a balanced budget. (Garbade 2014, p. 6, quoting Eccles)

Though Garbade queries both reasons on logical and empirical grounds, they are nonetheless the only ones he proffers—and humanity is hardly deficient in actions undertaken for illogical or empirically fallacious reasons. So arguably, and on the word of one of the most famous Chairmen of all time—for good reasons, for a change—the requirements that the Treasury should not run an overdraft, and also should not sell bonds directly to The Fed, reflect self-interest and ignorance of the monetary system, rather than logic and experience.

Technical stuff

The rest of this post is for nerds: if you’re interested in what how a monetary system would operate without government bonds, or with government bonds being purchased directly by The Fed, read on.

One clear advantage of both approaches is that it clears away the veil of unnecessary complexity created by believers in Neoclassical economics, to reveal the simplicity at the heart of fiat money creation: the government, as the fundamental creator of a nation’s money, creates money by incurring negative financial equity for itself, and generating identical positive financial equity for the non-government sectors of the economy.

No Government Bonds

Governments create “fiat money” by spending more than they get back in taxation: if the government didn’t run regular deficits, but instead ran a balanced budget, there would be no “fiat money” in existence. In fact, deficits have been the norm for the last century, as Figure 1 shows.

Figure 1: The average government deficit is more than 3 percent of GDP

If this were done by the Treasury having an overdraft at The Fed, and The Fed also paid interest on Reserve balances (more on that later), then the monetary system would look like Figure 2.

The first table in Figure 2 shows that, when the government runs a deficit, it spends more on the Private Sector than it gets back in taxes. This increases private deposit accounts, and therefore increases the net financial worth of the private sector. So, rather than borrowing money from the private sector when it runs a deficit—which is what economic textbooks claim, the government creates money for the private non-bank sector.

The second table in Figure 2 shows this from the point of view of the banks. As well as creating Deposits—which are a Liability of the banking sector—it also creates Reserves, which are an Asset of the Banking Sector. I also show the Banks receiving interest on their Reserves, since a legitimate role of bonds is to pay interest to banks to cover the social role they fulfil of maintaining the country’s payments system. If they didn’t have bonds, then there would be a legitimate case to pay them interest on Reserves. This interest income creates positive financial equity for the banking sector.

The final two tables show how these operations—the Deficit, and paying interest on Reserves—affects the two primary wings of the government, the Fed and the Treasury.

Figure 2: A fiat money system with no government bonds

The deficit doesn’t alter the net equity of the Fed, because as a Deficit reduces The Fed’s liability to the Treasury—the Treasury’s “General Account” in the USA—it increases its liability to the private banks at the same time, in the form of their Reserve accounts at the Fed.

Interest payments on Reserves does affect the equity of the Fed however: the interest payments are made by the Fed going into negative financial equity. This would be catastrophic for a private bank—negative equity for a private bank means bankruptcy, which is what happened to the Silicon Valley Bank. But The Fed isn’t a private bank, and Central Banks can operate with negative equity (Bholat and Darbyshire 2016, p. 15).

For the Treasury, a deficit reduces its financial equity, and sustained deficits would ultimately drive the Treasury’s General Account into the red as well. But this negative financial equity for the Treasury is the mirror image of the positive financial equity that the Deficit creates for the non-bank private sector.

Summarising this system in terms of financial equity, the Deficit creates positive financial equity for the non-bank private sector, while interest on Reserves creates positive financial equity for the private banking sector.

Some people might object to the government being in negative financial equity—hello, my Austrian friends!—but that’s ignorant on at least three fronts.

Firstly, financial assets are claims on someone else: your financial assets are other people’s financial liabilities. By construction therefore, the sum of all financial assets and liabilities is zero. Therefore, if the government were in positive equity, the non-government sectors would be in identical negative equity. Does that sound so attractive now?

Secondly, financial assets aren’t the only form of assets. There are also nonfinancial assets—things which are assets to their owners, but a liability to no-one. For the private sector, it’s things like houses; for the government, it’s things like roads, schools, hospitals, etc. The paranoia about the government’s negative financial equity has meant decades of deficits that are too small, and—for America in particular—not enough nonfinancial assets have been constructed because of the irrational obsession with a balanced budget.

