By Dan Kervick

Some people believe in endogenous money. They believe we live in a monetary system is which money is generated and extinguished as part of the ordinary flow of everyday economic activity. The economy tends to generate the money it needs in order to satisfy the exchange desires and saving preferences of participants in the economy, and to extinguish the money it doesn’t need.

The endogenous money picture is in some considerable tension with the idea that the monetary system is controlled by the government. The alternative exogenous money picture holds that the issuance and destruction of money is a task reserved for government alone, and that the total amount of money present in the economy is therefore a government policy choice.

We can achieve a happy medium between the endogenous money and exogenous money pictures by viewing things this way: Due to a combination of deliberate policy choices and historical contingencies, societies have chosen to institute complex monetary and credit systems in which the generation of the most commonly used means of exchange is primarily a market-driven phenomenon, but one that is heavily regulated and supplemented by government agencies that also issue their own forms of money. We can also note that those latter forms of narrow government money usually play a foundational role in constraining and underpinning the broader forms of money, since they are needed to settle the obligations that are incurred by issuing those broader forms of money.

So there is truth in each picture, and it is a mistake to adopt either extreme.  One of those extremes is a view that I have sometimes called “hyper-endogeneity.” Hyper-endogenists systematically exaggerate the role of commercial bank money in our existing monetary system, treating the banks as possessing certain powers that are actually reserved to the federal government alone.  Hyper-endogenists view banks as, in effect, operating their own fiat printing presses. They claim commercial banks manufacture money cost-free “from thin air” and therefore reap seigniorage profits from the exercise.  I tried to point out the errors of hyper-endogeneity in my essay “Do Banks Create Money from Thin Air.”  But since it was a long essay, let me recapitulate the main points as briefly as possible here.

Seigniorage is the profit earned by a money issuer from the spread between the real cost of creating the money and the real value of any assets that can be fetched for that money in markets. For example, suppose for whatever reason, you were privileged to own a perfectly legal and licensed government printing press (maybe it was awarded to you in a lottery.) The printing press makes $500 bills, and you are permitted to print 100 of these bills each year. Suppose the cost of each additional bill you print (the ink and paper you use) is 25 cents, and that this is a cost you have to bear yourself. Let’s say you print up a $500 bill, and use it to buy a fancy new tablet device that costs exactly $500.  You have just reaped $499.75 in seigniorage profits.

But now let’s think of a different kind of printing. You don’t have a printing press for $500 bills, but only a printing press that creates IOU’s, which again cost you 25 cents apiece to print out. You print up a $500 IOU, sign it, and give it to a stranger in front of a witness in exchange for a $2 package of chewing gum. Have you made $1.75 in seigniorage profits? No of course not. You have lost $478.25, since in addition to the 25 cent cost of printing the IOU, you now have a debt of $500. Of the total cost of $500.25, only $2 was offset by the pack of gum. The stranger will at some point press the claim for the $500 you owe.

A typical bank loan transaction is like the second case, not the first. Commercial banks don’t earn seigniorage. Rather, they make money by charging interest on lending, in more or less the same way any of us could make money by charging interest in lending. Banks just do it on a much larger scale.  Say you want to borrow $10,000 at 5% interest, with repayment due after one year. The bank creates a deposit account for you and credits it with $10,000. In exchange, you give the bank a promissory note for $10,000 plus the $500 in interest. Bank deposits are debts of the bank payable on demand, and the bank has thus incurred a $10,000 cost in the form of a debt. If things go well, they will have made $500, not $10,500.

Those bank debts represented by deposit balances are negotiable, and widely accepted at face value, and so drafts on those deposits function as a form of money in our economy. But the banks routinely have to make good on the debts they have incurred by issuing those deposits. They make good on the debts by making payments with a form of money that they, themselves do not issue and so must obtain through market transactions. The payment assets they use are issued by the government. They consist in both physical currency and deposit balances in the banks’ own deposit accounts at the central bank.

Hyper-endogenists sometimes go even further and suggest that governments have enslaved themselves to the banks, because the government somehow needs to obtain bank deposit money to carry out its operations. But this is erroneous. Governments choose to accept drafts on bank deposits in payment of taxes because the settlement of those payments is carried out with bank reserve balances or cash, which are a form of money that the government itself issues. In other words, payments to the government simply extinguish some of the money that the government itself has issued.

But government currency and central bank deposit balances are also usually classified as liabilities of the government that issues them. So are they debts in exactly the same sense as the liabilities issued by the commercial banks? No, they are special.  Those government liabilities are not debts for anything that the government does not itself control and that it can’t manufacture at negligible cost. The possession of a $100 bill or a $100 balance in a Fed account doesn’t entitle you to anything more than another $100 bill (or a combination of bills and coins of smaller denominations). And the government has an infinite money well. It does have a printing press and it does reap seigniorage. It is limited in doing this only by its own policy choice not to destroy the market value of the currency it issues.

It is true that the government can also impose tax obligations on you, and that the government’s money discharges those obligations. So doesn’t that mean that a $100 bill is a bona fide liability of the government worth $100 in real terms, since issuing it deprives the government of $100 in tax revenue it would otherwise have received? Not quite. While the nominal asset value of a $100 tax obligation for the government is $100, its real marginal value to the government is zero, since the government has an infinite money well and doesn’t need additional cash. And while the nominal liability value of a $100 Fed deposit balance for the government is $100, its real marginal value to the government is zero, since again the government has an infinite money well and can always afford to part with any amount of cash. The government taxes dollars to remove them from private hands, and spends dollars to put them in private hands.  And the ability to impose enforceable tax obligations is part of what fulfills the government’s policy purpose of creating a market demand for its currency.

So is bank lending constrained by the need for the government’s money, whether in the form of currency or deposit balances at the central bank? In one sense clearly, yes. Banks need that government money to fulfill the payment and withdrawal obligations that their lending and creation of deposit balances incurs.  But for a given particular expansion of lending they might not need to acquire any additional reserves at all.  And even if they do need more reserves, they don’t need to acquire the reserves first, before making the loan. They can make the loan and then acquire the reserves. Of course, the fact that they might not need to acquire additional reserves doesn’t mean that creating the deposit carries no cost.  It does carry a cost because it is an additional claim against their exiting assets, and they will therefore lose assets as they settle those claims.

The truth in the endogenous money picture is that the processes by which the most widely accepted means of payment are introduced into the economy are driven by the demand for that money.  Banks seek to satisfy that demand by making loans, and the government then satisfies the increased demand for government issued money that results.  But the commercial banks don’t have their own printing presses.

Cross-posted from Rugged Egalitarianism

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