The Bank of England released a new working paper on Friday (May 29, 2015) – Banks are not intermediaries of loanable funds – – facts, theory and evidence (updated June 2019) – which further brings the Bank’s public research evidence base into line with Modern Monetary Theory (MMT) and, thus, further distances itself from the myths that are taught by mainstream economists in university courses on money and banking. The paper tells us that the information that students glean from monetary economics courses with respect to the operations of banks and their role in the economy is not knowledge at all but fantasy. They emphatically state that the real world doesn’t operate in the way the textbooks construe it to operate and, that as a consequence, economists have been ill-prepared to make meaningful contributions to the debates about macroeconomic policy.
Here are the two substantive conclusions of the BoE first so you know where we are heading. The authors conclude that:
1. “The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist.”
In other words, the mainstream economic models that pervade textbooks and teaching programs in economics are fantasy – they analyse institutions that “do not exist”.
2. “in the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.”
If you read any macroeconomic textbook written for mainstream (neo-liberal) courses you will find some account of the money (deposit) multiplier as it applies to ‘reserve-constrained’ commercial banks.
But as the Bank of England now reliably informs the world, this sort of model is not “in the real world”. Banks are not reserve-constrained.
The only surprising thing about the paper is that it took so long for a major financial institution like the Bank of England to come clean and tell the world that the textbook theories that students rote learn are of no relevance to the real world we live in.
The US Federal Reserve Bank of New York, acknowledged the failings of mainstream monetary theory in the September 2008 edition of their Economic Policy Review – Divorcing Money from Monetary Policy.
That article demonstrated why the account of monetary policy in mainstream macroeconomics textbooks from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed.
I don’t recommend reading the BoE paper in full. It is a fairly arid technical exercise that attempts to salvage so-called dynamic stochastic general equilibrium (DSGE) models used by the central bank with more realistic understanding of the way banks operate in the real world.
Only read it if you are good at mathematics and want to waste 30 minutes of your life.
The DSGE framework is intrinsically flawed and should be scrapped altogether. There are now many attempts to resurrect the standard DSGE model, which failed dramatically to predict the crisis.
These attempts, in one way or another, add ‘financial frictions’ or other variations to the standard DSGE models.
Please read my blog from 2009 – Mainstream macroeconomic fads – just a waste of time – for more discussion on DSGE modelling and New Keynesian economics.
The BoE paper is another one of these attempts, albeit it does recognise that the failings of the previous mainstream models was rather catastrophic and required major rather than minor surgery to remedy. The problem is that the patient died a long time ago and the BoE is just operating on a corpse.
The BoE paper recognises that when the GFC struck:
Macroeconomic theory was however initially not ready to provide much support in studying the interactions between banks and the real economy, as banks were not a part of most macroeconomic models.
Which is not exactly correct.
They should have said ‘mainstream macroeconomic theory’ because Post-Keynesian economists and Modern Monetary Theory (MMT) theorists (the latter being a subset of the former in this context) certainly incorporated sophisticated understandings of how banks worked into their core macroeconomic models and had known about the financial vulnerability that was increasing in the lead up to the crisis.
The BoE paper note that after the crisis the mainstream literature has suddenly “started to pay attention to the role of banks and prudential banking legislation” but the dominant new intiatives remain flawed:
… due to the fact that this literature is almost without exception based on a version of the intermediation of loanable funds (ILF) model of banking.
The problem is that the core of the mainstream approach is wrong – at the elemental level and economist refuse to give up these notions because if they did the whole edifice of macroeconomic theory they preach would fall to the ground. The whole shebang is flawed and of no use for those keen to understand how the monetary system operates.
So instead of acknowledging that their fundamental approach is wrong, mainstream economists have adopted so-called ad hoc responses to anomaly to defend their flawed theory.
In his great 1972 book – Theories of poverty and underemployment, Lexington, Mass: Heath, Lexington Books), David M. Gordon wrote about this mainstream behaviour. His context was mainstream human capital theory, which at the time had been exposed as being deeply empirically deficient.
