Bank of England Endorses Post-Keynesian Endogenous Money Theory


Well, the Bank of England has finally come out and said it: loans create deposits; banks create money and don’t simply lend out savings; and the money multiplier in the economics textbooks is false. Actually, we’ve known this for a long, long time. While the BoE report references much Post-Keynesian work — including early work by Nicholas Kaldor and Basil Moore’s path-breaking 1988 book Horizontalists and Verticalists — they would have done well to look up the findings of the Radcliffe Commission in the UK in 1957 (I have written about this extensively here).

It is fantastic that the BoE has finally decided to lay its cards on the table and be honest with the public about how money is created. Unfortunately though, the report is not willing to make certain concessions. For example, it largely paints the Quantitative Easing programs as being effective — which they were not — and it also claims that the BoE still sets the variable that has the most influence on money creation; that is, the interest rate. This latter point ties into the whole debate surrounding the so-called ‘natural rate of interest’ (which I have dealt with extensively here).

With regards to the central bank’s power to control lending the BoE authors insist that the “ultimate constraint on lending” is monetary policy. They explain how this functions as such,

The interest rate that commercial banks can obtain on money placed at the central bank influences the rate at which they are willing to lend on similar terms in sterling money markets — the markets in which the Bank and commercial banks lend to each other and other financial institutions… Changes in interbank interest rates then feed through to a wider range of interest rates in different markets and at different maturities, including the interest rates that banks charge borrowers for loans and offer savers for deposits. By influencing the price of credit in this way, monetary policy affects the creation of broad money. (p8)
Now, the functionality of the mechanism that the BoE authors describe is perfectly in keeping with Post-Keynesian endogenous money theory — it is also perfectly in keeping with recent innovations (if we can call them that) in the New Keynesian literature by the likes of David Romer who replace the vertical-sloping LM curve in the ISLM model with a Taylor interest rate rule. But to a Post-Keynesian the characterisation of the setting of interest rates as being the “ultimate constraint on lending” is complete nonsense. Just to get a sense of the BoE authors’ belief in the borderline omnipotence of the central bank let us once again quote them in the original,

The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. (p1)

Actually no. The amount of money created in the economy is ultimately dependent on the demand for credit! Yes, the supply price of this credit — that is, the interest rate — will influence the demand for credit; but if we have learned anything from the economic stagnation of the past few years it is that the demand for credit is what truly drives credit creation and the supply price of credit is of secondary importance. Messing around with the supply price of this credit has very different affects, say, post-2008 as it did, say, at the beginning of the housing boom.

So, what decides the demand for credit? There are any number of different things that drive credit demand. Speculative excesses in the property or stock market might lead to substantially increased demand for credit as investors borrow money to speculate. Inflationary wage-price spirals may also drive the demand for credit as firms borrow money to meet increasing wage bills. But if we were to give one single determinate that is likely the most important in considering the demand for credit I would say: income growth. Yes, that’s right: GDP growth.

At this point we encounter the classic Keynesian accelerator effect where increases in income cause increases in investment which in turn cause increases in income and so on in a circular fashion. What central banks do in such cyclical upswings or downswings of income and investment is of secondary importance.

Now, here’s a controversial thought: what if the BoE authors actually understand this? We know that they have read the endogenous money literature which states all of this quite explicitly. Also, any time I encounter central bank economists they seem very pessimistic about their ability to spur lending. But what if in their official documents they simply cannot bring themselves to say it out loud?

Perhaps we should think of the central bank as a corporate institution that, like any corporate institution, seeks both funding/revenue and influence. And then perhaps we should understand their bald assertions that they are almost omnipotent in their creation of credit money not simply as self-aggrandisement — although there is surely an element of that — but as a sort of public relations exercise deisgned to keep the public interested and the politicians listening.

After all, it would be a strange emperor that would reveal his own nudity in front of his subjects. But still, the BoE — which is surely the most honest of the central banks — should certainly be given credit for at least giving its loyal subjects a little grin and a wink as it parades in front of us in its birthday suit.

