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Leveraged Bubbles and the Importance of Endogenous Money

If I had to pick out the biggest problem with modern macro it would certainly be the fact that banks are generally viewed as mere intermediaries. This means that money is just a veil between the real economy and the banking system isn’t an important part of the economy. And it further means that debt doesn’t matter that much because it’s just loanable funds being passed from depositor to borrower (which is of course all wrong!).  This view has finally started to shift pretty dramatically in the last few years and mainstream economists are increasingly beginning to adopt the endogenous money view and embedding banks into their models.

Here are two very good pieces that highlight these points:

  1. Banks Are Not Intermediaries of Loanable Funds – And Why This Matters.
  2. Leveraged Bubbles.

The first paper concludes:

To summarise, the key insight is that banks are not intermediaries of real loanable funds. Instead they provide financing through the creation of new monetary purchasing power for their borrowers. This involves the expansion or contraction of gross bookkeeping positions on bank balance sheets, rather than the channelling of real resources through banks. Replacing intermediation of loanable funds models with money creation models is therefore necessary simply in order to correctly represent the macroeconomic function of banks. But it also addresses several of the empirical problems of existing banking models.

This opens up an urgent and rich research agenda, including a reinvestigation of the contribution of financial shocks to business cycles, and of the quantitative effects of macroprudential policies.

The second paper concludes:

In recent years, central banks typically stayed on the sideline when asset price bubbles inflated. This hands-off approach has been criticized, among others, by institutions such as the BIS that took a more sanguine view of the self-equilibrating tendencies of financial markets and warned of the potentially grave consequences of asset price busts. The critical assumption was that central banks would be in a position to manage the macroeconomic fall-out. They could clean-up after the mess. While the aftermath of the dotcom bubble seemed to offer support for this rosy view of central bank capabilities, the 2008 global financial crisis dealt a severe blow to the assumption that the fall-out of asset price bubbles was always and everywhere a manageable phenomenon. This observation meshes well with the key finding of this paper: not all bubbles are created equal.

In this paper, we turned to economic history for the first comprehensive assessment of the costs of asset price bubbles. We provide evidence on which types of bubbles matter and how their economic costs differ. From a monetary and macroprudential policy point of view, our findings help understand the trade-offs involved in the “leaning against the wind” and “mopping up after” strategies. We show that when credit growth fuels asset price bubbles, the dangers for the financial sector and the real economy are much more substantial. The damage done to the economy by the bursting of credit-boom bubbles is significant and long-lasting. These findings can inform ongoing efforts to devise better guides to macro-financial policies at a time when policymakers are searching for new approaches in the aftermath of the Great Recession.

Bravo! That will all be familiar to anyone who’s been listening to me repeat these points almost every day for the last 7 years, but it’s sure nice to see that the message is spreading well beyond some heterodox blogs.