Money and Banking," which discusses the theoretical split between recent mainstream thinking and heterodox views on banking. From my perspective, he is addressing heterodox critiques of mainstream thinking that I am not particularly interested in; in fact, based on his criteria, I would be closer to "mainstream" than "heterodox" -- as would possibly be Hyman Minsky. I would view the problem with mainstream modelling as resulting from a blind spot regarding the business sector.
(Update: David Andolfatto reasonably asked: what is his model is missing about the business sector? My answer here is only sketched qualitatively, and based on a conjecture; I believe I would need to rebuild a similar model to prove my point. I hope to do that in the future...)
"Heterodox" versus "Mainstream"In the introduction, Andolfatto summarises the "mainstream" view as follows:
Let me review briefly, to the best of my ability, the key elements of two broad schools of thought on the matter. The mainstream view is that modeling the operational details of banking -- the financing of assets with deposit liabilities -- can be safely ignored for questions related to the business cycle. According to this view, the degree of liquidity associated with liabilities issued by the private sector lies on a continuum, so it makes little sense to draw a sharp distinction between which of these liabilities constitute "money" and which do not (Tobin, 1963).Conversely, the heterodox view is summarised as:
The heterodox view is that banks are critically different from other financial market participants. In particular, while non-bank agencies wanting to investments first need to acquire the requisite funding, this is not the case for banks. In contrast to the non-bank sector, banks can create the money they lend. Consolidating the banking sector with other actors in a market for loanable funds stems from the misguided notion that banks lend out reserves that they must first acquire. Banks do not in fact lend reserves -- they lend their deposit liabilities (which are incidentally made redeemable for cash). While banks make use of reserves for settlement purposes, reserves do not constrain bank lending (Fullwiler, 2012).As long as we do not go into theoretical paroxysms about the term "loanable funds," the theoretical propositions labelled as "mainstream" seem more plausible to me. All financial intermediaries emit liabilities that can be treated as "cash" by investors, and so the balance sheet operations end up looking similar to how the formal banking system operates. I did not arrive at this view by being indoctrinated in mainstream economics courses -- I got it from reading Hyman Minsky, who is normally viewed as "heterodox."
The problem here is one that is familiar to anyone who has interacted with economists: they tend to not agree with each other as soon as you get more than one in a room. In this case, banking seems to be a popular area for discontent.
- People who are mad about banks for political reasons.
- Heterodox modellers mad about "mainstream" economics for a variety of reasons, and who take heterodox models with explicit banking sector models somewhat literally.
This article is aiming at heterodox critiques that I do not agree with. For example, his policy take-away is pretty much my view:
But even if one accepts the heterodox proposition, it's not clear what the implications are for monetary policy. If financial stability is a concern, then a monetary authority must monitor economy-wide leverage, and not just the leverage emanating from the banking sector.
Proposed Model and Its DefectsHe proposes a relatively simple overlapping generations DSGE model to frame the discussion. It may be that I will dig into this model if I want to include it in my upcoming book on business cycle analysis. For now, I will just accept his description of the properties of the model.
My concern is that the model is based on households, with "workers" and "investors" making investment/work/consumption optimisation decisions based on a two period life span. Even if we put aside my distaste for overlapping generations models (how long a calendar time does one period represent?), it misses the business sector.
From a mainstream perspective, the omission of the business sector can be excused on a number of theoretical grounds. The problem is that heterodox economists dispute every single one of those grounds.This makes accepting that the model captures the theoretical dispute a non-starter.
If we want to express this in terms that would make mainstream economists happy, firms should be making investment decisions based on an infinite horizon. Furthermore, there is no "utility function" associated with this maximisation decision, since most large firms are corporations, and the managers do not know the utility functions of their shareholders. (Firms with a dominant owner would be an exception, but are hardly the norm.)
The next problem is that firms have no choice but to maximise nominal profits from a heterodox perspective. In simplified mainstream models where a single representative firm produces all goods in the economy, its pricing decisions directly set the price level. In heterodox theory, pricing decisions are complicated (often based on heuristics), and so we can only have a heuristic for determining future prices. Since a single firm's investment/production decisions are obviously not a factor in those heuristics, price forecasts are essentially fixed for a firm, and so maximising real profits is equivalent to maximising nominal profits.
This then runs into the feedback loop created by the Kalecki Profit Equation (primer) -- increasing investment increases profits. The profit increase is income for the business sector, which can be used to finance the investment. The heterodox argument is that this circular flow dominates the factors that Andolfatto emphasises -- the real policy rate, consumption preferences of households. Although there are real constraints on production created by a fixed stock of existing capital and a limited number of work hours, nominal profits do not face obvious constraints.
(Update: This infinite loop property is why I think we run into problems. If firms wanted to optimise profits, they should invest arbitrarily large amounts in nominal terms, and/or give arbitrarily large dividends, assuming that firm owners also want to support the profit maximisation. Under mainstream assumptions about price level setting, that would break the price level, but it might work under post-Keynesian assumptions about price-setting behaviour.)
The business cycle is driven by the animal spirits of fixed investment. The self-financing nature of investment explains why heterodox economists like myself poo-poo the notion of "loanable funds" in the context of the private sector.
In summary, although it is good to see this debate happening, the tricky bit is that the heterodox positions are a moving target from the perspective of the mainstream. As soon as one model is proposed to deal with one critique, someone else (like me) pops up with another critique...
(c) Brian Romanchuk 2018