Roundtable: Monetary Policy in the EU
Money and the Debunking of Myths


February 3, 2021

Jamee K. Moudud, Professor of Economics, Sarah Lawrence College

In recent years a number of authors have argued that in order to achieve vital social and environmental goals such as the Green New Deal, legislatures must democratize the banking system including the central bank which is at the heart of the financial system.  An important aspect of the democratization of the central bank is to recognize that its operations cannot and should not be delegated to “experts” at its helm, quite simply because it is socially-embedded and monetary policies have real social consequences. As the ultimate source of high-powered money, in a democratized system the central bank has to play an accommodating role vis-à-vis the banking sector, beyond its generally accepted lender of last resort function.  However, this requires us to call into question the notion of central bank independence, the attainment of which, has become the gold standard of economic policy over the past three decades. This article argues that the rationale for central bank independence rests on a mythology and that an institutionally-grounded theory of state–central bank relations can provide a new way to mobilize credit while blunting criticisms by proponents of central bank independence.  This in turn requires an understanding of the exogenous versus endogenous theories of money, Keynes’ insights on central banks, and the histories of European central banks.

In neoclassical economics the purported ability of apolitical technocrats to control both the money supply and inflation is seen as the key to promote economic growth.  “Independence” entails legal restraints on the legislature and executive branches from influencing the supply of money.  In general equilibrium theory it is assumed that money is neutral and subject to exogenous control with no effects on the real economy which is assumed to be barter-based.  The New Classical Macroeconomics (NCM) approach argues that in controlling the money supply central bankers face a time-inconsistency problem.  This problem arises when, despite their commitment to a price anchor, they become tempted to follow discretionary short-term monetary policies.  On the basis of the NAIRU (non-accelerating inflation rate of unemployment) framework, an unexpected increase in the money supply by the central bank will only temporarily lower the unemployment rate below the NAIRU level thereby raising the actual rate of inflation. With the implicit assumption that workers believe in the NCM model and have rational expectations, they will expect future inflation to increase.   They will therefore successfully push for higher money wage growth so that, at the end of the day, output will return to the NAIRU level. Persistent such “surprises” by central bankers will only generate higher rates of inflation with no effect on long-run output and employment.  Thus, the optimal solution to this time-inconsistency temptation is for central bankers to commit themselves to a rule-based policy in which money supply growth should be rigidly tied to maintaining price stability.  Monetary policies to promote employment or industrial transformation (say a Green New Deal or equivalent policies) should be abandoned since public policies of such types will always be short-circuited by wily, far-seeing market actors who, by believing in the NCM framework, will correctly predict future inflation. This is the policy ineffectiveness criterion with “market forces” automatically short-circuiting progressive public policies.

The policy ineffectiveness criterion is consistent with zero involuntary unemployment (i.e. full employment) giving workers the bargaining power to raise their money wages.  The further assumption is that firms will not face a profit-squeeze with the higher money wages, leading to layoffs (including outsourcing or investments in labor-saving technological change) and thus unstable labor markets, i.e. the increased precarization of work which would lower workers’ bargaining power. This point is all the more significant when one considers that even during the boom of the 1990s labor market insecurity actually increased as Alan Greenspan observed in a testimony to Congress in 1997.  Finally, it should be noted that the inflation – unemployment tradeoff at the heart of the NAIRU model is a relationship that has been violated in several periods – for example in the stagflation of the 1970s or the falling unemployment and stable inflation rates in the 1990s. Further the NAIRU has been periodically redefined, including in an upward direction in the deepening crisis of the 1970s and 1980s.  This recasting of structural involuntary unemployment as “full employment” is mythology masquerading as science, suggesting the incapacity of the framework to deal with growing labor market distress.  

