Debunking another cornerstone of the Austrian-Keynesian dialectic: do central banks really control the money supply?
Austrian economists have, since Ludwig von Mises, tended to blame central banking for almost all our economic and societal woes. According to the Daily Bell, a noted Austro-libertarian “alternative” media outlet:
“The boom-bust cyclicality of modern economies can be laid directly at the feet of central banking, with its monetary stimulation, which first expands an economy and then contracts it when the expansion has gone too far. Thus, central banking is responsible for the manifold disasters that have overtaken the Western world in the past century at least.
Wars, industrial collapse, recessions and depressions can all be laid at the feet of central banking and the great families that insist on its ongoing implementation.”
In fact, the “End the Fed” mantra has become so prevalent among Libertarians that they do not even bother to verify the Austrian claim that central banks are truly in control of the money supply. To be fair, the Keynesian school, the mainstream-approved dialectical “opposite” of the Austrian school, also promotes this idea, so much that this meme has permeated both mainstream and “alternative” thinking.
However, authentic truthseekers have a duty to inform themselves and seek confirming evidence before accepting the “central banking dogma” at face value, especially because it is a cornerstone of both the Keynesian and Austrian schools, two elite creations.
I should make it clear at the outset that my goal, with this article, is not to defend the institution of central banking. Rather, my aim is to confront the central banking dogma with facts and empirical evidence, in an effort to establish the truth about the control of our money supply.
Endogenous versus exogenous theories of money creation
According to the mainstream neo-Keynesian economic theory, money creation is an “exogenous” phenomenon (in the sense that it is exogenous to the economy), and the broad money supply is a function of the quantity of “government money” (the “monetary base”) and the money multiplier (the inverse of the reserve ratio) which constrains the amount of credit created by commercial banks.
Interestingly, Austrian economists are for the most part in agreement with this statement. While some Austrians denounce the credit expansion generated via fractional-reserve banking, they generally consider “central bank printing” to be the main source of inflation.
On the other hand, several non-mainstream economic schools have suggested an alternative, “endogenous” model of creation, beginning with Knut Wicksell and “renegade” Austrian Joseph Schumpeter. According to this model, loans create deposits and private banks are not reserve-constrained in practice.
The endogenous model, which predicts that central banks have little or no control over the broad money supply, is considered to be a “heterodox” economic theory associated with the post-Keynesian school. Offshoots and associated schools include Chartalism (or Modern Monetary Theory), Circuit theory, and Horizontalism.
A few prominent bankers, no doubt based on their practical experience, publicly rejected the exogenous theory. Already in 1969, Alan Holmes, vice-president of the Federal Reserve Bank of New York, ridiculed the exogenous model, noting that it “suffers from a naive assumption that the banking system only expands loans after the system (or market factors) have put reserves in the banking system.” According to Holmes, “in the real world, banks extend credit, creating deposits in the process, and look for the reserves later… the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier.”
Post-Keynesian economist Basil Moore, associated with Horizontalism, was perhaps the first researcher to provide extensive data suggesting that bank lending was not reserve-constrained, leading him to propose instead that loans “cause” deposits which then lead to increased reserves.
However, the most convincing debunking of the exogenous theory was unexpectedly provided by neoclassical economists Kydland and Prescott, co-winners of the 2004 Nobel Memorial Prize in Economics. In an article titled “Business Cycles: Real Facts and a Monetary Myth”, published in 1990, they found “no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth”. In fact, they observed that “the monetary base lags the cycle slightly” and that the “difference of M2-M1” leads the cycle by “about three quarters”, prompting them to conclude that:
“The fact that the transaction component of real cash balances (M1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.”
More recently, Carpenter and Demiralp (2010) have shown that “changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending”, concluding that “the textbook treatment of money in the transmission mechanism can be rejected”.
The tail that wags the dog?
