Wednesday, August 7, 2013


I have recently had a "big discussion" with a very good friend, more or less on the following question: "Which Comes First: Loans or Deposits?"

 If deposits come first, then this validates the loanable funds theory that I learned in Econ 201 - that there is nationally a pool of savings, stimulated by interest rates, that forms the basis for what level of investment is possible in the economy and, similarly, how much money the banks can loan out. In other words, Savings, largely determined by Interest Rates, decides how much Investment there will be, and how much Banks can loan out.

There's lots of mainline ideas/concepts/beliefs that fall out of this loanable funds model. Will just focus on two:

          *Government Crowding Out: If there is only so much money available for lending/investment, then Government deficits, requiring bond market financing, will "crowd out" worthwhile private industry projects, causing, at a minimum, interest rate inflation and deferral/cancellation of much private investment.
          *Fed Control of Broad Money Supply: If Reserves and Deposits come before loans, and the Fractional Reserve/Money Multiplier is an accurate way of describing the banking system, then what the Fed does via monetary operations ultimately determines the broad money supply with its dreaded ability to create inflation.

These are two core tenets of neoliberal orthodox macroeconomics. I am now convinced they are both wrong.

          *Deposits do not come first. Loans do. Loans create deposits - i.e., money out of thin air. Bankable customers and asset/equity ratios are the constraints on lending, not the supply of funds through deposits. So bond-financed deficits do not compete with private investment projects in a limited pool of funds called the savings pool. And as Keynes showed us long ago, Savings are not a function of Interest Rates; rather Savings are determined by the level of Income in the Economy, the Tax Rates, and the Propensity to Consume versus Save. It is actually more accurate to say that GDP/Investment levels create Savings, and not the other way around.
          * The Fed controls the supply of Base Money (Reserves plus Currency). Banks control Broad Money (M1, M2, M3). Shadow banks too, when they make collateral based repo loans. The Fed is not as powerful as everyone in the world thinks they are. The Fed simply does not control the broad money supply through reserve management or anything else. They do control rates, both short and (through their ability to do unlimited QE) the long rates as well.

Some of you may well disagree with these two conclusions. But for the moment, imagine I am right, and then do your own noodling how shifting the macroeconomic ground in these two areas might affect the rest of the economic policy landscape:

          1. Government and Private Industry Investment are not in competition anymore. What is spent by Government does not reduce what Private Industry can do.
          2. Banks can loan what they want to, whenever they find creditworthy customers, subject only to capital constraints.
          3. Banks control the money supply, not the Fed. But the Fed has a lock on short interest rates, and long rates, if they want to commit their unlimited buying power.
          4. Deficits do increase broad money by injecting new net financial assets into the economy (over what is removed by taxes) in the form of Demand Deposits (M1). But QE does not increase broad money, since the Fed is trading reserves for bank-held securities (asset swap); this does increase base money, but not broad money, as reserves cannot and do not enter the economy.
          5. If the Fed does not control the broad money supply, but does control base money and rates, how could the US suffer a bond market meltdown as long as the Fed will always be a buyer? Doesn't this mean that the Bond Vigilantes arguments we always hear are groundless ? (Yes.) And isn't this why Japanese Government bonds have never jumped out of control, despite huge deficits and debt? (Yes.)
          6. Finally, if Government deficits do not crowd out private spending or cause interest rate inflation, can we then begin to consider the idea that deficits are not automatically inflationary, and that like any form of increased spending, whether or not deficits will cause inflation depends not on monetary issues, but rather on fiscal concerns - is there spare capacity in the economy? (Yes!)

This, I believe, is very big stuff. Most of us have been getting the macroeconomic picture wrong - not as a matter of values or political preference, but as a matter of economic, operational fact. And this is one of the biggest problems our country, and the rest of the world, faces. MMT gets it right. Neoliberalism (our country's economic orthodoxy) gets it wrong. We have much to do!

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