Credit River and the Green Cheese Factory: The Scandal of Endogenous Money

Alejandro Nadal

In 1964 Mr. Jerome Daly took a mortgage for $14,000 US dollars from the First National Bank of Montgomery in Minnesota. In 1967 he was $476 in arrears, the bank initiated foreclosure proceedings and bought the property at a sheriff’s sale. The bank then sued for possession and a jury trial was held in December 1968 in a township with a very appropriate name, Credit River.

Daly argued that the mortgage contract was null and void because it lacked consideration on the part of the bank. In legal parlance this means that in any contract both parties must exchange something of inherent value. When the bank had granted the loan it had simply inserted an entry in a ledger, thus “creating money out of thin air.” Because the bank did not commit anything of value into the contract, there was no consideration and the contract was null and void. The plaintiff had no legal base to claim Daly’s house.

A critical witness took the stand: the president of the bank, Mr. Lawrence V. Morgan. He told the jury that Mr. Daly’s claim was essentially correct and that this was common practice in banks. In the curious words of Mr. Morgan, the money was ‘created and born into existence’ when the ledger was filled out.

The jury handed its verdict in favor of Daly and justice Martin V. Mahoney cancelled the foreclosure. It was a momentous decision: the theory of endogenous money had been vindicated in court. In monetary economies like ours, money is indeed created out of thin air by private banks.

But today most people believe money is supplied exclusively by central banks. It is a simple and easy to grasp notion, but it is wrong and misleading. Typically, in today’s economies coins and bills in circulation add up to 5% or 7% of total money supply. The rest is created by private entities known as banks.

Mainstream macroeconomic theory embodies an inaccurate view on money and banking. In its most extreme presentation, the notion that central banks have the monopoly to emit money is linked to the idea that private banks have a limited role as simple intermediaries between economic agents who save and those who want to borrow. According to this idea, banks intervene in a market of loanable funds where the rate of interest is the price that equilibrates the supply and demand of these funds.

Even Keynes, the great challenger to orthodoxy, hesitated in his views about money. In contrast with his Treatise on Money, the General Theory assumes that the money supply is fixed and thus implicitly adopts an exogenous money perspective. This is confirmed by his analysis of the essential properties of interest and money.

In his General Theory the rate of interest on money plays a peculiar part in setting a limit to the level of employment because it sets a reference for the new production of any capital asset. Chapter 17 examines “wherein the peculiarity of money lies” and resorts to the theory of own-rates of interest of all assets. That asset with the greatest own rate of interest “rules the roost because it is the greatest of these rates that the marginal efficiency of a capital asset must attain if it is to be newly produced (GT, p. 223).”

According to Keynes, money possesses this characteristic because of its very small (or zero) elasticity of production it cannot be produced by private firms. Money also has a very small elasticity of substitution: as its exchange value rises there is no tendency to substitute some other factor for it and money can become a “bottomless sink for purchasing power.” Thus, Keynes concludes with his famous metaphor:

“Unemployment develops (…) because people want the moon; -men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.”

In fact, the green cheese factory was privatized a long time ago (even before Keynes’ times). The supply of money is not determined by the central bank but by the private banking system. Money creation is not independent of the requirements of the economy.

Banks do not need to have access to prior deposits in order to extend loans: loans create deposits, as established in Daly vs. First National Bank. By the granting of loans money is created ex nihilo. This is a critical point: the only thing needed is a borrower with a credible project and adequate collateral. And when bank customers request cash, banks can get the required amount directly from the central bank. So, in the end, even high-powered money (reserves and currency), just like bank money, is endogenous and demand-determined. In fact, the volume of high-powered money is directly related to the supply of bank loans and bank money through the credit divisor. Bank money is not a multiple of high-powered money, as claimed by neoclassical theorists. On the contrary, high-powered money is a quotient of the quantity of bank money (as Lavoie and other post-Keynesians have established).

It is important to clarify that the notion of endogenous money should not be mistaken with the practice of fractional reserve banking or, for that matter with the idea of the money multiplier. To right-wing libertarians and neo-Austrians fractional reserve banking is a scam, but to neoclassical economists (like Paul Krugman) it provides an accurate description of banking operations. That reserves are not a reference for banks’ monetary creation is shown here and here. The myth of the money multiplier is dispelled here.

Today’s reserve requirements for banks in OECD countries are extremely low (in countries like the UK, Canada and Mexico, it is zero). This may be due to central banks’ recognition of their inability to regulate the money supply. In any case, establishing reserve requirements for prudential reasons or for liquidity management (as in Basel III) should not ignore the essentials of endogenous money creation by private banks.

Many important macroeconomic issues need to be addressed once a perspective of endogenous money is adopted. Perhaps the most important one concerns the analysis of the global financial crisis. The control over monetary creation is the most fundamental element in our understanding of the political economy of contemporary capitalism. As the crisis evolved in the US and Europe attention centered on fiscal austerity or the role of the ECB. More discussion is needed on the role of private banks in creating de toutes pièces the primal soup for the financial crisis through their production of green cheese in a river of credit.

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