According to the available data, it seems that the endogenous model is a clear winner: the evidence strongly suggests that loans are created first by private banks, and that the central bank then adds reserves to match loan creation. The statistics also show that, contrary to the textbook model, it is private banks, rather than central banks, that create most of the additional purchasing power “out of thin air”. Finally, this newly-created purchasing power is achieved by nothing more than double-entry bookkeeping: credit expansion does not require prior savings. Schumpeter offers a clear summary: “It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing”.
As noted by Moore, central banks have to accommodate the need for reserves if they want to avoid a credit crunch: “once deposits have been created by an act of lending, the central bank must somehow ensure that the required reserves are available at the settlement date. Otherwise the banks, no matter how hard they scramble for funds, could not in the aggregate meet their reserve requirements”. This means that the money multiplier is a poor control mechanism: increasing the amount of reserves will merely decrease the money multiplier ratios (for instance, the M2 to base money ratio).
In fact, this is what has happened since the Federal Reserve embarked on a reckless program of quantitative easing in 2008: the ratio of the broad money supply to the monetary base has decreased tremendously, meaning that in spite of all the “central bank money printing” so virulently denounced by Austrians, the effect on the broad money supply has been surprisingly limited. To put it simply: no matter how much they print, central banks cannot force commercial banks to lend.
Central banks still retain a modicum of control over the money supply through interest rates, but the impact of the official interest rate is mostly limited to the quantity of reserves held by private banks and, indirectly, the relative profitability of privately-created loans. Furthermore, this is mostly a one-sided tool: while high official interest rates may effectively induce private banks to increase their reserves and reduce the quantity of private credit, the recent crisis has shown that even zero or near-zero interest rates have little impact on commercial bank lending.
In conclusion, commercial banks, rather than being simply the “distribution arm” of central banks, are truly the “tail that wags the dog”. The broad money supply, 97% of which corresponds to credit created by commercial banks, is in fact modulated according to the market’s demand for credit rather than by government or central bank intervention. This turns the “money multiplier” mechanism on its head and renders the entire concept of “reserves” irrelevant.
Although Austrians may wish to blame “paper money” for this situation, claiming that this would not happen if we used a commodity-based currency, credit created by commercial banks had already replaced notes as the most important form of money in the 19th century, while the United States were still under the gold standard, according to Congressman Wright Patman’s Primer on Money.
The role of the central banking dogma in the Austrian-Keynesian dialectic
The obvious question to ask, after considering the evidence in favor of the endogenous model, is why both Austrians and mainstream Keynesian economists are still defending the exogenous theory, although it is unsupported by the data. My view is that Keynesianism and Austrianism are two poles of an elite dialectic, focusing mostly on four dualities:
|Government||Big||Small or none|
|Control of the money supply||Central banks||The “free market” (ideally)|
|Causes of recession||Excessive saving||Government intervention|
This is evidently an oversimplification. Nevertheless, I think that it captures the essential dichotomies between these two theories. However, while these dichotomies are important and meaningful, they do not reveal what is obfuscated by both schools. In that context, it is remarkable that both schools want us to believe that central banks play an important role (good or bad), a claim that is debunked by the available evidence. It is likely that the goal of these apparently competing elite memes is to conceal the role of private banks and the importance of commercial credit behind the false “central banks versus free market” dichotomy.
Moreover, although both schools make a sharp distinction between central banks and private banking, the data tend to support the idea that the banking system is one (which as we know is controlled mostly by the same people), with central banks acting simply as a backstop to stabilize the system and justify the legal monopoly on currency. Viewed in that light, proposed reforms to the banking system, such as the BIS raising “capital reserve requirements”, can be seen as mere posturing: a pathetic effort to maintain the illusion that reserves and the “money multiplier” effect actually matter.
Finally, let us not forget that each school ascribes the cause of economic recessions to a phenomenon which is actually endorsed by its “opponent” (Austrians support “excessive saving” while Keynesians favor government intervention), but both ignore what is likely the main reason for our economic problems: usury.
Thanks to Anthony Migchels