In his paper Deeper in Dept, Dr. Steve Keen over at the Centre for Policy Development examines four possible explanations for the Australian housing development (p.14):
(quoted)
- Lower interest rates - the increase in debt is simply a rational response to the fact the credit is cheaper, and there’s nothing to worry about
- Higher incomes. As our incomes have risen, household budgets have been in a better position to absorb higher debt-to-income ratios
- Profligate households. Gens X, Y, Z, and the always irresponsible Generation BB have mortgaged and charged themselves to the hilt, and they only have themselves to blame;
- Irresponsible lenders. They have enticed us into debt we can’t manage, so it’s really their fault.
Which is it? According to Keen, the fourth explanation, irresponsible lenders pushing loans on gullible borrowers, is correct.
First I will examine a logical error in the way that he dismisses the first explanation. The first point combines an explanation (low interest rates) with an evaluation (and it’s ok because asset values were inflated as much as debt loads). His commentary on this point essentially endorses the role of low interest rates but he rejects the explanation because he rejects the evaluation (it’s not ok). He rejects the explanation because he shows that the evaluation is false.
I will now examine a side point that Keen uses to blame the bankers for the Australian housing bubble. The claim is that banks create money in response to demand and that this is the driver of credit expansion.
From p.21:
A relatively new school of thought in economics (see the Bibliography) argues instead that banks have the power to create money, even in the complete absence of government money. In this “endogenous money” vision of how the financial system operates, rather than “deposits create loans, it is “loans create deposits”, and the mechanism is far more straightforward than the “money multiplier” story.
This new school of thought is post-Keynesian economics. Dr. Frank Shostak has done a great job addressing the fallacies in this argument. In the remainder of this blog post I will rely on his analysis and add some observations of my own.
Keen goes on to say
The standard explanation of how money is generated argues that banks can only create credit if the government “kick starts” the system, effectively by creating cash that a citizen then takes to a bank for safe-keeping. Once the citizen has deposited that government-created “fiat” money, the banking system can create additional credit-based money via what is known as the “money multiplier” ...
This story has the banker sitting anxiously, waiting for a customer to walk in the door and make a deposit of government-created cash, before the banker can then begin the credit money creation process. Once the essential deposit has been made, the banking system can weave its money multiplier magic; but without the deposit, the banker--and the banking system--is impotent.
Does that sound like banking to you? It barely has credence as a description of the 1960s, let alone today’s “would you like a $25,000 credit limit with that?”
Keen’s description of the process is a bit of a straw man. Currency deposits by individuals play a miniscule role in the addition of bank reserves. The primary driver of this process is the purchase of assets by the central bank when it wishes to add reserves to the banking system. The central bank pays for these purchases with money that it creates out of nothing. The seller of the assets receives the payment in the form of a bank deposit. This process, far from being old-fashioned, happens in every country that has a central bank.
According to Keen, this is how it really works:
The real story: “Loans create deposits”
Think of your own credit card. If your balance is sufficiently below your limit, then you are completely at liberty to go to (say) Harvey Norman and buy a new widescreen TV. When you do, your debt to the bank is increased by the cost of the TV--and an equivalent amount of money is simultaneously created and deposited in Harvey Norman’s bank account.
There is absolutely nothing stopping you from doing that, right out to your credit limit (apart from personal financial prudence!), and the same observation applies to every other credit card holder in Australia. If we all went out and did something similar tomorrow, we would increase the money supply by over seven per cent overnight. Taking advantage of the loans that we have every right to take out (the gap between our credit card balances and card limits) instantly and simultaneously creates both new debt and equivalent deposits in the accounts of the lucky retailers who swiped our cards.
Keen’s argument rests on three errors: a) his argument contains a fallacy of composition b) while it is true that loans create deposits and deposits create loans, he fails to identify the ultimate cause of this expansionary process and c) the process cannot go on without limits.
Let’s look at the fallacy of composition first. While it is true that, from the point of view of an individual borrower, their debt load has increased when they borrow from their credit card company, it is not necessarily true that total lending has increased.
Credit card transactions would look approximately the same under a 100% reserve system as they do under fractional reserves. When a consumer makes a charge, the bank loans them money. What the consumer cannot see is whether the bank created the loan out of nothing, used funds from an offsetting loan that was paid off around the same time or acquired the funds in the secondary lending market by bidding them away from other borrowers.
Under 100% reserve, anyone who wanted a loan could obtain a loan by bidding for existing savings. The volume of credit could only increase as the interest rate rose, because a higher rate would be required in order to call a greater volume of savings into the credit markets.
Under fractional reserves, banks can expand credit while keeping the price more or less unchanged as long as there is a central bank in the background that is supplying whatever volume of reserves is necessary in order to defend its target rate of interest. There is no way that an increasing volume of credit could be supplied without a rise in interest rates, unless a central bank is adding reserves to the system.
It is not true, as Keen says, that this process can proceed without limits. Banks are limited in the extent to which they can expand credit. When Rothbard wrote The Mystery of Banking, this process was easier to understand. Banks were required to maintain a reserve ratio. The money multiplier was simply the reciprocal of the reserve ratio. For example, a 10% reserve ratio resulted in a money multiplier of 10x. Now, the mandated relationship between bank assets and liabilities are governed by the Basel II Accords. Regulators in countries that have adopted this framework specify a required amount of bank capital using a more complex set of formulas. The result is that the liabilities of banks are limited by their assets, but not in such a way that the money multiplier can be trivially calculated.
But even under the new regime, there is a regulatory limit to the amount of credit expansion, unless there is a central bank adding reserves to the system. When new reserves are added, bank capital increases, and there is more room for credit expansion.
There is another possible limiting factor, namely, the willingness of banks to take on more leverage. In the current crisis, we have seen that in most cases, this limit was not reached before regulator limits, any explanation of credit expansion needs to show why banks do not care how much equity they have.
Keen fails to identify the ultimate cause of the credit expansion process. Keen describes the behavior of the banking system after new reserves have been added but before they have been fully loaned out to the regulatory limit (or before a crisis has caused a credit contraction). During this middle phase, deposits do create loans and loans do create deposits. But that does not tell us which is the ultimate cause. By starting as he does with the credit card borrower, Keen commits the in media res fallacy - entering a causal chain in the middle and attributing causality to the most recent event in the chain.
