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Debunking another cornerstone of the Austrian-Keynesian dialectic: do central banks really control the money supply?

November 18, 2012

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:

Keynesianism Austrianism
Government Big Small or none
Currency “Soft” “Hard”
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

23 Comments leave one →
  1. Tao Jonesing permalink
    November 18, 2012 11:20 pm

    I’d argue that the “dialectic” is not Austrian-Keynesian but Austrian-Chicagoan. This actually fits your theory of a false dialectic better because the Austrian School and Chicago School are both “libertarian” (more aptly named “propertarian”) schools of economic thought.

    The monetary policy of the Fed is distinctly that of Chicago School monetarists, which is what Bernanke is. He is not now and has never been a Keynesian.

    John Kenneth Galbraith, an actual Keynesian, viewed the Fed as inconsequential:

    By the way, I recall reading something from Mises that acknowledged endogenous money in the absence of a central bank. Given the presence of a central bank and the alleged “coercion” it employs, he assumed endogenous money away.

    • Memehunter permalink
      November 19, 2012 6:21 am

      Thanks for your comment. Yes, I recall reading something similar on your blog.

      But I don’t see where in my article I make the claim that Bernanke is a Keynesian, or that the Fed follows Keynesian policies. I am aware that Bernanke was more influenced by Friedman and the Chicagoans,and I was only using the Fed actions as an example.

      On the other hand, I think we can agree that Krugman is a Keynesian who still believes in the exogenous model.

      Interesting about Mises. It sounds like he actually knew the truth, but his “propagandist” inclinations got the better of him.

    • Tao Jonesing permalink
      December 7, 2012 3:12 am

      For support of my assertion about Mises, see Human Action, Vol. 3, Chapter 31, Part 5 “Credit Expansion” p. 793-794.

  2. Abu Aardvark permalink
    November 20, 2012 10:29 am

    Memehunter, if we remove all your fancy words and over-reliance on mainstream central bank economists, your argument boils down to the idea that commercial banks cause tremendous booms by lending too much money. But this argument assumes that 100s or 1,000s of banks suddenly start to lend. The question is WHY. The answer is because central banks – that have the power to raise and lower interest rates – create artificial booms by keeping rates too low for too long.

    Likewise, modern monopoly central banks (in concert with the Treasury in the US) can choke off a boom if they wish by raising rates and demanding that banks stand by these rates. When price inflation was at a peak and money was circulating with incredible velocity in the late 1970s, Fed chairman Paul Volcker punctured the inflationary bubble by raising rates to nearly 20 percent. This caused a terrible recession. But then the Fed lowered rates and the 1980’s boom was on.

    This is irrefutable stuff. Commercial banks don’t have the power to raise and lower rates throughout the world with the stroke of a pen as Ben Bernanke does. This is simple common sense.

    Central banks create business cycles by manipulating credit. To try to maintain that central banks do not have this power is an exercise in futility. To try to maintain that commercial banks somehow have a mystical, larger power than the power LODGED LEGISLATIVELY in modern, monopoly central banks to manipulate rates, etc. is a contradiction of observable fact.

    No doubt you will now respond with more big words. But even the biggest words cannot change reality. You can cite all the Nobel Prize winners and Fed economists you want, but in fact, these individuals are simply trying to absolve modern central banking for the terrible pain it causes. They want central banking. They seek to justify that control. In fact, you are acting, unfortunately, as an agent of central banking by promoting this stuff.

    You want to blame the private sector (commercial banking) for a boom-bust cycle that in the modern era is generated by central banking rate manipulation. You are intent on doing this because Anthony Migchels (like Ellen Brown) wants to make a case for a government takeover of the private banking sector.

    Of course, as we know, the current banking system is nothing like a private one. But allowing government to run central banking will just make things worse. Despite Mr. Migchel’s apparent infatuation with pre-World War II German economic solutions, the dirigiste model of monetary production will always produce terrible distortions in the banking system.

    Get rid of monopoly central banking and you will be surprised how quickly modern commercial banks lose power and profitability.

    • Memehunter permalink
      November 20, 2012 9:37 pm

      Do you have any evidence to invalidate the data or the conclusions of Kydland and Prescott’s paper, which debunk the Austrian dogma about the role of central banking? If not, why should we take seriously anything you say?

      I do not deny the role of interest rates, but as documented by serious researchers (not people writing undocumented assertions like you), interest rates set by central banks have only a relatively limited effect, and central banks are in effect following private banks, as explained in the article.

      The point is not necessarily to “blame the private sector”. I am simply pointing out that commercial credit plays a much bigger role than what Austrians and mainstream Keynesians (or Chicagoans, for that matter) would have us believe. When private credit constitutes 97% of the total money supply, I think it is safe to say that we should perhaps spend a bit more time analyzing the role of commercial banks, instead of focusing almost exclusively on central banking.

      I see that you want to play the “affiliations game”, but you seem to ignore that a mainstream economist like Krugman (himself a Nobel Prize winner) is in fact defending the exogenous model of the mighty central bank, and that people like Kydland and Prescott are neoclassical economists. Interestingly, Prescott has been involved in political activity sponsored by the Cato institute:

      His colleague Kydland was a fellow of the Hoover Institute, another neoliberal think-tank. So I don’t think that the “affiliations game” will lead you anywhere in this case. The data favoring the endogenous model is very solid and has been confirmed independently by several researchers.

