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In his paper Deeper
in Dept, Dr. Steve Keen over at the Centre for Policy Development
examines four possible explanations for the Australian housing development
(p.14):
(quoted)
- Lower
interest rates - the increase in debt is simply a rational response to
the fact the credit is cheaper, and there's nothing to worry about
- Higher
incomes. As our incomes have risen, household budgets have been in a
better position to absorb higher debt-to-income ratios
- Profligate
households. Gens X, Y, Z, and the always irresponsible Generation BB
have mortgaged and charged themselves to the hilt, and they only have
themselves to blame;
- Irresponsible
lenders. They have enticed us into debt we can't manage, so it's really
their fault.
Which is it?
According to Keen, the fourth explanation, irresponsible lenders pushing
loans on gullible borrowers, is correct.
First I will
examine a logical error in the way that he dismisses the first explanation.
The first point combines an explanation
(low interest rates) with an evaluation
(and it's ok because asset values were inflated as much as debt
loads). His commentary on this point essentially endorses the role of low
interest rates but he rejects the explanation because he rejects the
evaluation (it's not ok). He rejects the explanation because he shows that
the evaluation is false.
I will now
examine a side point that Keen uses to blame the bankers for the Australian
housing bubble. The claim is that banks create money in response to demand
and that this is the driver of credit expansion.
From p.21:
A relatively new
school of thought in economics (see the Bibliography) argues instead that
banks have the power to create money, even in the complete absence of
government money. In this "endogenous money" vision of how the
financial system operates, rather than "deposits create loans, it is
"loans create deposits", and the mechanism is far more
straightforward than the "money multiplier" story.
This new school
of thought is post-Keynesian economics. Dr. Frank Shostak has done a great
job addressing the fallacies in this
argument. In the remainder of this blog post I will rely on his analysis
and add some observations of my own.
Keen goes on to
say
The standard
explanation of how money is generated argues that banks can only create
credit if the government "kick starts" the system, effectively by
creating cash that a citizen then takes to a bank for safe-keeping. Once the
citizen has deposited that government-created "fiat" money, the
banking system can create additional credit-based money via what is known as
the "money multiplier" ...
This story has
the banker sitting anxiously, waiting for a customer to walk in the door and
make a deposit of government-created cash, before the banker can then begin
the credit money creation process. Once the essential deposit has been made,
the banking system can weave its money multiplier magic; but without the
deposit, the banker--and the banking system--is impotent.
Does that sound
like banking to you? It barely has credence as a description of the 1960s,
let alone today's "would you like a $25,000 credit limit with
that?"
Keen's
description of the process is a bit of a straw man. Currency deposits by
individuals play a miniscule role in the addition of bank reserves. The
primary driver of this process is the purchase of assets by the central bank
when it wishes to add reserves to the banking system. The central bank pays
for these purchases with money that it creates out of nothing. The seller of
the assets receives the payment in the form of a bank deposit. This process,
far from being old-fashioned, happens in every country that has a central
bank.
According to
Keen, this is how it really works:
The real story:
"Loans create deposits"
Think of your own
credit card. If your balance is sufficiently below your limit, then you are
completely at liberty to go to (say) Harvey Norman and buy a new widescreen
TV. When you do, your debt to the bank is increased by the cost of the
TV--and an equivalent amount of money is simultaneously created and deposited
in Harvey Norman's bank account.
There is
absolutely nothing stopping you from doing that, right out to your credit
limit (apart from personal financial prudence!), and the same observation
applies to every other credit card holder in Australia. If we all went out
and did something similar tomorrow, we would increase the money supply by
over seven per cent overnight. Taking advantage of the loans that we have
every right to take out (the gap between our credit card balances and card limits)
instantly and simultaneously creates both new debt and equivalent deposits in
the accounts of the lucky retailers who swiped our cards.
Keen's argument
rests on three errors: a) his argument contains a fallacy of
composition b) while it is true that loans create deposits and deposits
create loans, he fails to identify the ultimate cause of this expansionary
process and c) the process cannot go on without limits.
Let's look at the
fallacy of composition first. While it is true that, from the point of view
of an individual borrower, their debt load has increased when they borrow
from their credit card company, it is not necessarily true that total lending
has increased.
Credit card transactions
would look approximately the same under a 100% reserve system as they do
under fractional reserves. When a consumer makes a charge, the bank loans
them money. What the consumer cannot see is whether the bank created the loan
out of nothing, used funds from an offsetting loan that was paid off around
the same time or acquired the funds in the secondary lending market by
bidding them away from other borrowers.
Under 100%
reserve, anyone who wanted a loan could obtain a loan by bidding for existing
savings. The volume of credit could only increase as the interest rate rose,
because a higher rate would be required in order to call a greater volume of
savings into the credit markets.
Under fractional
reserves, banks can expand credit while keeping the price more or less
unchanged as long as there is a central bank in the background that is
supplying whatever volume of reserves is necessary in order to defend its
target rate of interest. There is no way that an increasing volume of credit
could be supplied without a rise in interest rates, unless a central bank is
adding reserves to the system.
It is not true,
as Keen says, that this process can proceed without limits. Banks are limited
in the extent to which they can expand credit. When Rothbard wrote The Mystery of Banking,
this process was easier to understand. Banks were required to maintain a
reserve ratio. The money multiplier was simply the reciprocal of the reserve
ratio. For example, a 10% reserve ratio resulted in a money multiplier of
10x. Now, the mandated relationship between bank assets and liabilities are
governed by the Basel
II Accords. Regulators in countries that have adopted this framework
specify a required amount of bank capital using a more complex set of
formulas. The result is that the liabilities of banks are limited by their
assets, but not in such a way that the money multiplier can be trivially
calculated.
But even under
the new regime, there is a regulatory limit to the amount of credit
expansion, unless there is a central bank adding reserves to the system. When
new reserves are added, bank capital increases, and there is more room for
credit expansion.
There is another
possible limiting factor, namely, the willingness of banks to take on more
leverage. In the current crisis, we have seen that in most cases, this limit
was not reached before regulator limits, any explanation of credit expansion
needs to show why banks do not care how much equity they have.
Keen fails to
identify the ultimate cause of the credit expansion process. Keen describes
the behavior of the banking system after new reserves have been added but
before they have been fully loaned out to the regulatory limit (or before a
crisis has caused a credit contraction). During this middle phase, deposits
do create loans and loans do create deposits. But that does not tell us which
is the ultimate cause. By starting as he does with the credit card borrower,
Keen commits the in
media res fallacy - entering a causal chain in the middle and attributing
causality to the most recent event in the chain.
Robert Blumen
Also
by Robert Blumen
Robert Blumen is
an independent software developer based in San Francisco, California
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