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Wednesday, January 18, 2023

Old Heterodox Banking Debates

Banking and money is an area of ancient debates between post-Keynesians (and their fore-runners) and mainstream economists. Many of these showed up in my earlier book Abolish Money (From Economics)!, with the theme more focussed on money. Although I believe I need to touch on this topic, I want to keep it short. Partly because it appeared in another book, and partly because I am less and less convinced that these debates are that useful for discussing banking.

Note: Once again, this is a draft of a manuscript section from my banking book. It will be in a chapter on modelling banking.

Banks and Money

As a quick reminder, “money” is a variable that appears in standard economic models (both post-Keynesian and neoclassical), and is important for behaviour. The problem is then mapping real world economic time series to “money.” Economists have developed a variety of monetary aggregates. The narrowest aggregates are just central governmental liabilities (“monetary base”), wider aggregates include private sector liabilities — with bank deposits being a key component.

The explanation of the title Abolish Money (From Economics)! is that “money” is given far too much importance in economic theory, and there is a great deal of mysticism about the concept. This mysticism makes clear discussion of the topic impossible.

As an example of the confusion, “money” in benchmark neoclassical models is a central government liability — private sector debt is not included. Anyone with training in the applied sciences or mathematics would observe that we cannot substitute in wider monetary aggregates that include bank deposits as “money” in analysis using such models — but of course, people do.

The Big (Vague) Debate: Endogenous Money

Any reader of heterodox economic disputes will sooner or later run into discussions of “endogenous versus exogenous money.” This seen as being very important. However, the discussion is buried under jargon — starting with the terms endogenous and exogenous themselves.

I am going to offer a radically simplified version of the debate (with the justification for the simplification offered later). The terms endogenous and exogenous are fancy words that economists love to throw around (one economist I knew essentially dumped them at random into statements). From the perspective of a mathematical model, the terms are straightforward (if you pick up on the Greek roots).

  • An endogenous variable is a variable that is determined by the other variables within the model. The prefix endo- is from Greek, referring to internal.

  • An exogenous variable is a variable that is set externally, which then influences the model solution. The prefix exo- is from Greek, referring to external.

If we were solving a problem in the physical sciences, an exogenous variable would be set in the problem text, and we then use it to work out the other (endogenous) variables. For example, if we modelled the water temperature of a shower, the hot/cold tap settings chosen by the user would be exogenous, while the water temperature is endogenous.

In economic models, exogenous variables tend to be set by policymakers, and the endogenous variables are determined by the reaction of the economy to the policy variables.

We then arrive at the simplest — and best defined — version of the “endo-/exo-genous money debates.”

  • If money is exogenous, the “money supply” (which one?) is under the direct control of policy makers.

  • If money is endogenous, the “money supply” is out of the control of policymakers.

If we use this simple definition, it is clear that money supply measures are not under complete control of policymakers.

  • Central bankers cannot directly control how many banknotes households will keep on hand — a key part of the monetary base.

  • Central bankers cannot directly control private lending decisions, so the stock of private debt instruments (including bank deposits) within wider monetary aggregates cannot be directly controlled.

I would argue that these points make it clear that monetary aggregates are endogenous — although there is one desperate way to save exogenous money, the money multiplier (discussed later). However, the problem is that the “endogenous/exogenous money debate” has drifted into more complex — and not very well defined — directions. Even if one agrees about my assessment about this definition, there are other definitions.

The Debate Is a Mess

Arkadiusz Sieroń published the article “Endogenous versus exogenous money: Does the debate really matter?” (URL:

The abstract:

Whether money is exogenous or endogenous is the subject of one of the most important and intriguing debates in monetary economics. The aim of this article is to contribute to this longstanding debate through detailed examination of different notions of endogeneity and exogeneity of money. I argue that the debate has been too simplified. In reality, money can be either endogenous or exogenous, depending on several factors. Not only has the debate prompted some economists to draw too far-reaching conclusions, but it also misses the point.

The article is brief and easy to read, and I do not want to do too much violence to it by attempting to summarise it. However, I will focus on the key observation: Sieroń notes that there are multiple definitions being used within this debate. Furthermore, one can argue the endo-/exo-genous side of the debate depending upon the definition used.

This is why I stick with the simple, model-based definition of endogenous/exogenous. It eliminates ambiguity about what is being discussed. However, it also means that some of the more sweeping generalisations being made — e.g., “endogenous money invalidates neoclassical economics” — cannot be made.

Money Multiplier

One way to save “exogenous bank money” is to rely upon the dreaded money multiplier. The premise of this idea is as follows.

  1. We assume that banks are forced to hold deposits at the central bank — reserves — as a fixed percentage of their deposits. The reserve ratio in these examples is invariably 10%.

  2. Central banks completely control the amount of reserves within the system.

  3. This reserve requirement is assumed to be the only constraint on bank lending, and banks will maximise lending activity. Which means that if the central bank allows the creation of $1 in reserves, banks will almost immediately extend an extra $10 in loans to “use up” the excess reserves (and create $10 in deposits). The ratio of new deposits to reserves is 10 — the money multiplier — and is the inverse of the reserve ratio (0.1 or 1/10).

Unfortunately for fans of the money multiplier, all three of these points are currently incorrect in most developed countries.

  1. Reserve ratios have generally been abolished in the developed world. (There might be guidelines — like in the U.K. — but the guidelines are somewhat squishy.

  2. Central banks set a policy rate, and need to supply enough reserves so that interbank rate hits that target. If there was a global shortage of reserves — and the central bank refused to create them — banks would essentially bid “infinity %” for overnight money. Remember that reserves are a requirement, and not something banks can ignore.

  3. Reserve requirements are not the only constraint on lending. In addition to liquidity and capital requirements, banks face the behavioural constraint of not wanting to lose money on bad loans.

Only the second point — that central banks target a policy rate, and reserve creation is subordinated to hitting that target — is even mildly controversial. And the only reason it is controversial is because Monetarists refuse to accept the reality that they were totally wrong about the fad of “monetary base targeting” in the 1970s/1980s, so they continue to make stuff up.

The current regime in developed countries is unusual and does not fit into this story too well. Central banks are creating “excess reserves,” (modulo reserve requirements being abolished) and as long as the amount of balances at the central bank are excessive, they can pretty much put the size of their balance sheet wherever they want. However, this has no real macroeconomic effect. Firstly, the overnight rate will end up being whatever interest rate is being paid on those balances, so the “reserves” are not non-interest bearing “money” that appears in economic models (unless interest rates are locked at 0%). Secondly, since the reserves are excess, there is no stable multiplier from “reserves” to deposits — the multiplier of 10 in my example only occurred because the banking system immediately made loans to get rid of excess reserves.

Concluding Remarks

With these old debates somewhat covered, I will then discuss some of the “banking controversies” associated with Modern Monetary Theory.

References and Further Reading

  • Arkadiusz Sieroń, “Endogenous versus exogenous money: Does the debate really matter?”, Research in Economics, Volume 73, Issue 4, 2019, Pages 329-338.

  • Brian Romanchuk, Abolish Money (From Economics)!. 2017.

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(c) Brian Romanchuk 2023

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