Thirdly—and again, hello Austrians!—even if the Austrian wet dream of a purely private monetary system were enabled by a government that always ran a balanced budget, this would mean that the private non-bank sectors must be in negative financial equity. This is a corollary of the definition of bankruptcy for a bank: it is bankrupt if its Liabilities exceed its Assets, and to function properly, it has to maintain positive equity. Therefore, the private banking sector must be in positive equity, which would mean—in a pure credit economy—that the non-bank private sector would necessarily be in negative financial equity.

I think this structural dialectic is why, when governments get seduced by the siren song of running a surplus, the private sector almost always indulges in an bacchanalian private-debt financed orgy of speculation on the value of nonfinancial assets—primarily houses and stocks—which almost always ends in a financial crisis.

Direct Fed bond purchases

Figure 3 shows the situation when The Treasury issues bonds to cover both the Deficit and Interest on Reserves. The outcome doesn’t change for the non-government sectors: the Deficit creates money (and net financial assets) for the non-bank private sector, while the Interest on Reserves creates money (and net financial assets) for the banking sector.

Figure 3: The financial flows when The Fed buys Bonds directly from the Treasury

Likewise, the aggregate situation for the government sector—the Treasury plus The Fed—doesn’t alter either: it goes into negative financial equity to enable the non-government sectors to go into positive financial equity.

The differences, therefore, are more nuances than fundamental changes. With the Treasury issuing bonds to cover both the Deficit and Interest on Reserves, and The Fed buying them, the Treasury’s account at The Fed remains constant and positive. Interest payments no longer push The Fed into negative equity. Instead, all of the negative equity of the government sector is now concentrated in the Treasury.

Conclusion

There is no substantive difference between these two alternatives to the current situation, but the sale of bonds by the Treasury to the Fed in the second case has the cosmetic benefit that, as under current laws, the Treasury’s account at The Fed remains positive. This eliminates the obvious negative optic of the government appearing to be running an overdraft with the Central Bank, and spending from that overdraft indefinitely. Instead, the Treasury spends from a deposit account that is always positive, and wears its negative equity on its own books rather than on The Fed’s.

The advantage of both situations, and especially the second, is that the fiction that the government borrows from the private sector when it runs a deficit disappears. Far from borrowing money from the private sector, the government, through both its Deficit and paying interest on Reserves, creates money for the private sector.

The case of direct Fed bond purchases is also just a hair’s breadth different to the current situation: there is nothing, absolutely nothing, preventing The Fed from reproducing the essence of this model today by simply buying, on the secondary market, all the bonds the Treasury currently sells to banks on the primary market.

This enables us to kill that old and stubborn furphy of the government debt being, to quote that father of Neoclassical economic fantasists Gregory Mankiw, “an unjustifiable burden on future generations” (Mankiw 2016, p. 557). It is in fact a gift to current generations, which lets them achieve positive financial equity, while the deficit itself—if it were large enough—would enable the creation of substantial nonfinancial assets for the country.

References

Bholat, David, and Robin Darbyshire. 2016. “Accounting in central banks.” In, edited by Bank of England. London.

Garbade, Kenneth D. 2014. ‘Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks’, Federal Reserve Bank of New York Staff Reports, No. 684.

Mankiw, N. Gregory. 2016. Macroeconomics, 9th edition (Macmillan: New York).

 

Though Silicon Valley Bank contributed to its own demise, the root cause of this crisis is the fact that private banks own government bonds. If they didn’t, then SVB would still be solvent.

Its bankruptcy was the result of the price of Treasury bonds falling, because The Federal Reserve increased interest rates. As interest rates rise, the value of Treasury Bonds falls. With the resale value of its bonds plunging, the total value of SVB’s assets (which were mainly Bonds, Reserves, and Loans to households and firms) fell below the value of its Liabilities (which are mainly the deposits of households and firms), and it collapsed.

Why do banks own government bonds? Largely, because of two laws: one that prevents the Treasury from having an overdraft at The Federal Reserve; and another that prevents The Federal Reserve buying bonds directly from the Treasury. If either of these laws didn’t exist, then banks in general wouldn’t need to buy Treasury Bonds, and SVB would still be solvent.

Neither of these laws are inviolable. As Elon Musk once put it, the only inviolable laws are those of physics—everything else is a recommendation.

