Another nail (or two) in the coffin of endogenous money theory?

Ben Southwood sent me the following new piece of research. The abstract is telling:

We provide empirical evidence for the existence, magnitude, and economic cost of stigma associated with banks borrowing from the Federal Reserve’s Discount Window (DW) during the 2007–2008 financial crisis. We find that banks were willing to pay a premium of around 44 basis points (bps) across funding sources (126 bps after the bankruptcy of Lehman Brothers) to avoid borrowing from the DW. DW stigma is economically relevant as it increased some banks’ borrowing cost by 32 bps of their pre-tax return on assets (ROA) during the crisis. The implications of our results for the provision of liquidity by central banks are discussed.

MMTers and other endogenous money theorists are very mistaken to ignore this very important phenomenon, which questions the very validity of their whole theoretical framework.

Meanwhile, SNL reports (via Valor Econômico) that Brazil is weighing up relaxing reserve requirements to boost the supply of credit. Impossible according to endogenous money theory. Unless…

In fact, Brazil plays with reserve requirements all the time. It already lowered them in May this year, in July 2014, and even in September 2012. In contrast, it had raised them in 2010 to counter inflationary pressure. Perhaps those policies did not have any effect, as endogenous money theory would speculate. In fact, research published in June 2015 on the effects of Brazil reserve requirement changes does highlight impacts on lending:

We compare the macroeconomic effects of interest rate and reserve requirement shocks by estimating a structural vector autoregressive model for Brazil. For both instruments, discretionary tightening results in a credit decline. Contrary to an interest rate shock, however, a positive reserve requirement shock leads to an exchange rate depreciation, a current account improvement, and an increase in prices.

Endogenous theorists (including some economists at the BoE) claim that their models reflect the reality of ‘modern’ fiat monetary and banking systems. A quick look at the facts seems to prove them wrong.

PS: the Farmer Hayek blog published a short interview of me over three posts. The first post covers why inflation seems low in the US. The second post what economists get wrong about banking. And the last post what my thoughts were on NGDP targeting and free banking.

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5 responses to “Another nail (or two) in the coffin of endogenous money theory?”

  1. Justin Merrill says :

    What scares me about this is that the macro-prudential crowd will take this as proof that reserve requirements are potent, and therefore a useful policy tool. I’d like to do away with RR’s and prefer to explain how the banking sector behaves without them. Otherwise, if your theory of the money supply is M=H*RR, how will you understand how things work with no reserve requirements, or especially in a free banking economy?

    • Julien Noizet says :

      Sadly, the current economic fashion is for a managed economy. So policymakers will try to play with every variable they find to influence the financial sector and the economy.

      But I agree, reserve requirements and their derivatives like the LCR don’t teach us how banks really react and create money in a free system.

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