Update: It looks like some young economists in the BoE are very intent on getting this message out. They have even created some Youtube videos explaining the reality of money. Wow!


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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17 Responses to Bank of England Endorses Post-Keynesian Endogenous Money Theory

  1. NeilW says:

    You got to admit it’s a start though, and they’ve known this is how it works for a very long time

    My favourite quote on the subject is from ‘Post-War Banking’ by Reginald McKenna (the former Chancellor of the Exchequer) which I believe is from 1928

    “While banks have this power of creating money it will be found that they exercise it only within the strict limits of sound banking policy.”


    “I am afraid the ordinary citizen will not like to be told that the banks or the Bank of England can create or destroy money. We are in the habit of thinking of money as wealth, as indeed it is in the hands of the individual who owns it, wealth in the most liquid form, and we do not like to hear that some private institution can create it at pleasure. It conjures up a picture of an autocratic and irresponsible body which by some black art of its own contriving can increase or diminish wealth, and presumably make a great deal of profit in the process.”

  2. Rob Rawlings says:

    I have a question (actually 2)

    you say:

    “The amount of money created in the economy is ultimately dependent on the demand for credit!”

    Lets say that the interest rate set by the BoE is 5%, and the demand for credit increases for endogenous reasons. lending increases. The BoE then increases interest rates from 5% to 20%.

    Would you agree that potentially this increase in interest rates could actually cause the total amount of loans to decline to below the level before the initial increase in the demand for credit ?

    If you answer yes: Doesn’t this apply that demand for credit and BoE interest rate both have an effect on the actual amount of lending ?

    If you answer no: What effect does the BoE IR have if it has no influence on the amount of lending ?

    • I already dealt with this in the piece:

      Yes, the supply price of this credit — that is, the interest rate — will influence the demand for credit; but if we have learned anything from the economic stagnation of the past few years it is that the demand for credit is what truly drives credit creation and the supply price of credit is of secondary importance. Messing around with the supply price of this credit has very different affects, say, post-2008 as it did, say, at the beginning of the housing boom.

      • Rob Rawlings says:

        “Messing around with the supply price of this credit has very different affects, say, post-2008 as it did, say, at the beginning of the housing boom.”

        Well, (other these equal) both at the start of the housing boom and now increasing interest rates would reduce the qty of loans supplied. Both at the start of the housing boom and now an increase in the demand for credit would have caused the qty of loans supplied to increase.

        I’m just not clear why:

        ” The amount of money created in the economy is ultimately dependent on the demand for credit!”

        is any more true than:

        ” The amount of money created in the economy is ultimately dependent on the interest rate set by the BoE”

        And really: The amount of money created in the economy is ultimately dependent on both the demand for credit and the the interest rate set by the BoE” seems more correct than both.

    • The demand for credit is the primary driver. This in turn is driven by, among other things, income growth. The supply price of credit is a secondary driver.

      It’s a bit like talking about the force of gravity when I jump. Does my jump counter gravity? Yes. But which is stronger? Obviously gravity. The gravity “overcomes” my jump more than my jump “overcomes” gravity. Ditto for the demand for loans.

      Similar things are discussed in any supply-demand relationship. Example: which is more formative, price effect or underlying demand? Etc.

      • Lord Keynes says:

        “The amount of money created in the economy is ultimately dependent on the interest rate set by the BoE”

        Except demand for credit is complex and caused by many factors well beyond the interest rate. You’re just trying to reduce complex real world phenomena to silly linear functions: e.g, capital investment is a function of the interest rate, quantity demanded a simple function of price, and the list goes on and on.

  3. Deus-DJ says:

    “After all, it would be a strange emperor that would reveal his own nudity in front of his subjects.”


