Chapter 1
Rethinking Monetary Economics

Money has disappeared from economic thinking, absorbed into Interest and Prices.1 Its essential role in the economy is as invisible to economic theory as water is to fish. This is not just a problem for theory. When the monetary system breaks, it is the job of economists to fix it, and theory is the economist's sharpest tool.

The last great proponents of the view that money matters in the economy-monetarists like Milton Friedman, Karl Brunner, and Allan Meltzer-were humbled by the failure of Paul Volcker's "monetarist" experiment at the Federal Reserve from 1979 to 1982.2 For the next 40 years, the Federal Reserve's monetary policy drove interest rates downward until they could go no lower.3 We are now surrounded by the legacy of this policy: mountains of debt, insane real estate prices, eye-watering equity valuations, and Gilded Age levels of inequality. Perhaps the pathologies of an era that ignored the quantity of money as a factor in economic growth are a good reason to pay attention to the quantity of money once again.

Our goal is not to rehabilitate the old monetarism. Instead, we want to reexamine the role of money in the economy, taking the classic quantity theory of Irving Fisher and the Cambridge economists as a point of departure. We want to build a monetary economics that coheres with the current state of our financial architecture. The economic impact of money has not vanished from real life, even if we now carry less cash and the role of money has been abstracted away from economic theory. The quantity of money continues to affect growth, inflation, and asset prices. This book explains how.

Macroeconomics Without Money

The preferred tool of the vanguard in moneyless macroeconomic theory is dynamic stochastic general equilibrium (DSGE) modeling.4 The paradigmatic DSGE model is the "real business cycle" (RBC) model in which large-scale macroeconomic fluctuations are traceable to changes in productivity or household preferences.5 Random fluctuations or "shocks" affecting technology and tastes take center stage in contemporary macroeconomic analysis.

The RBC model supports a distinctive narrative about the macroeconomy. Developments in the economy are the result of technology-driven fluctuations in output and the efforts of households to optimize after observing them. Wages, interest rates, consumption, and investment adjust to the new state of technology through optimizing activity and quickly converge to their equilibrium values. All analysis can be carried out in terms of "real" variables, measured independently of their monetary values.

To achieve even a modicum of influence for money, some kind of external device is needed to extend the RBC model. "Neo-Keynesian" economists shoehorn an assumption about "sticky" wages or prices into a model that is otherwise largely identical to an RBC model.6 These stopgap theoretical devices, reverse-engineered to generate the short-term effect on inflation they are meant to explain, are defended with elaborate handwaving about why sticky prices are obvious to economists but imperceptible to economic actors.

Sticky-price models of the economy include a "price level" whose changes can be interpreted as inflation. The price level establishes a one-size-fits-all exchange rate between monetary values and "real" quantities like aggregate consumption, aggregate output, and the opportunity cost of leisure. As the inverse of the price level, in effect, money is a redundant variable and may be excluded from the model. The price level is influenced in the short term by changes in an interest rate, which is set by a central bank and taken to capture the stance of "monetary policy." Everything one needs to know about money, it seems, is encapsulated in the interest rate (a price for consumption today versus consumption tomorrow) and the price level.7

Such grudging admission of an economic role for money via interest rates and the price level comes with the enormous caveat that changes in monetary conditions affect the economy only in the "short run," as "transitory" responses experienced on the way to a new, "long-run" equilibrium in which money once again takes a back seat to shocks in tastes and technology.

Given this state of consensus in macroeconomic theory, current thinking on monetary economics consists of situating the rate of interest controlled by the central bank relative to an unobservable rate of interest called "r-star," or the rate of interest that would prevail in capital market equilibrium. Monetary policy is tight or loose depending on whether the central bank's policy rate is above or below r-star.

Unsurprisingly, RBC and Neo-Keynesian models have little useful to say about phenomena like proliferating debt, asset price inflation, growing inequality, the Global Financial Crisis (GFC) of 2007-2009, or the post-COVID episode of inflation. We can hardly look to current monetary economics to understand our current situation.

Broad Money and the Banking System

The old monetarism defined money too narrowly, focusing on the liabilities of the central bank as the decisive instruments of control for monetary policy. Much of contemporary economics repeats the same error, limiting money to cash and reserves supplied by the central bank. The relevant quantity of money for economic activity is much broader. Most of it is deposit money supplied by banks. Accordingly, much of this book is devoted to centering banks in a conception of the monetary economy.

Contrary to what is taught in basic economics courses, banks do not lend pre-existing funds. They do not intermediate funds between depositors and borrowers or multiply the reserve money supplied by the central bank. Banks create deposit funding out of nothing.8 Over the course of this book, we will justify this claim and refute the standard textbook stories.9

Banks create money when they make new loans. Deposit money is credited to a borrower on the books of the bank against the recognition of a loan asset. The deposit money created by the loan remains in circulation until the principal of the loan is repaid. Excess money balances can be exchanged for goods, services, or assets, but these transactions only transfer the ownership of the money balance. Society cannot collectively "get rid of" deposit money except by repaying loans.

The ability of banks to create their own funding in the form of deposit money has enormous consequences for economic analysis. It means that any investment that can be funded with bank credit need not draw on aggregate savings. Aggregate savings are costly because they can only be formed when someone in the economy reduces their consumption. Bank credit economizes aggregate savings. This was once well-known to economists like Walras, Fisher, Marshall, Wicksell, and the Keynes of the Treatise on Money. As the great Joseph Schumpeter wrote in his monumental History of Economic Analysis,

Banks do not, of course, "create" legal-tender money and still less do they "create" machines. They do, however, something . which, in its economic effects, comes pretty near to creating legal-tender money and which may lead to the creation of "real capital" that could not have been created without this practice. But this alters the analytic situation profoundly and makes it highly inadvisable to construe bank credit on the model of existing funds' being withdrawn from previous uses by an entirely imaginary act of saving and then lent out by their owners. It is much more realistic to say that the banks "create credit," that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them. And the reason for insisting on this is that depositors should not be invested with the insignia of a role which they do not play. The theory to which economists clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the "supply of credit" which they do not have. The theory of "credit creation" not only recognizes patent facts without obscuring them by artificial constructions; it also brings out the peculiar mechanism of saving and investment that is characteristic of full-fledged capitalist society and the true role of banks in capitalist evolution.10

The meaning of those "patent facts" for that "peculiar mechanism of saving and investment" is the axis on which this book turns.

The centrality of banks in the monetary system points to the credit- and claim-based nature of fiat money. Bank money is not backed by reserves, fractionally or otherwise. Instead, it is underwritten by credible claims to future economic surpluses. The same is true for money issued by the government: the government's ability to redeem its debt and preserve the unit of account in terms of its monetary standard depends on the credibility of its claims to future tax revenues. We explore this and other aspects of fiat money systems at length in Chapters 2, 5, and 9.

Bringing out the role of banks in the contemporary economy is complicated by two main obstacles. First, academics tend to view banks through the same corporate finance lens as other firms, despite the special...