In part, therefore, my purpose today is to consider a piece of intellectual history: the strange amnesia of modern macroeconomics. But also to reach some conclusions about the policies needed to avoid a repeat of the 2008 crisis and to secure greater financial stability, in the advanced economies but also in the developing world.
Standard undergraduate textbooks express the following views on credit, money and banking: banks borrow money from savers, which they then lend out; banks lend to businesses to fund investment and working capital, for productive purposes; and the liabilities of banks are “money” for which one can define a stable demand function, with income and the rate of interest as independent variables.
This picture is almost entirely misleading. First, banking institutions create credit and so both purchasing power and money. Second, credit does not mainly finance investment, but now has a bigger role in financing the purchase of existing assets. Third, the credit and debt are more important than “money”, because they determine the fragility of the economy and so its vulnerability to crises.
The oversimplified view is not just a feature of elementary textbooks. Even advanced macroeconomic textbooks are largely silent on the way banks create credit and money. Even Michael Woodford’s “Interest and Prices”, a defining statement of new Kenyesian macroeconomics, ignores the structure and role of the financial system.
Simplification is necessary, but dangerous. It is necessary, because the world is too complex to be understood, in all its detail. But it is dangerous, because what is omitted might be essential. That is the case, this time. The simplifications that animate sophisticated academic thinking on the role of credit and banking derive from the neo-Walrasian, general-equilibrium research agenda. In this perspective, the economy is a (more or less complete) set of barter arrangements. Money is viewed as universally acceptable tokens that have no impact on relative prices or savings and investment.
Even advanced macroeconomic textbooks are largely silent on the way banks create credit and money.
This perspective is wrong. As the great Swedish economist, Knut Wicksell, noted in 1899, unanchored banking systems create credit and money, thereby financing investment booms. In this view, then, banking, the financial sector, money and credit are dynamic, unstable and interactive processes. Without them, the present prosperity would never have been achieved: the advanced barter economy is a figment of the imagination, as Walter Bagehot noted in the 19th century. But the actual economy is also unstable: these credit processes simply mislead people. The targeting of inflation will, for example, not stabilise such as system, because booms in credit will not necessarily show themselves in inflation, particularly if they take the form of attaching ever more debt to existing assets.
In new teaching, the elements of the actual monetary and economic systems need to be explained. Banks (and shadow banks) create credit, influenced by central bank interest rates and other policy levers, but also by the self-reinforcing dynamics of credit creation and asset price effects. Such teaching will have to emphasise the following points:
- Private institutions create credit as a by-product of their lending.
- The state uses its ability to create fiat money to back such private money.
- The monetary and financial system is a complex public-private partnership.
- The creation of purchasing power ex nihilo by banks also creates debt.
- The new purchasing power will add to actual spending in the economy, creating booms in consumption or investment.
- The new credit may also leverage up existing assets.
- The central bank may fail to stabilise this system by stabilising the prices of current goods and services. Indeed, the policies chosen to stabilise inflation in goods and services may even destabilise prices of assets.
- In this case, the long run consequence of policies aimed at keeping inflation up might even be deflation.
- A system in which the liabilities of risk-taking private institutions are believed to be the safest form of purchasing power is unstable and prone to panic and collapse.
- New technologies and financial innovations allow the financial system to create new forms of credit and money, particularly if the old ones are tightly regulated.
- The state cannot and will not allow this system to collapse.
- This is an economy in which balance sheets, financial institutions and the central bank play central roles.
- None of this has anything at all to do with a barter economy in which credit and money are mere veils.
Martin Wolf is Chief Economics Commentator, Financial Times, London