The UK equivalent of the former law was broken during Covid, with the Treasury and the Bank of England agreeing to extend what they call the “Ways and Means Facility” which is “the government’s pre-existing overdraft at the Bank.” The use of an overdraft sped up the UK’s fiscal response to Covid (such as it was).

The US law only came into force in 1935. Before then, The Federal Reserve regularly purchased Treasury Bonds directly from the Treasury. “The Banking Act of 1935” banned this practice—though it too was ignored during WWII, and at various times until 1981. Marriner Eccles, who was Chairman of The Federal Reserve from 1934 till 1948, asserted that this law was drafted at the behest of bond dealers, who were cut out of a lucrative market when The Fed bought Treasury Bonds directly from the Treasury, rather than on the secondary market where bond traders made their fortunes:

I think the real reasons for writing the prohibition into the [Banking Act of 1935] … can be traced to certain Government bond dealers who quite naturally had their eyes on business that might be lost to them if direct purchasing were permitted. (Garbade 2014, p. 5)

Call me callous, but, given a choice between bond traders losing a lucrative gig, or the financial system collapsing, I’d be happy to see bond traders become rather less wealthy.

So, a simple solution to the current crisis—which was caused by The Federal Reserve itself, as its “hike interest rates to fight inflation” policy trashed the value of Treasury Bonds—would be for:

• The Fed (and its equivalents) to buy all Treasury bonds held by banks, hedge funds pension funds, etc., at face value; and also,
• The Deposit guarantee to be made limitless, rather than capped at $250,000; then in future,
• The Fed should either allow the Treasury to run an overdraft, or it should buy Treasury Bonds directly from the Treasury.

If even just the first of those recommendations was acted upon, today’s crisis would be over. Banks would swap volatile Treasury Bonds at face value for stable Reserves—thus restoring the solvency they had before The Fed started to raise rates. Hedge funds, pension funds, etc., would swap Treasury Bonds for deposits at private banks—and those deposits would be backed by Reserves, rather than Bonds.

The second recommendation would mean that bank deposits—which can be huge, running into the billions of dollars for the largest companies—would be safe from any future banking crises. If they were going to be lost, it would take idiocy by the company or hedge fund bosses themselves, rather than idiocy by The Federal Reserve, or any individual bank.

The third recommendation would end the charade of pretending that the private sector lends money to the government when it runs a deficit. It would make obvious the reality that the government doesn’t borrow money, it creates money. Governments could focus on the important issue of how much money it creates, and for what purposes, rather than pretending that its spending is constrained by what it can borrow from the private sector.

So, why do I think that none of these easy solutions to the current crisis would be taken? Largely, because mainstream, “Neoclassical” economists are in control of our current system. They know nothing about the monetary system—or nothing accurate. They’ll fight against proposals like this, even though they would fix a crisis that they created themselves by not considering what interest rate hikes would do to the resilience of the financial sector that they are supposed to safeguard.

References

Garbade, Kenneth D. 2014. ‘Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks’, Federal Reserve Bank of New York Staff Reports, No. 684.

 

The collapse of Silicon Valley Bank has many parents. Twitter is alight with fingers pointing at venture capitalists for starting a run against a bank whose many wealthy customers had deposits far in excess of the maximum that is guaranteed in the event of a bank failure ($250,000). Michael Hudson blames the aftermath of the Fed’s Quantitative Easing, which boosted asset prices—including bonds—via massive bond purchases by the Fed and matching low interest rates. Alf at the Macro Compass blames the failure of the bank to hedge its risk to changes in interest rates. Frances Coppola blames the failure to carry sufficient capital to cope with a bank run.

Running through all these explanations is the impact of rising interest rates on bank solvency. In this post, I want to give a simple explanation of why this can cause systemic failure—not just to a single bank like SVB, but to the entire banking system.

When inflation returned to the economic scene after a 3-decade absence, The Fed fought it the only way it knows how—by raising interest rates on government bonds. Its mainstream economic models, which ignore banks, debt and money—weird, eh?—predicted that raising interest rates would lower the public’s expectations of inflation, and this would cause actual inflation to fall. Problem solved—in mainstream economic model world.

Meanwhile, in the real world, rising interest rates on government bonds can cause banks to go insolvent. SVB was the canary in the coal mine here, but the factor that brought it undone is shared by all financial institutions, because government bonds are a major component of their assets. When interest rates rise, bond values fall, and this can drive financial institutions into insolvency—where their Liabilities exceed their Assets.