  4. Dan says:

    This is really interesting and the paper is a good discovery, but I doubt it represents ‘The Bank view’ in any overarching sense. It’s a research paper by three economists, and probably an important one, but not necessarily to be taken as a guide to future bank policy. I don’t see Carney announcing his conversion to post-Keynesianism. Like in most institutions there will be people at the Bank who disagree, and I suppose in that sense the Bank should be congratulated for its openness and for its minor outbreak of pluralism. You are probably right about your Emperor’s clothes analogy.

  5. Robert White CANADA says:

    Keynes academic work was responsible for the inception of the International Monetary Fund, World Bank, and the European Union. Keynes work informs
    our knowledge of Global Economics and Theory. Bankers and their minions in government finance departments don’t like Keynes and _never_ did in the past. Keynes is simply a theorist they would rather not contend with given their incessent longing for profit at a cost to our collective economies. Disregard Keynes at your peril.

  6. Pingback: La Banca d’Inghilterra: “Tutto quello che sapete sulla moneta è sbagliato” | Justicia Economica Global

  7. Pingback: Money Primers | Stephen Hannah

  8. Jake says:

    How does income growth increase demand for credit? bussinesses and families purchasing homes through mortages would have less of a need for credit if they had increased income.If they have more money surely they need to borrow less.

    Also if Central banks’ interest rate has zero realtionship with banks propensity to lend,why on earth do they raise interest rates on mortages depending on the BoE’s interest rate.

    And if there is zero realtionship between central banks and commercial bank lending,are you ulitmately saying that role of the governor of the bank of england :to set interest rate is entirely redundant.As banks create money endogenously how is their any relationship to the price they impose on borrowers through interest charges and this interbank interest rates and BoE interest rate?why do banks need to borrow from each other anyway?

  9. jake says:

    Also the recent spate of predatory behaviour by banks like RBS who deny credit to viable small bussinesses inorder to foreclose and aquire their assets and improre the banks liquidity contradicts the idea that credit expansion is purely demand led.This is case of banks rescinding credit despite their being a demand for it by businesses.

    • Jake says:

      I think a more realistic cause for increased demand for credit would be low credit costs or interest rates at the retail level.Increased M4 will spur economic activity.IF the cost of credit is low, people will borrow (as they will feel that they will be able to afford the borrowing),Banks will create new money through retail loans which then increases economic activity(consumption which also increases income).

      This is the odd thing about our economy .Private banks with a monopoly on seignorage are not lending because economic activity is low because private banks are not lending.

      Also banks have a huge advantage from the spread between the base rate and the interest they demand from retails borrowsers.The Central bank base rate is the rate at which central banks create reserves for private banks on demand for interbank lending and transfers for the clearing of the balance of pyaments between indivdual banks.

      • Lionel says:


        As you can see from current situation, households do not borrow (and firms either) even though credit is cheap! Moreover, that credit is demand-driven does not mean that any household or firm gets the credit it asks for. Banks have restrictions standards when they grant credits. For instance, they analyze borrower’s creditworthiness. Then, in 2008, due to the lack of confidence within the interbank market and the credit market, combined with overall financial turmoil, banks either refused to grand credit to some borrowers who would have got it before the crisis, or accepted to lend them money, but with higher credit standards (for example borrowers must hold higher equity).

        Thus, banks analyze the credit demand coming from borrowers and, according to their credit standards, grant the loan or not. It is in this sense that credit is demand-driven. In fact, that credit is demand-driven is pretty obvious for entrepreneurs I guess. If you speak with them, they will tell you that their decisions to borrow some money from the bank depends on financial/business opportunities in the future. Once again, this does not mean that each time entrepreneurs ask for credit they get it (banks assess entrepreneurs’ creditworthiness and the viability of their projects in order to decide whether or not they grant the loan).

