Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

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  1. Bingo!

    An increase in demand for credit is a kind of dissaving, while an increase in demand for money is a kind of saving. There is no better illustration of how absurd the equivocation of money and credit can be.

  2. Mr. Kelly, its kind of boring that you agree with me;-) But I kind of expected that…this are so obvious issues that everybody should understand it and agree, but it seems very controversial…

  3. Oh, I’m sorry. I mean, you’re wrong. What are you, a shill for the big banks? We all know that MONEY IS DEBT. That’s how the system is screws everyone over. Capitalism is going to inevitably collapse because money is debt and debt charges interest, and so there can’t possibly be enough money to pay all the interest. It’s one big Ponzi scheme. They’re going to bring back debtors prison and make us all into debt slaves, and you are one of their enablers! The only way to fight back is to occupy something and live in tents and fight with the police. Viva la Revolucion!

    More seriously, I’m a nobody from nowhere who knows nothing. It is highly unlikely that I know what I am talking about.

  4. Haha…good one!

  5. Allow me to be the dissenting opinion, then.

    I understand why you are making the distinction between “credit” and “money,” and I see how it might help clarify the issue if you focus directly on the concept of the “demand for money.” But, I think that once you let go of that focus then your distinction is going to cause more confusion than anything else.

    Credit is money substitute, so for all intents and purposes I don’t think there is any use in distinguishing between money and money substitute beyond this. The demand for money substitute is the same as the demand for money (just like there is no difference between the demand for outside money and the demand for inside money, by definition). These are all referring to different money substitutes, and thus different types of physical units of, but ultimately they all fall under the umbrella of “money.”

    When an entrepreneur borrows credit from a bank, more than that credit he is demanding the capital goods he plans to buy with the loan. So, I think that what you refer to as the “demand for credit” is really a demand for savings. If someone had a demand for credit then that would be a demand to hold credit, which is not what is occurring here (although, it can happen — I took out student loans, and ended up holding a good deal of that money, because I had nothing to spend it on).

    Let me put it another way. Let us say that there are no physical bank notes or no physical outside money in circulation. Instead, all we use is credit (electronic money) as our money substitute. Does this suddenly change the “economics” of what we’re talking about? Absolutely not. There is still a demand for money and there is still a demand for savings.

  6. David Pearson

     /  January 12, 2012

    “The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.”

    I’m not sure this is what Svensson is saying. In fact he seems to discard the “direct money” effect in his paper. Rather, he is saying the Fed controls a relative price in the economy, and that setting this relative price can increase inflation expectations, reduce the real rate, and turn the terms of trade in favor of manufacturing. Each of these three elements operates by influencing credit demand, not “the money supply”. Similarly, deficit monetization is foolproof because it can lead to growth in total bank credit at the zero bound.

    While I agree with Svensson, I take issue with the “real devaluation” component in a large, services-dominated economy. It is not clear that turning the terms of trade in favor of manufacturing provides a net benefit in this case.

    MM’s argue that banks don’t matter because the Fed can increase velocity. However, what MM critics are saying is that the Fed can only influence velocity if it has a credible mechanism for influencing demand for bank reserves — i.e. credit growth. Thus, demand for bank reserves — the only thing the Fed is actually capable of producing — is always at the heart of monetary policy effectiveness in a liquidity trap.

  7. Lars,I´d forget about it if central banks had their own banks to distribute money. I cannot see how central banks could circumvent the demand of money by the banks -if is not by their own distribution system.
    I see an automatism in MM argument between M and NGDP that is not so evident for me.

  8. It seems to me the takeaway from ABCT is that money must come in through some channel and that depending upon what channel that is, you’re going to see some short-run distortions. Austrians concentrate on that channel being the banking sector for the same reason that Keynesians concentrate on the central bank targeting interest rates: Because when they wrote it down, it was true. I think we’re coming back to Scott’s critique of Keynesianism, just applying it to other things: Nobody really looks at monetary policy the right way. Economists have some basic assumptions about monetary policy which they take to be fundamental aspects of money. But really those aspects are just a description of the current regime. No you don’t have a liquidity trap, you have a central bank that sets interest rates and doesn’t know how to put them below 0. No you don’t have malinvestment caused by easy money entering through the banking sector, you have malinvestment because the money enters through somewhere as opposed to uniformly raining from the sky. But both of those assumptions can change. All we need is the Fed to decide that instead of buying treasuries, they will now drop money from helicopters or for the ECB to decide that it’s not going to worry about the interest rate and instead just carry open-market operations until they hit their actual target (i.e. the inflation rate at 2%).

    Those are really strange problems to have. Nobody’s economic theory starts by assuming a certain fiscal policy. That would be silly because fiscal policy is made by humans and they can change their mind. The same is true for monetary policy, assume it at your own risk.