  3. turtle permalink
    November 21, 2012 4:32 am

    In conducting monetary policy, the focus for central banks has changed over the last few decades from managing the money supply by adjusting the required reserve ratio to managing the “price” of money. ie. the official cash rate. It is this regulated price of money to which Austrians economists object (by my reading). Central banks change the cash rate directly by adding or removing liquidity (base money quantity) in the money markets.

    This is what Bernanke is doing now – keeping down short term rates via QE and long term rates via “operation twist”. But he can’t directly influence the velocity of money ie. commercial bank lending to households and businesses – only encourage it with low interest rates so we are not seeing M2 growth nor the associated inflation.

    Prescott and Kydland talked about M1 and M2 but did they mention the cash rate?

    This still does not absolve commercial banks like JPMorgan and Goldman Sachs of any guilt for predatory lending and misrepresentation in selling risky CDO’s.

  4. December 3, 2012 2:08 am

    Without a Central Bank to Backstop the usury system it becomes unsustainable (see 1907) and causes bank runs. However it is true that reserves follow lending, and some Austrian economists do acknowledge this (Mike “Mish” Shedlock for example does so here

    This is why private central banks always lobbied for central banking, because without a gov enforced cartel of the banking industry these private behemoths would have compete with each other. (see the creature from Jekyll Island)

    The evil here is fractional reserve banking (public or private) which the libertarians have extensively debunked and railed against. It is the MMT or the Chicago school (which actually booted the austrians out of the mont perlin society over disagreements) that still endorses fractional reserve banking. The dichotomy is between Keynesian and Chicago. The only element the Austrians still carry with them is the neoliberal free trade policy, but even in that they are more problematic than helpful due to their decrying of managed trade agreements and copyright laws. In their own words:

    DiLorenzo on Mont Perlin

    On Mises and Mont Perlin

    If the entire operation of the Libertarian movement is to distract focus away from Big Banks and blame the whole thing on government they are failing miserably. Most rank and file libertarians also want an end to fractional reserve banking and abhor the private banks as well as the central banks.

  5. December 4, 2012 12:24 pm

    I’ve nothing against fractional reserve lending in itself, but if you have sound money that cannot be manipulated by force then this is impossible. Can you fractionally reserve bitcoin? (purely as an example).

    How is it that only banks can fractionally reserve? Why can’t I? Why can’t I write a fictitious ledger in my accounts and increase my holdings by 1000%? Why can’t I then lend this money out?

    What gives banks the power to become banks?

    That is the question we should be asking. The answer of course is government regulation.

    Governments create a completely unfair playing field by force. I could imagine they could do the same with bitcoin and why not? They could degree it that banks are only allowed to write fictitious bitcoins out of thin air. It is the question whether the public will buy into that or not.

    I doubt they would or could (purely thinking off the top of my head here) because unlike gold, bitcoin is infinitely more useable for electronic transactions. There is no need (or even the possibility) to store it somewhere physically and get paper or electronic receipts for it which we would then call money.

    I mean tomorrow could decide to make up a new currency and lend it out at ten times the value of an actual bitcoin. There is nothing wrong with this. They couldn’t of course falsely manufacture bitcoins because bitcoins has no central source to manufacture fake ones from. They are impossible to fake and so institutionalized fraud (the banks’ fractional reserve lending) is impossible also.

    My 2 cents.

  6. December 4, 2012 12:31 pm

    My only real gripe with the daily bell is that they still support fake oppostion political entities and parties (even though they admit this) such as Ron Paul and UKIP.

    Sure I agree with these fake opposition parties but I am supposed to as these are the honey traps. I fancy a complete break from it all and I am the only one who can change my circumstances so that is what I do.

    • The Daily Knell permalink*
      December 4, 2012 5:24 pm

      You sound like you are on the right track 🙂

      Only one thing to add: the Daily Bell supports fake opposition political entities and parties because they are themselves gatekeepers.

  7. Kenn permalink
    February 19, 2014 3:15 am

    All of you claimers that it’s the banks there create the money, have not yet proved it with simple showing a bank book account that proves it. All I can say is show me a bank account where this bank money creation can clearly be seen.

    It’s the central banks there create the money, not anyone else.

    • Kenn permalink
      February 19, 2014 3:17 am

      Should use that instead of there.

    • dialetheistic permalink
      November 22, 2014 9:45 pm

      All you need to do to find proof is talk to finance people working in the right places; ask an average bookkeeper at any bank whether they wait for a ‘green light’ from the Federal Reserve before extending credit to forthcoming customers, or whether they lend to whoever they can given their financial position, worry about how to get enough reserves in the vault to cover them afterward, and generally don’t coordinate with the Fed outside of liquidity crises. Not a single one will reply “Oh yeah we can’t lend at all unless the Fed tells us we can and gives us reserves to work with,” which is in essence what exogenous money theories claim must be the case.

  8. eithan permalink
    September 18, 2015 6:37 pm

    Great, à throughly reseached subject with a rational approach. I have my research on réal Economics I’ll be sharing it in my later comments.


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