How a Central Bank contradicts itself, part 2


Endogenous money

Foremost among those economists who have long rejected the ‘state-of-the-art’ in their models, and refused to teach it in their classrooms, is Professor Steve Keen: a long-time proponent of the alternative view, endogenous money – i.e. that everyone in the economy has a role in affecting the value of currency, not just central banks.

Anyone who heard Prof. Keen speak in Bangkok last year would have seen him show very simply that his endogenous money beliefs stand up to real-world tests, whereas neo-classical models did neither and also failed the common sense test. The ‘man on the Clapham omnibus’ knows that borrowing your way out of debt while your returns are dwindling makes no sense.

Dr. Terzi suggests that, “The views expressed in the BoE publication do not come out of the blue. Several studies have recently challenged the notion of the money multiplier. The fact that this is now stated by a central bank marks good progress in the understanding of monetary operations, especially in light of conventional wisdom having inspired a number of erroneous interpretations during the banking and financial crisis.”

The BoE article also stated that another common “misconception” about QE was that it “involves giving banks ‘free money’ “; it also explains how the amount of central bank money (banknotes and bank reserves) is fixed by the demand of its users and not by the central bank “as it is sometimes described in some economics textbooks.”

The article then seems to try to underplay its own admissions or re-think policy. As Dr. Terzi points out, “The BoE makes two accurate statements regarding central bank money (banknotes and bank reserves): 1) it is not chosen or fixed by the central bank; 2) it does not multiply up into loans and bank deposits.” This would seem to imply that a central bank does not control the money supply.

However, the BoE concludes that a central bank can “influence the amount of money in the economy. It does so in normal times by setting monetary policy – through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation. This in turn affects the prices and quantities of a range of assets in the economy, including money.”

This came as a surprise to Dr. Terzi: the Swiss-based economics professor suggests that more work needs to be done in understanding the linkages between policy actions and their results, in terms of how changing interest rates impact bank lending and thus the money supply and the overall economy. “This view that interest rates trigger an effective ‘transmission mechanism’ is one of the Great Faults in monetary management committed during the Great Recession.”

“There are various channels through which interest rates influence demand, output, and the price level, yet none is empirically strong, and some work in different directions,” he adds. “Bank lending is primarily pro-cyclical, as a famous quote attributed to Mark Twain explains effectively (“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”), and the Global Crisis proved central banks to be powerless in trying to reverse this course. The reality is that the level of interest rates affects the economy mildly and in an ambiguous way. To state that monetary policy is powerful is an unsubstantiated claim.”

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