  9. Alex Salter

     /  January 13, 2012

    I disagree. Modern elaborations of ABCT (e.g. Garrison’s “Time and Money”) in no way depend on the first injection point being in the banking sector. The injection point is of secondary consequence (Cantillon effects, etc.); of primary importance is whether the new money is in excess of the amount required to maintain equilibrium in the money market. If there is too much money, i.e. and excess supply, it will eventually be reflected in the loanable funds market, and the usual ABCT story takes off from there.

    I’ll repeat the key takeaway point, because it’s very important: The relevant margin is monetary equilibrium, not direct injection into credit markets/the banking sector.

    (Of course, if the money injection was intended to offset an existing excess demand to hold money, none of the above applies.)

  10. Alex,

    Even in “modern elaborations” of ABCT do depend on the point of injection. ABCT is all about investment that requires a greater quantity of capital goods that have been saved, and so the point of injection must spur investment. If it stimulates consumption than an ABCT cannot occur.

  11. Alex and Jonathan, I think the issue that you come from different Austrian traditions. I would say Jonathan’s interpretation is the “right one” in terms of being true to for example Hayek’s Price and Production. In the Hayekian model (which I think is the one Garrison basically is trying illustrate) money is injected into the economy through the credit channel and the banking sector. If instead money enters the economy as a money drop to consumers the Hayekian triangle will shift will actually shift in the other direction a less “randabout” structure of production (damn this Austrian lingo is odd….) and that will short the production process. This also mean that the ABCT hardly can be said to be a general theory of the business cycle as Austrians often claim.

    Alex, I think your model is not a traditional Hayekian ABCT, but rather a Horwitzian model. I like that model much better, but don’t really think it is Austrian.

  12. Martin

     /  January 14, 2012

    I too am a nobody from nowhere who knows nothing, but I’m still going to take my chance and defend the ABCT anyway. The great thing about the internet is that you can take the risk to look like a fool 🙂

    ”The assumption that “new money” is injected into the economy via the banking sector” might not be always truth, but it’s business as usual and it seem to me that the bubble really started with an important increase in credit through the ”credit channel”.

    I’m not trying to argue against the keynesian or market moneratism view that the problem we are in is due to a lack of demand/ngdp. I completely agree, too, that waiting for bank to make loan now is foolish and we should just use a more direct channel to increase demand.

    But I also think their was a bit of an austrian boom and bust cycle element to the whole thing, at least at first. My problem with ABCT is that it does a better job of describing what happens before the recession than the recession itself. It fail completely in my eyes to explain why unemployment is still so high in 2012 (and participation low). Still, I fell that it might be a mistake to reject it completely too fast and doing so might be like throwing the baby with the bathwater.

    The problem I see is that austrians economists are making a bad diagnostic in claiming that all our current problem can be explain with ABCT. On the other hand, other schools are also making a mistake in refusing to even consider one instant the idea that monetary policy, under our current regime where most money create is done throught the credit channel, can indeed distort the structure of production in a way that is far from optimal. It’s not that we should not be more aggressive with our monetary policy, but at least we should consider the idea that in doing so we might be choosing a lesser bad to prevent a greater one.

    More fundamentally, even if we forget the ABCT for an instant, what I think is problematic with modern macroeconomy is not that it’s all bad, as many austrians seem to think, but that it’s incomplete without a capital theory and that it doesn’t even seem to bother any moderns macroeconomists at all. I see it as a form of complacency. Market monetarism being a new school of thought, it seem excusable to me but from keynesians it really annoys me. It’s not because AD matter that it’s all that matter…

  13. Martin, good point(s).

    I, however, would say that you seem to think that there was a “bubble”. I on the other hand agree with Scott Sumner that it is far from clear that there was a “bubble” (whatever that is) in the US economy prior to the crisis. But let for the sake of it assume that there indeed was a bubble that had economic wide impact. Can the bursting of that bubble then explain the scope of the drop in economic activity? An can it explain why the US economy (and the European economy for that matter) still is in deep crisis? I think not. To me it is very clear that overly tight monetary policy is to blame.

    I am, however, happily acknowledge that some countries saw serious bubbles prior to the crisis. Small countries such as the Baltic States and Iceland clearly had some sort of a bubble (I on my own part forecasted the bursting of these bubbles back in 2006-7).

    Furthermore, I fundamentally think that Market Monetarists has a great deal in common with some Austrians such as Steven Horwitz and obviously with Free Banking Theorists such as George Selgin. I have written extensively on my blog on this “connections”. Both Steve and George would argue that the US economy was in some sort of a bubble prior to the crisis and I think David Beckworth who of course is a funding member of the Market Monetarist school would argue that as well.