David Gordon said that mainstream economists continually responded to empirical anomalies with these ad hoc or palliative responses.
So whenever the mainstream paradigm is confronted with empirical evidence that appears to refute its basic predictions it creates an exception by way of response to the anomaly and continues on as if nothing had happened.
Please read my blog – In a few minutes you do not learn much – for more discussion on this point.
The BoE paper outlines the basic mainstream model of banking – the “intermediation of loanable funds (ILF) model” – which is says:
… bank loans represent the intermediation of real savings, or loanable funds, from non-bank savers to non-bank borrowers. Lending starts with banks collecting deposits of real savings from one agent, and ends with the lending of those savings to another agent.
But in “the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor.”
MMT has for two decades been writing that loans create deposits and are not reserve constrained. The BoE paper says that in doing so:
The bank therefore creates its own funding, deposits, in the act of lending. And because both entries are in the name of customer X, there is no intermediation whatsoever at the moment when a new loan is made. No real resources need to be diverted from other uses, by other agents, in order to be able to lend to customer X.
So in one paragraph we learn that:
1. That scarce savings are not on-lent by banks, which means that the mainstream theories about crowding out are erroneous.
2. Banks do not operate to attract savings from depositors and then on-lend them.
But there is more. I have often written in the past – building on the work of Michal Kalecki and others – that investment brings forth its own saving.
Please read my blog – Why budget deficits drive private profit – for more discussion on this point.
This was in direct refutation of the mainstream view that savings were lodged in banks as a prior source of funding for investment and competition for those savings (say from government deficits) would drive up interest rates and crowd out private investment.
It is one of the mantras of mainstream theory and drives the relentless attacks on fiscal deficits by conservatives. It hasn’t an ounce of truth to it.
To fix ideas, this is what the mainstream model tells students. The flawed Loanable Funds doctrine is derived from the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times.
If consumption spending fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.
So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
This is the reasoning that leads mainstream economists to eulogise about the ‘efficiency’ of the free market and warn us against the dangers of government intervention which inhibits this ‘efficiency’.
The following diagram shows the market for loanable funds. The current real interest rate that balances supply (saving) and demand (investment) is 5 per cent (the equilibrium rate). The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.
One of the most popular macroeconomics textbooks by Greg Mankiw claims that this “market works much like other markets in the economy” and thus argues that (p. 551):
The adjustment of the interest rate to the equilibrium occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage … would encourage lenders to raise the interest rate they charge.
The converse then follows if the interest rate is above the equilibrium.
I provide a refutation of the theory of loanable funds in this blog – Budget deficits do not cause higher interest rates – for more discussion on this point.
Its conception of the way the banking operates is deeply flawed. There is no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.
In addition, please read the following blogs – Money multiplier and other myths – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.
But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or ‘finances’ private saving not the other way around.
The mainstream approach was to see interest rates as adjusting to equilibrate (real) saving and investment and thus ensure that aggregate demand would always be equal to aggregate supply – thus negating the possibility that the economy could suffer from a shortage of demand.
This denial of unemployment was the basis of Say’s Law (later Walras’ Law).
However, Keynes and Kalecki clearly understood that saving and investment were brought into equilibrium (in a closed economy without a government sector) by variations in national income driven by changes in effective (aggregate) demand.
That insight provided the fundamental break with classical thinking that dominated economics (and policy) at the onset of the Great Depression and which, when applied, worsened the depression.
This is also the basic idea that drives the spending multiplier model. Please read my blog – Spending multipliers – for more discussion on this point. Thus increased investment spending stimulates aggregate demand and firms respond by increasing production.
This, in turn, leads to higher wage and salary payments and higher induced consumption which feeds back into the spending stream and promotes further output and income. At each stage of the process, some of the income generated goes to saving and so the successive consumption spending flows become smaller and smaller until they exhaust. At that point, the sum of the saving generated by the income responses will equal the initial investment injection and the economy regains equilibrium.
