by Keith Weiner
I just read a book. The Age of Debt Bubbles, An Analysis of Debt Crises, Asset Bubbles and Monetary Policy is edited by Max Rangeley, with Roger Koppl, Harry Richer, William White, Barbara Kolm, Syed Kamall, and Miguel Fernandez Ordoñez. I recommend it to any serious student of our monetary and banking system.
The Age of Debt Bubbles fills the hole created by the mass quantities of bunk written about our monetary system. For example, there is the endless propaganda to get us to believe that central banks give us something for nothing. But, even a topic which ought to be apolitical—the mechanics of the creation of what we call money—is rife with misinformation.
So it’s great to see a book which sets the record straight on this topic. If we are to be scientists, and study monetary economics as a science, we need to begin with good observations of the system in action. We can quibble over how to interpret what we see, and of course over the consequences. But the observation itself should be uncontroversial.
Imagine living before Galileo’s observations about motion. The prevailing view was that, if you throw a rock, it flies straight until it runs out of force and drops to the ground. However, anyone could have gone out to a field to ask a boy to throw a rock. It would be easy to observe that it traveled in an arc.
Today, the prevailing view of the mechanics of motion is solid. But the prevailing view of the mechanics of bank lending is not. Nearly everyone from economists down to financial reporters will tell you that a bank lends out the deposits which it receives.
They picture it as you bring this thing called money to the bank, which the bank holds in its vault, until it makes the next loan. There is only one problem with this picture.
It’s wrong!
What we call money is not a thing. It’s a relationship, that of being owed. To have money is to have a counterparty who owes you.
This is hard to picture. So let’s look at a simple payment. Mary buys something from Joe, and pays by check. Joe deposits the check in his bank, Bank Alpha. Now Alpha owes Joe the money.
The check is drawn on Mary’s bank, Bravo. So Bravo owes Alpha the money. For a brief moment. But Alpha does not want to be owed by Bravo. Commercial Banks do not generally prefer to hold balances at other commercial banks. If they hold money, it is in the form of reserves held at the Federal Reserve. So, Alpha presents the check to the Federal Reserve. The Fed transfers some reserves from Bravo’s account to Alpha’s account. Alpha has swapped Bravo’s credit for the Fed’s credit. Now the Fed owes Alpha.
Joe may think—and as The Age of Debt Bubbles shows, so do many economists and even central bankers—that he has money. What Joe actually has, is a claim against Bank Alpha. Joe’s money is nothing more than Alpha’s liability. Alpha does not have money either. What it has is a claim against the Fed. Alpha’s asset is the Fed’s liability.
As an aside—this is my view, and not the view presented in the book—the above discussion is describing irredeemable currency, not money (which is why I use italics for this word). Money must be a commodity, a physical good. But the dollar, pound, euro, etc. are not commodities. They are liabilities owed by a counterparty. This is no minor quibble, but it does not detract from the book or its treatment of the topic. The book makes it clear that we’re dealing with counterparties and liabilities.
Banks do not have cash on deposit (other than their reserves at the Fed, which are not transferable except to other banks). When a bank lends, it creates new money. The Age of Debt Bubbles describes the process, with the first chapter beginning thus:
“The way in which money is created in a modern economy is misunderstood by many academics and practitioners of finance, including in some cases even central bankers. Broadly speaking, the confusion arises from the view that banks lend out depositors’ money when they make loans—this is what is taught in the vast majority of economics textbooks. In reality, when a bank makes a loan, it creates that new money ex nihilo—out of nothing. Rather than taking money that it has in the form of deposits from Bob and lending this out to Alice, the bank expands both sides of its balance sheet when it makes a loan to Alice, thereby creating new money. This idea that banks create new money is often called endogenous monetary theory.”
There are two fundamental observations here. One, that banks create new money at will. Two, that it’s not really something-for-nothing because when they create the asset, they also create a matching liability.
The Age of Debt Bubbles raises the key question. If banks can do this at will, what stops the process? Why do they not issue infinite quantities of money? And it offers an answer (which I won’t spoil here). I’d like it to go further, though to be fair it is not trying to offer a theory of interest and prices.
Mainstream economics and analysis is stuck with its failure to understand point #1. Therefore, they can’t really understanding banks, banking, the monetary system, or the rules by which it operates. Their predictions suffer, and their policy prescriptions are like a senile old general ordering the troops on Hill 341 to move north—when they are not on that hill at all.
Many non-mainstream critics of the system don’t understand the second point. They think banks are printing free money. Their predictions are often spectacularly wrong. Hyperinflation is a common prediction in some circles. Bankers putting trillions in their own pockets. That sort of thing. To criticize a system, first one must understand it.
I recommend The Age of Debt Bubbles for another reason. It takes a more interest-rate centric view, rather than the ubiquitous and wrongful Quantity Theory of Money (though it does talk a bit about quantity, including the so called Cantillon Effect).
I like how Rangeley and Koppl tie Keynes’ idea of a liquidity trap to suppressed interest rates, and their discussion of government price-fixing schemes generally and specifically interest-rate-fixing schemes, which includes this indictment:
“Why don’t more economists understand that governments create a mess when they interfere with interest rates just as they create a mess when they interfere with other prices?”
This also caught my attention:
“The monetary injection drives interest rates below their ‘market equilibrium’ levels. In other works, it drives interest rates below the level that would have been reached by the interaction of unmolested supply of credit with unmolested demand for credit. Trouble is brewing.”
My own theory of interest and prices begins with the question of what happens when the government pushes the interest rate below marginal time preference.
Hayek famously (well in monetary circles, it was famous!) battled with Keynes over the proper policy response to a bust such as the one which began in 1929. Keynes was irredeemably wrong. But unfortunately, Hayek’s theory of the business cycle had a fatal flaw.
When interest rates are suppressed, there is malinvestment. But Hayek said that this malinvestment occurs in roundabout and longer-process-of-production activities. This idea is problematic. How do you define or measure these activities, to see if credit flows into them? Are shoes a mere consumer good, or are they roundabout means of production for factory workers? Hayek attempted to respond to critics, but ended up backpedaling. The Austrian Business Cycle Theory may have been set back many decades by this mistake.
The Age of Debt Bubbles discusses a relatively recent amendment to Hayek’s theory, which preserves the essence and corrects this error. I won’t spoil it here, I’ll just say the book is worth it for just this discussion alone.
Needless to say, Rangeley and his co-authors are for allowing the market to set interest rates!
Other highlights include showing a correlation between falling interest rates and declining bond quality, and the idea of a “faded-market” environment where crony corporations’ behaviors and capital structure increasingly deviate from risk levels and other real-world factors.
I also think they are on to something when they tackle the question of why Mises’ Crack Up Boom has not occurred yet. They argue this dire consequence of irresponsible credit policy has been delayed due to the faded-market and soft budget constraints. I don’t want to spoil it by summarizing here, and I am not sure I could do it justice without further thought.
In conclusion, I will say that any book which can boldly and correctly state the following gets my attention:
“…the majority of economics textbooks have the money creation system wrong, and in a sense they have it backwards.”
