Posted by: Dirk | July 28, 2014

The ECB on money: enhancing monetary analysis

The ECB discusses money in its paper “Enhancing monetary analysis”. Chapter 1 is titled “The role of money in the economy and central bank policy”. It was prepared by Giacomo Carboni, Boris Hofmann and Fabrizio Zampolli. The ECB distinguishes inside and outside money.

Banknotes and coins – or in short, currency – are normally the most secure form of money. They are issued by the central bank and/or government, which vouches for their general acceptability and the stability of their purchasing power. Equally safe are the deposits held at the central bank, normally available only to banks. Banks use them both as a means to settle payments among themselves and as a reserve to meet unusual demands for withdrawals of currency by their depositors. Along with the currency in circulation, the deposits held at the central bank constitute the so-called “monetary base”, “central bank money” or “outside money”.5 This money is usually “legal tender”, which means that any potential creditor is obliged by law to accept it in settlement of any debt.6

5 It is known as “outside” money to highlight the fact that it is created by the public sector as opposed to the private sector (and could be in principle controlled more easily) or as “high-powered” money to stress the fact that it constitutes the basis of the entire monetary pyramid whereby banks – by operating a fractional reserve system – create a volume of media of exchange that is a multiple of the money created by the central bank.
6 Importantly, the exact definition of “legal tender” may differ from country to country.

The second paragraph are the footnotes of the first. A different term for central bank money would be reserves. The paragraph on legal tender is somewhat interesting. Footnote 6 says it may differ from country to country. Nevertheless, tax payments ultimately are made in reserves (or what the ECB calls central bank money). Sadly, the ECB does not mention this and completely erases the fiscal part from the whole story. That probably has created the blind spot which led to the creation of a euro zone in which sovereign bonds were not risk free. The ECB continues then describes endogenous money (my highlighting):

Deposits issued by private banks, which are what most individuals and companies have access to, are held for the safety and the convenience that they offer over currency. Not only are they less subject to the risk of theft, but they also offer the convenience of a range of payment options, such as cheques (now less common than in the past), debit and credit cards, and electronic transfers. Other types of securities are also used as a means of payment – for example, certain IOUs issued by private non-financial corporations and widely traded on financial markets (commercial paper), or units in money market funds. The overall amount of money in circulation is, to a large extent, determined by the behaviour of banks and the (profit-seeking) behaviour and interaction of a myriad of private agents.

This, I think, is correct. The amount of money (=deposits in banks) in circulation is largely determined by banks lending to the private sector. What does not determine the amount of money (=deposits in banks) is the central bank, which is in the business of setting the interest through, as the ECB says, variations of the amount of reserves (=central bank deposits of banks). The text goes on describing the money multiplier, but then backing away from this concept:

However, as recently pointed out by Goodhart (2010), a major drawback of the money multiplier approach to money supply analysis is its entirely mechanistic character, which does not offer an account of the behaviour of the central bank, private banks or the private sector money-holders. The pace of financial deregulation and financial innovation over the last few decades has certainly challenged the notion of a stable money multiplier. Also, in times of crisis, money multipliers may prove to be highly unstable and hence may be a poor guide to predicting the effect of monetary policy measures on the money supply. This has become manifest during the global financial crisis, where the massive expansion of base money by central banks was not reflected in the development of broader monetary aggregates because of a collapse of money multipliers when banks were hoarding reserves.

So, the view of the ECB of money is correct. There are some parts omitted from the picture, like the idea that taxes drive money and not price stability, but the description of the two monetary circuits – bank deposits and central bank deposits – is correct. One would have hoped for some more detailed descriptions of interbank clearing and fiscal operations, but there is some good literature (like Fullwiler 2008 and Wray’s MMT Primer) out there which explain it from a balance sheet perspective. Since the BoE and other institutions and academics agree with this, maybe we have New New Consensus?


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