A person thinking from a micro perspective might think that if people spend more now (that is save less) they will have less funds at the end of the period. It is here that the fallacy of composition enters the fray.
To illustrate, Kalecki asked “what would be the sources of financing this investment if capitalists do not simultaneously reduce their consumption and release some spending power for investment activity?”
He responded as such (in his 1966 book – Studies in the Theory of the Business Cycle (Blackwell, Oxford), page 46):
It may sound paradoxical, but according to the above, investment is ‘financed by itself’.
So, while that might be true that an individual business firm or person, acting in isolation will have less funds if it (they) spends more now, it cannot be true for the economy as a whole.
Why? Answer: the consumption of one capitalist are the source of profits for another capitalist. Spending by a consumer is another consumer’s income. So investment brings forth its own saving!
Kalecki clearly understood that counter-intuitive notion that investment “automatically furnishes the savings required to finance it” as long as there is idle capacity. That is, as long as increasing aggregate demand does not outstrip the real capacity of the economy to produce.
This has all been known for decades and the BoE has taken a while to catch on.
But the BoE paper is now emphatic:
Furthermore, if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does. To argue otherwise confuses the respective macroeconomic roles of resources (saving) and debt-based money (financing).
Therefore, there can be no crowding out of private spending by public deficits through interest rate channels.
The BoE paper correctly notes that:
… banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But the most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency.
Please read my blog – Lending is capital – not reserve-constrained – for more discussion on this point.
Banks lend if they can make a margin given risk considerations. That is the real world. If they are not lending it doesn’t mean they do not have ‘enough money’ (deposits). It means that there are not enough credit-worthy customers lining up for loans.
Banks lend by creating deposits and then adjust their reserve positions later to deal with their responsibilities within the payments system, knowing always that the central bank will supply reserves to them collectively in the event of a system-wide shortage.
The BoE paper links that reality to a conclusion that the money multiplier theory, which is central to mainstream textbook expositions of the monetary system, is inapplicable.
We read that:
The deposit multiplier (DM) model of banking suggests that the availability of central bank high-powered money (reserves or cash) imposes another limit to rapid changes in the size of bank balance sheets. In the deposit multiplier model, the creation of additional broad monetary aggregates requires a prior injection of high-powered money, because private banks can only create such aggregates by repeated re-lending of the initial injection. This view is fundamentally mistaken. First, it ignores the fact that central bank reserves cannot be lent to non-banks (and that cash is never lent directly but only withdrawn against deposits that have first been created through lending). Second, and more importantly, it does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate, in order to safeguard financial stability. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.
Please read my blog – Money multiplier and other myths – for more discussion on this point.
This reinforces the MMT understanding that loans are made independent of their reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period.
They can borrow from each other in the interbank market but if the system overall is short of reserves these transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the ‘discount window’. There is typically a penalty for using this source of funds.
At the individual bank level, certainly the ‘price of reserves’ will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.
So the idea that reserve balances are required initially to ‘finance’ bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the ‘penalty’ rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.
In other words, the stock of reserves at any point in time is a reflection of bank lending activity rather than cause.
Which means that one of the basic premises of Monetarism – that the central bank can control the money supply is false.
The BoE paper is one of many emerging from central banks in the wake of the GFC which seek to resituate the institutions in the economic literature.
They are now openly critical of the mainstream approach to banks and the monetary system that dominates the mainstream academic literature.
So while a few years ago, MMT was vilified by US macroeconomics academic Mark Thoma who said ““I think it’s just nuts” (Source), the large central banks are now letting Dr Thoma and his mainstream ilk know just what they think of his viewpoint.
Thoma and Mankiw, both academic commentators with prominent public profiles represent what is wrong with economics. They teach and prosletyse theories that are not applicable to the real world we live in.
Whether they are applicable somewhere else is moot!
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.