  Equally problematic is the broad neoclassical tradition’s ignoring of not only the intellectual history of money and creditbut its incapacity to acknowledge how actual central bankers understand the money creation process.  As McLeay et al of the Bank of England’s Monetary Analysis Directorate discuss, textbooks misrepresent the money creation process.  According to the neoclassical money multiplier model, taught in all standard money and banking classes, banks first passively accept reserves and then create the loans and thus deposits.  According to this model, the central bank, by controlling the supply of high powered money, controls the money supply. McLeay et al observe that money creation is exactly the opposite of this model.  The banking sector makes loans by creating deposits, increasing the money supply automatically, and generally obtains reserves on demand from the central bank.  Individual banks also obtain reserves by borrowing from other banks with excess reserves (Fed funds market) and via asset and liability management.  And of course, as Post Keynesian economists have long argued, loan supply is demand-driven subject to banks’ profitability and solvency goals.

In short, banks are not passive intermediaries of household savings as in the neoclassical loanable funds model.  As Keynes argued savings are not synonymous with bank finance and whether households consume more or less of their income does not change aggregate bank reserves by an iota.   The supply-side vision of money creation, controlled exogenously by the central bank, was the basis of an important critique by Banking School theorists like Thomas Tooke in the nineteenth century. These authors argued that the supply of credit is demand-driven and thus cannot be controlled by the Bank of England as the Currency School argued. As Marx and Keynes and later authors in heterodox economics discussed, the capitalist economy is fundamentally a monetary system, beginning with monetary outlays by firms that need to be recouped as monetary profits. This is what enables firms to be what John R. Commons called going concerns.  In short once one recognizes that actual business investment is driven by the expectation of profits, as Marx, Veblen, Keynes, and business management textbooks discuss, the economy cannot possibly be anything but a monetary system. Money has real consequences and is not a veil.

Given the demand-driven nature of money it is not surprising that industrialization has entailed the need for a relatively elastic supply of credit as economic historians have argued. Central banks have historically been at the core of the mobilization of credit. For example, despite being a private institution, the Bank of France (BoF) played a key role in fostering industrialization in effect acting as the Treasury’s banker.   Despite this close relationship inflation was negligible throughout the nineteenth century until the First World War. And the Bank of England also played an important role in the development of English public financethereby enabling the state to act in a developmental capacity  while maintaining an Empire that benefited British economic development.

What is one to make of these examples where major central banks were clearly not “independent” in the modern sense but were not “piggy banks” either of the government? As Bertrand Blancheton discusses, the BoF maintained an autonomous role vis-à-vis the French state throughout the time period leading up to the Second World War.  There was a clear asymmetry of power between the two institutions (in no small measure generating conflict at times) and yet the central bank maintained a certain level of freedom to pursue its aims.  As Eric Monnet discusses, despite being a nationalized institution in the postwar period the BoF continued to play a key role in facilitating domestic re-industrialization a consequence of which were the so-called trentes glorieuses.  

In line with Jörg Bibow ’s discussion, the above examples suggest a type of relationship between the government and the central bank that Keynes proposed. Keynes suggested that the relationship between the two institutions should be such that while the government, acting under the control of parliament, would make the key decisions on national economic policy it would not provide diktats to the central bank management.  Rather policy coordination with the latter would have to be done cooperatively. How can such an institutional framework exist where one institution is clearly subordinate to the other and yet maintains a high degree of autonomy? One can clearly see such a relationship in regards franchises which operate quasi-autonomously while observing the rules created by the parent corporation.  In fact Robert Hockett and Saule Omarova treat private commercial banks as public franchises of the government.  This franchise framework suggests the need for a particular legal-institutional framework or bundle of rights undergirding central banks granting them the privilege to operate autonomously within the context of the state’s governance goals.

Debunking neoclassical myth-making about money and central banking requires a deeper understanding of institutions and the ways in which politics and the law provide varying foundational frameworks to the economy. This insight, at the heart of the approaches of institutional economists such as John R. Commons and American Legal Realists Robert Hale and Wesley Hohfeld, is vital to understand how bargaining power is determined in all markets (including that of labor) and between institutions (say central banks and parliaments).  And of course, we cannot understand the nature of money without recognizing its legal foundations. The neoclassical failure of the imagination to recognize alternatives to the independent central bank model with the concomitant aim of democratizing credit reflects an analytical weakness in regards the understanding of institutions and how they construct the economy.