  14. Martin

     /  January 14, 2012

    My personnal opinion, for what it’s worth, is that past monetary policy have led to massive capital consumption (redistribution of factors of production toward short term production/lower order goods). The part about the boom in higher capital goods is less relevent, although it still happpened. This necesserely imply a decrease in factors of production in the middle of the the structure of production. From this result :
    -Short term boost in the production of consummer good
    -Followed by a decrease (relative to what would have otherwise have been the case, not in absolute term necessarily)
    -Stagnant wage even in the boom (capital consumption = less investment in capital formation = less demand for factors of production, thus labor)

    The phenomenon of capital consumption in the boom was pretty evident to me :
    -Massive equity withdrawal
    -Huge boom in service sector
    -Huge increase in importation of consummer goods
    -I also think, but can’t find the source now, that theyre was a huge surge in stock buyback in the boom and that the money ”invested” in the boom didn’t went to finance capital formation. All the action seem to have been only in the secondary market.

    The boom in the production of higher order goods, and the bust, is also pretty evident.

    The way rapid credit injection bring that about, even if NGDP and inflation follow normal trend, is that it increase the total value of the stock market and real estate market. It doesn’t take that much money to do that, since price are set at the margin. It just take one buyer and one seller to increase the price of a stock, and people easily fool themselve thinking they are richer because they don’t realize that nobody would want to pay that much if it wasn’t for access to cheap credit and that such increase might only be temporary. (It is a common mistake to calculate our wealth by looking at market price, those just tell us how much, today, one could buy or sell an house/stock for. It tell us nothing about tomorrow.) People think the are getting richer fast by looking at the ”appreciation” of their wealth and thus reduce their saving, engage in equity withdrawal, don’t bother invest to maintain their capital since it seem to appreciate automatically, etc. Consumtion increase relative to investment, the structure of production is distort, etc. Then, at some point, the credit flow decrease, price of assets stop to appreciate, people , who invested only in expectation of such appreciation going on panic, the market crash, velocity go down, ngdp go down, and we get a new problem on our hands that now subsist independently of the actual boom and bust and is actually much worse.

    This is my current understanding of what happened, at least the big picture.

  15. Martin,

    I would not disregard that and say that that is not the true story. However, if the “bubble” was so clear to spot why did emerge in the first place? That is basically my key problem with boom-bust theories like the ABCT.

  16. Martin

     /  January 15, 2012

    I didn’t say it was clear, it wasn’t to me before it burst. It’s only clear when you look at it backward. Investors can be quite often irrationnals. We all are.

    -People are used to believe there is something permanent to increase in the value of assets when they are market wide. They don’t think of price as just what assets can be bought or sold for at a given moment. People really felt richer, which led them to save less, etc. The real capital stock, meanwhile, didn’t really increase all that much.

    -Those who buy new assets with cheap credits at first are not in my eyes making a mistake. The problem is the effects on assets price, how it influence others, and the fact that the demand for such assets must drop at some point if the rate of credit injection slow down, which it must. People weren’t really saving all that much during the boom (or because of it…) and only the constant injection of credit could sustain it. It take real demand to sustain a bubble afterall, not just some desire and expectation.

    -People can be blind collectively by optimism (or pessimism) and have a tendency to extrapolate to much from current trend. but it’s credit injection that create such a trend, and sustain it.

    -The bubble burst if credit slow down, or if people start to fear the good time are ending and velocity drop. The ratio of the value of the stock market and real estate market relative to ngdp cannot increase forever afterall.

    Anyway, this is just a theory, I’m not 100% sure of anything. My point was just that much in austrian theory, like it’s capital theory and even ABCT (at least some versions, with minor modifications maybe) doesn’t really contradict modern macro, even keynesian one, and that one can both like austrian capital theory and believe in market monetarism or keynesianism.

    I’m happy to see that market monetarism aren’t that hostile to austrian economics. It’s not perfect, and the austrians economists sometime want to apply it when it doesn’t work well (like explaining why there still unemployment now) but I still see it as very valuable. It’s why I felt like defending it 🙂

    I’d like to see a sort of synthesis between market monetarism and austrian capital theory. I’ve always found the main weakness of austrian economics was it’s rejection of the importance of the impact of variation in AD, and the main weakness of keynesianism it’s absence of any capital theory.

    Thank you for listening anyway.

  17. Alex Salter

     /  January 15, 2012

    I only say the point of injection isn’t of primary importance because, if the additional money is in excess of the amount required to maintain monetary equilibrium, it will eventually find its way into the loanable funds market. The injection point determines the Cantillon effects, which determines the precise quantity and type of sectoral maladjustments, but from a general perspective these particulars don’t really add much to the illustration of the theory.

    “I’d like to see a sort of synthesis between market monetarism and austrian capital theory.” Market Monetarism is monetary equilibrium theory plus the policy recommendations which logically follow. In that sense much of the free banking literature, and much Austrian macro following “Time and Money,” is in effect such a synthesis.

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