        To better understand what credit-driven means, maybe is it easier for some to understand why credit is not supply-determined/driven. Think again about our entrepreneur. It is because he believes there are good market opportunities in the future that he asks for credit. Hence, it is the demand for credit from the entrepreneur that is the starting point. Said differently, it is because entrepreneurs want credit that they get it, if the bank decides they are creditworthy. A contrario, it is not because credit is cheap (trough low interest rates, say 1%) that entrepreneurs automatically ask for credit. If they believe that there is no opportunity in the future to make money, they will not ask for credit. This is especially obvious with the credit easing “solution” that has been conducted by many central banks. The idea is to flood banks with liquidity, so that the latter will redirect this liquidity to firms and households to increase production and employment. The underlying idea is that firms and households get credit because banks, central banks or governments want they to get credit (supply-driven), in order to boost production and employment. Similarly to credit easing, very low interest rates are supposed to increase investment and, therefore, output and employment. Because interest rates are low, credit is cheap, hence firms and households borrow. This is the supply-side view. But the current situation leads everybody to see that it does not work!

        One step is probably needer in order to better understand the supply-side view of banks credit. Basically, as you can read in several macroeconomic textbooks, the money multiplier explains how banks create money. They lend money, relative to the deposits they hold. Hence the view that deposits create loans. Deposits stand at the liability side of banks’ balance sheets, whereas credits are at the asset side. Then, banks have deposits, from which they can lend some money. Therefore, this implies that banks have to hold some liabilities to grant credit to firms and households. With credit easing, the idea is to expand the amount of money banks hold so that they can lend more to the public. It is because central banks, governments and banks want households and firms to ask for credit (supply-side view).

        However, banks do not need deposits to grant loans (as it is well explained in the BoE’s paper). The reverse causality is actually true: banks create deposits when they make loans. Therefore, the suppy-side view is not only wrong, but also useless to boost the economy.

        I hope my explanations could help some of you to understand the underlying idea of the endogenous money view. I have explained it at length here (hopefully it did not bore you :)), but it is an important aspect to understand, whether you agree with it or not.

  10. Jake says:

    Not boring at all.very interesting.appreciate the effort to explain.

    The fact that banks do not lend despite low interest rates and quantitative easing which improves their balance sheet is indicative of a banking confidence issue.

    My point was that “(as they will feel that they will be able to afford the borrowing”) because the cost of credit is low at the retail level.But Critically as you say the key is that the borrower has to believe he can make a return,either through wages to pay off the mortage or profit to pay off a bussiness loan.

    When banks decided that no one is credit worthy and decided against lending and creating new money in to the economy, this has the effect of depressing the economy.Which was due to a credit crunch in the interbank market.

    If however the banks did aggressively lend to productive businesses or as they are doing now in the London property market into residential mortages.Then the economy would improve.As new lending would create the conditions that would convince banks that conditions were suitable for increased lending.Basicly htis would support “viability of their projects”

    What the failure of the banks to invest in businesses in the last few years has indicated is that when banks fail to lend to businesses due to poor confidence(in the broader economy) a public lending agency should intervene to get new money into the economy.This public agency should lend to small and medium businesses at a low rate which will help sustain employment and consequently demand which feeds back in.(Preferable not fuelling property asset prices)

    So in a sense I still see it as supply side issue as while borrower needs to believe that they will be able to repay the loan,it is only when banks are lending into the economy that this is likely to take place.It’s just that the banks actually have to Lend to create the demand that engenders the conditions ideal for the borrower,as opposed to being a well liquedated inactive zombie bank.

  11. jake says:

    OK now I Get it.Bank lending isn’t affected by the supply price (interest rates) as much as Demand (borrowers believing that they can create sufficient return and meeting a bank’s credit worthiness standards,although these will be variable,think about Minsky’s credit cycle,)

    However the way I see it is that banks are more likely to lend when other banks are lending as new money is being entered into the economy,or high government spending.We need these things to happen to stimulate ecnomic growth.Which is why I support ideas like Professor Richard Werner who advocates providing banks with a quota system (in return for central bank buying up their bad assets) which forces banks to lend to productive bussinesses and households.

    It’s just that initally it seemed a bit catch22 to say that bank lending increases when income rises as I didn’t understand how incomes can rise without banks lending in the first place; stimulating business and economic activity.I suppose this would happen when government spending increases.

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