For teachers and students of economics
A post I wrote nearly two years ago had the emphatic title “Kill the money multiplier!” A recent article in the Bank of England’s Quarterly bulletin, by Michael McLeay, Amar Radia and Ryland Thomas, is a little more circumspect, but the message is essentially the same. One of their ‘headlines’ is: “Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.”
The article has created quite a stir. (See this post from Frances Coppola.) Some have tried to suggest that it represents a fatal blow to mainstream theory, or current policy. David Graeber writes that the article has “effectively thrown the entire theoretical basis for austerity out of the window.” This is nonsense. What the article does is outline the understanding of most of those currently involved in monetary policy (including academics), and contrasts this with how monetary policy is taught in undergraduate textbooks. (I should add that the article does this rather well, and is well worth reading.)
So why is there this disconnect between current thought and the undergraduate textbooks? The textbook approach does have its supporters: see this post by Nick Rowe for example. I could try and portray this as a continuing battle between Wicksellians and Monetarists, and discuss whether Quantitative Easing is a win for either side. That would make a nice discussion. However I think using textbooks as a pretext would be wrong.
Think of another standard part of textbook macro besides the LM curve and money multiplier. One of the first things students also learn is the Keynesian multiplier, where changes in government spending can lead to much larger changes to output because the marginal propensity to consume is closer to one than zero. Again this does not correspond with how most macroeconomists today think about the real world. Is this disconnect because of a rearguard action by old fashioned Keynesians who insist that the 1960s way of doing macro must survive? Of course not. (Any new readers please note, I am not arguing against Keynesian economics or that the multiplier is zero - see here. I just think we would be better off with new undergrads assuming a multiplier of one, and focusing instead on why output was demand determined in the first place.)
In both cases, this disconnect between undergraduate textbook macro and current practice has a far simpler explanation - the textbooks are out of date. The core of what is taught to undergraduates has not changed in fifty years, whereas macroeconomic thinking has changed substantially. However we are not using fifty year old textbooks. You will actually find a great deal of the more modern stuff in the textbooks, but essentially in the form of add-ons. So first students are taught that central banks fix the money supply, and then they learn about Taylor rules. First they are taught about a Keynesian consumption function (with a large mpc), and then they learn about consumption smoothing.
This is silly. It is also dangerous, because the problem with add-ons is that they may not get added on. In particular, students who learn all about the money multiplier may never go on to be taught that if banks are not short of reserves or have easy access to them, they can simply create deposits by issuing loans. I suspect it is this lacuna which helped motivate the Bank’s authors to write their article.
So how does this silly and dangerous situation persist? One clue is that the same gap between what is taught and current practice does not exist at masters level. Masters teaching is much less dependent on the textbook. So I think we really need to look at the production of textbooks to understand what is going on. Now what follows is a theory, and as I have never written a textbook or talked about this to those who have it is based on no empirical evidence - but my theory is microfounded!
Suppose a leading macroeconomists wants to write a textbook, and they want to throw away the LM curve, and the Keynesian consumption function - or at least not start off with these out of date bits of kit. The publisher will do some market research. The market will consist of two types. There are the young radicals, who are just starting out and are desperate to teach in a more modern way. There are also the older traditionalists, who have been teaching macro according to the existing textbooks for some time. They will tell the publisher that while they have no objection to this more modern stuff appearing somewhere - indeed they think it is a good idea - they really need a textbook that starts off in the traditional way so that they do not need to rewrite their whole course. The publisher then persuades the author that, to make any money, they need to start with the traditional stuff.
If this textbook writer is representative, then the radicals will only have traditional textbooks to choose from. They have to be very radical indeed to teach without a textbook, so they start teaching in the traditional way. This unfortunately means that the radical becomes over time a traditionalist, and the process continues. The once radical will tell themselves that assuming money is fixed, while clearly not literally true, is not so misleading. The marginal propensity to consume may in practice be nearer zero than one, but at least it gets the kids to do some simple algebra and think about system feedbacks. And hey, a reserve constraint on banks issuing money could exist in some situations.
As a result, some students end up believing that banks just lend out deposits and that the central bank controls the money supply via a multiplier. And a central bank feels it needs to write an article pointing out that this is not so. That I think is a bit shocking.