I want to give a very simple explanation of why this can lead to systemic disaster—and, therefore, why it is vitally important that the Fed stop using economic models that ignore the banking sector.

The basic mechanism is extremely simple: bond prices move in the opposite direction to interest rates. A bond promises to pay a fixed sum every year in return for buying that bond for a fixed price. If the bond costs $1000 and the “coupon rate” is 3%, then the bond issuer—the Treasury in the case of government bonds—pays $30 each year to the bondholder.

If interest rates rise, to say 5%, then this bond cannot be sold for its $1000 face value. The most extreme case here are “Consol” bonds, which never expire: a Consol’s price is the fixed sum it pays each year, divided by the market interest rate. If that is 3%, then the $30 the bond pays every year is valued at $30/0.03, which is $1000—its face value. But if the market interest rate rises to 5%, then the sale price of the bond will be $30/0.05, which is $600. The bond’s value falls by $400.

To illustrate why this is a serious problem for the banking sector in the current policy regime of rising interest rates, I’ve built a very simple Minsky model in which all bonds are Consols, banks don’t hedge their risk, and where banks instantly write down the value of Bonds when interest rates rise.

The real world is far more complicated than this of course: almost all bonds are fixed term, so the impact of rising interest rates on their value isn’t as extreme; banks do hedge their interest rate risks (Alf’s post explains this very well) and they don’t instantly “mark to market” (Frances Coppola’s post gives a nice account of what they do instead). But the systemic factors remain. Its arguable too that, though an individual bank can hedge its risk, the banking system as a whole can’t; and while the whole system can delay a day of reckoning with falling asset values, it can’t avoid that day while interest rates remain well above those paid by the bonds they own.

The model has just 4 stocks and 4 flows. The stocks are bank Reserves, Treasury Bonds owned by the banking sector, Loans to the Private Sector, and the Deposits of the public. The initial values are such that the banking sectors Assets well exceed its Liabilities, so that it is in positive Equity—which is a requirement for every individual bank, let alone the entire banking sector.

Figure 1: The financial stocks and flows in the model before interest rates change

The flows are interest on outstanding private sector debt, interest on government bonds, spending by the banking sector on the non-bank private sector, and bond revaluation. Interest on outstanding private sector debt, and interest on government bonds, remain constant because I’ve left new bank loans out of the model, and I’ve omitted factors that alter bank bond holdings as well (primarily the selling of bonds by banks to non-banks, and purchasing of bonds by The Fed). Bank spending is proportional to Bank Equity: I’ve assumed banks spend half their (short-term) equity every year, so their spending starts at $2,250 billion per year.

Revaluation of Bonds starts at zero, because the prevailing interest rate is the same as the interest rate paid by existing government bonds, which is 3%. The Equity of the banking sector stabilizes at $4,890, because at that point its spending is identical to its interest income ($2,445 billion per year).

Once the banking sector’s equity has stabilized, I increase the prevailing interest rate from 3% to 5%. This is much faster than The Fed’s 0.25% monthly interest rate hikes, but again, the function of this simple model is to show what the systemic implications of these rises for the whole banking sector.

The banking sector goes into negative equity.

I emphasise that nothing this extreme will happen in the real world: this model is just to illustrate the key point that rising interest rates reduce the value of existing government bonds, and that this will affect the solvency of bondholders.

In the real world, banks sell much of their bond portfolio to non-banks, which reduces their exposure to effects like this—though that exposure doesn’t go away, but is instead felt by the non-banks that bought the bonds. Banks hedge their exposure to movements in fixed rates too, as Alf explains—but as we should have learnt from the Global Financial Crisis, hedging risk doesn’t mean eliminating it. Instead, somewhere else, someone else is on the end of a losing trade. The fall in the value of bonds still affects the solvency of the system.

Figure 2: A rate rise drives the banking sector into negative equity

SVB was the canary in this event—or perhaps the turkey—because it had an extraordinary level of government bonds on its books. But the financial sector as a whole is the real turkey that The Fed is inadvertently roasting as it thinks it is reducing inflationary expectations.

It’s The Fed that deserves to be roasted instead, for attempting to manage the financial system using models that ignore banks, debt, and money.