A Brief History of the Bank of England’s Endogenous Money Policies: An Ode to Roy Harrod

by Philip Pilkington

Roy Harrod, usually remembered today for his part in the development of the Harrod-Domar growth model was also, so far as I can see, the most sophisticated monetary economist among the early Post-Keynesians. His book Money, designed as a sort of textbook put together over the years using his lecture notes, is a testament to how a course on monetary economics should be taught.

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Harrod should probably be credited, for example, with the first truly institutional description of endogenous money theory — a theory that the Bank of England has now come to endorse. In his book he discusses how the British banks of the time lend to one another in the open market — this was done by scrambling for ‘call money’ when they found that their books didn’t balance. Call money is so called because you literally pick up the phone and call a variety of lenders to try and raise the money needed to meet the reserve requirements in place at any given moment in time.

Harrod was well aware that “loans create deposits” — indeed he uses the phrase quite a few times in the book — and that banks then seek to raise the money to meet the reserve requirements after, not before, the loans are made. If they cannot fill the gap in the market for call money they turn to the Bank of England. Here I will quote from Harrod at length to show just how ahead of his time he was.

If, as a result of these operations, including of a calling in of call money, they [i.e. the banks] find themselves unable to balance their books, they can resort to the Bank of England, and rediscount bills with it. Here the Bank of England operates in its role as lender of last resort. In normal conditions the discount market has to borrow from the Bank of England at Bank Rate [i.e. the British equivalent to the Fed Funds rate]. This is above the market rate on bills, and thus during the period of such borrowing the Discount Houses [i.e. effectively, the banks] find themselves making a loss. They will have lent money on bills at one rate and have had to borrow from the Bank of England at a higher rate, commonly called the penal rate. It is accordingly highly expedient for them to get out of debt to the Bank of England as quickly as possible. They must therefore firm up their own rates, so as to discourage borrowers and encourage lenders. The Bank Rate thus has a powerful effect on open market interest rates. (pp51-52)

Clearly the Bank of England sets the Bank Rate and allows the quantity of money to float. The Bank Rate and the lending rate gravitate toward each other because when banks extend sufficient loans that they are forced to borrow at the penal rate from the central bank they will quickly be incentivised to raise their own rates to squeeze off lending. Harrod is quite clear that this is how the process of money creation works. He continues,

When the market borrows from the Bank, this has the effect of increasing the money supply (deposits and notes) in the country, so long as this borrowing is outstanding. (p52)**

Harrod goes on to note that this system is different to the one in the US at the time (i.e. the post-war era). In the US the Federal Reserve was far less concerned with penalising banks. Although the mechanics of the monetary system were very similar, the institutional structure of the British system (in the post-war era) was far more geared toward penalising banks that borrowed from the central bank.

This was because of the peculiar situation in Britain at this time. In the post-war years, the British were very self-conscious about their balance of payments. Any time the balance of payments began to deteriorate the British authorities would try to bring the economy to a halt. This became known as the economic policy of ‘stop-start’ and it greatly hampered the ability of Keynesian policymakers to keep economic growth high at the time. Thus, the institutional structure of the Bank of England came to reflect the need for a central bank that could quickly ‘squeeze’ the market for funds when the balance of payments started to deteriorate.

The US, on the other hand, were rather cavalier about their balance of payments position in this era. After all, the Bretton Woods system at the time was based on the dollar and they issued the dollar. Indeed, many countries were more than happy when the US ran balance of payments deficits as this meant an outflow of dollars which developing countries could use to expand economic activity.

After the demise of the Bretton Woods system and the rise of Thatcher, the British began to care less and less about their balance of payments position. This is because they came to find — rather accidentally, it should be added — that capital inflows into the City of London were usually (but not always) sufficient to maintain the value of the sterling. And so, the era of stop-start economic policy came to an end. Since then the structure of the Bank of England has come to more so resemble that of the Federal Reserve in the post-war era; right up to their recent endorsement of endogenous money theory this year.

Harrod is also quick to note that the Bank of England stands behind the market for government debt at all times and effectively sets the interest rate on this debt through its operations. This is as true today as it was in Harrod’s time but is not spoken about very often. Harrod’s presentation is top-class in this regard in that he highlights that the rules put in place for bidding in the primary market for government debt operated seamlessly with central bank operations to set the effective interest rate on government debt. He writes,

Discount Houses are under an implicit obligation to take up Treasury Bills at issue each Friday. If the rise in interest rates has not achieved an attraction of outside funds into the market, nor deterred borrowing [by the government], the Discount Houses may be in a difficulty. The Government cannot trim down at short notice the amount of Treasury Bills it asks the market to take up. In such circumstances the Discount Houses will be unable to balance their books without resort to the Bank of England. If they go to the front door, they will lose money [i.e. they will be penalised, as we saw above]. They may have to put up with this for a week or two. But if the market remains inelastic and the Discount Houses have to go and borrow at the Bank week after week, the situation becomes intolerable. The Bank may seek to ease it by allowing borrowing at the ‘back door’. To the extent that it does this, or indeed to the extent that there is borrowing at all, the purpose of the original squeeze will be frustrated. The Bank will have reduced the money supply by Open Market operations and have had to replenish it again by ‘back door’ lending. (p56)

What does this mean? Well, basically that the central bank is under an implicit obligation to stabilise the market for government debt. If the government borrows and this puts upward pressure on interest rates, this does not lead to ‘crowding out’, as the textbooks say. Rather it leads to the central bank stepping in to put a ceiling on interest rates through ‘back door’ lending.

This also means that government borrowing and spending can trump any attempt by the central bank to control the level of economic activity. If the central bank tries to squeeze interest rates to curtail economic activity but the government insists on running deficits, the central bank will be under the obligation to undo their tight monetary policies by effectively providing the funds to the government.

Anyway, Harrod’s book is a fascinating read and, although long out of print, is far better than the textbooks used in monetary economics courses today. After picking it up I am convinced that Harrod should be recognised as one of the eminent monetary economists of the post-war era.

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** It should be noted that in the book Harrod does seem to think, as the Bank of England continues to maintain today, that through such interest rate manipulations the central bank can “control the money supply”. This is probably false, but that I have discussed that particular topic elsewhere.