Frank Decker and Charles Goodhart — Credit mechanics: A precursor to the current money supply debate

The insights presented by Lautenbach and Stützel support the points made by one author of this column (Goodhart 2017), who noted that loans to the non-bank private sector are commonly negotiated in advance in the form of overdraft and stand-by, or credit, limits. The actual drawing of the loan is then left entirely in the hands of the borrower. Nor is the balance of power in the prior negotiation entirely in the hands of the bank. Competition and regulation constrain the power of each bank to fix loan terms, just as the availability of collateral security limits the ability of the borrower to obtain credit.

Nevertheless, recent publications on money creation – for instance, McLeay et al. (2014), Jakab and Kumhof (2015) and Werner (2014, 2016) – predominately focus on the money-creating capacity of the individual bank, not taking much, or any, notice of the developments in German monetary economics since Hahn (1920). The theoretical analysis of the determination of the money supply in the US and UK has for too long been based on misleading partial equilibrium approaches. Earlier it was based on the money multiplier, which implied that the money stock was driven primarily by changes to the central bank’s monetary base. This ignored the fact that, if the central bank wanted to fix a short-term interest rate – which it generally did – then the base had to adjust to commercial banks’ need for base money, rather than the reverse. Subsequently the divorce between the recent explosion in bank balances at the central bank and the sluggish growth in the broader money stock has scuppered the money multiplier approach. But this void is being filled by yet another partial equilibrium analysis, whereby the emphasis is focused entirely on the, supposedly unilateral, ability of the individual bank to create loans, and money, ex nihilo. In contrast, we argue that a more general approach to money supply theory involving credit mechanics and the influence of all those participating, bank debtors and creditors, both the non-bank private and the public sector, needs to be established.

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Credit mechanics: A precursor to the current money supply debate

Frank Decker, Honorary Associate, The University of Sydney Law School and Charles Goodhart, Emeritus Professor in the Financial Markets Group, London School of Economics