The Magical Economic World Where Money 'Just Happens'

October 7th, 2012
in Op Ed

Should we take inside money more seriously?

by Dirk Ehnts

magician-levitating-lady

This question is actually the title of ECB working paper #841 from December 2007 by Livio Stracca. Inside money is understood as "money produced by the private sector and not by the government or the central bank" (p. 5). The author incorporates inside money in the standard DSGE (Dynamic Stochastic Dynamic Equilibium) model and comes to the following conclusions:

Follow up:

Fourth, simulating a banking crisis as a simultaneous increase in the cost of bank lending to firms and of producing deposits leads to an unambiguous contraction of economic activity and inflation and to a fall in interest rates. Finally, the inside money shocks enter in an optimal simple linear monetary policy rule, but their contribution to the overall central bank loss is found to be minimal. In other words, it appears that reacting to inflation is sufficient for stabilization purposes.

It might seem unfair to use hindsight in order to highlight the mistakes of some author, but let me assure you: if we don't learn from the mistakes of the past, then designing a better financial system will not be possible. For too long, central bankers have ignored endogenous (=inside) money and its implications. This ignorance led central bankers to focus on inflation while at the same time the biggest external instabilities of the post-WWII era built up.

The ECB could have done much better, if only they had more knowledge about the economy. If the ECB of today would understand that endogenous money creation - which is loans from banks to households with no connection to the money supply - is driving the economy they would understand that aggregate demand in countries like Spain and Ireland will not go up until either:

a) the creation of endogenous money moves up again (highly unlikely),

b) external demand is rising or

c) the government spends more (wherever the funds would come from).

Option b) is problematic, because it implies that either the rest of the world increases its price level or Spain decreases hers. Which would lead to an increase in real debt and probably make matters worse until debt has come down to sustainable levels.

Let me stress one more time that this crisis is one of intellectual failure to grasp reality. Central banking is not the only field where this happened, so no particular blame should be shifted to the institution. However, blame must be put on it if it refuses to learn. Perhaps the central bankers of today don't like the (Post-)Keynesian academics that have been developing 'endogenous money'. and they are reluctant to leave their DSGE models in which they have invested so many years of work.

However, this is not the time for academic bickering.

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Read more by Dirk Ehnts.


About the Author

Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.
















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1 comment

  1. Derryl Hermanutz says :
    *****

    Dirk wrote
    "The ECB could have done much better, if only they had more knowledge about the economy. If the ECB of today would understand that endogenous money creation - which is loans from banks to households with no connection to the money supply - is driving the economy they would understand that aggregate demand in countries like Spain and Ireland will not go up until either:"

    It is a continuing source of astonishment that highly intelligent people like central bankers can be so mesmerized by the false assumptions of their flawed economic models that they are literally unable to see the plain functioning of the real world. Private commercial banks create money every time they make a loan or purchase government debt securities. Almost all of the "money" that is used for buying and selling in the economy is this "bank deposit money". But central banker economic models ("neoclassical") do not include money creation by banks, nor debt-credit imbalances. So central bankers are self-blinding themselves to the very factor that "drives" (as Dirk correctly observes) changes in the rate and direction of GDP growth. They couldn't see 2008 coming because they consult their models, they don't look at the real world. Shockingly, most of the public who has any monetary 'knowledge' shares the central bankers' neoclassical blindness to the reality of private bank money creation. So we truly have the blind leading the blind, and people like Dirk whose eyes are open to the reality bang their head against self-satisfied and self-reinforced monetary ignorance.







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