Private Debt and Growth:-A Review of the Endogenous Money Debate

Amogha Sahu

Introduction

This paper will attempt to present the debate over the macroeconomic effects of private debt in the
Post-Keynesian literature. The central piece of contention is Keen (2014), where a ‘credit monetarist’
a la Werner(2006) is used to demonstrate that aggregate demand is equal to effective demand and
the change in debt. Keen aims to demonstrate that private debt is the main driver of
macroeconomic change. However, this has led to a significant reaction in the literature. Palley (2014)
and Lavoie(2014) have critiqued Keen for what they call ‘a return to black box economics’, accusing
him of using ill-defined concepts such as ‘velocity’.

Keen’s Argument

Steve Keen has recently made the argument (Keen, 2014), that the proposition that Aggregate
Income+ Change in Debt= Aggregate Expenditure is perfectly consistent with a Post-Keynesian
Sectoral Balances approach. Keen wishes to demonstrate that private debt is vitally important to
economic growth, and allows entrepreneurs who borrow to ‘live beyond their means’ in order to
finance future income. Keen quotes Hyman Minsky to demonstrate this point:-

“ For real aggregate demand to be increasing, given that commodity and factor prices do not fall
readily in the absence of substantial excess supply, it is necessary that current spending plans,
summed over all sectors, be greater than current received income and that some market technique
exist by which aggregate spending in excess of aggregate anticipated income can be financed. It
follows that over a period during which economic growth takes place, at least some sectors finance a
part of their spending by emitting debt or selling assets. For such planned deficits to succeed in
raising income it is necessary that the market processes which enable these plans to be carried out
do not result in offsetting reductions in the spending plans of other units.”

The first part of Keen’s exposition demonstrates this below:-

(S-I)+(T-G)=0
(I-S)=(T-G)
This might suggest that the an act of saving on the one side (an addition to savings balance for either
the private sector or the government) has to be balanced out by an act of spending on the other
side, to fulfil the accounting identity. Therefore, aggregate expenditure is always equal to aggregate
income. Even if one sector is dissaving, the other sector must be saving.

Keen develops an alternative framework to dispute this claim, borrowed from Minsky (1965). Given
equations for consumption and investment, looking at a closed economy. This is shown below, with
C as consumption spending, W as wage payments, D as distributed earnings and interest payments
and α as the propensity to spend out of distributed earnings and interest payments. For investment,
ϒ is the leverage factor and Q represents retained earnings for firms.

C=W+(α)D
I=(1+ϒ)(Q)
Given u as the proportion of savings available for investment, we have this equation:-

ϒQ>u(1- α)D
or Leveraged investment> Savings available for investment

ϒQ- u(1- α)D>0

Excess ‘unfunded’ leveraged investment>0
This is the proposition that Keen has to demonstrate, to show that investment can be financed
without effective savings. He bridges the gap between ϒQ and u(1- α)D by using money creation and
excess velocity as a variable (∆M):-

ϒQ=∆M + u(1- α)D

Money creation bridges aggregate income and aggregate expenditure. Keen also suggest that there
is a bridge between aggregate expenditure and aggregate income through Debt. Therefore,
according to Keen, aggregate expenditure can be in excess of aggregate income due to money
creation, which equates aggregate income equal to aggregate expenditure of the previous period.
Keen sets out an alternative framework, to show the relationship between debt, aggregate
expenditure and aggregate income:-

CW=W+δ⋅ddtDWC
CΠ=ΠD+δ⋅ddtDΠC.
I=ΠR+δ⋅ddtDFI.

Note:
Cw = Consumption for workers
CΠ= Consumption for firms
W= Wage payments
δ= Propensity to spend out of debt
I= Investment
ΠD= Distributed Profits
ΠR= Retained Earnings
ddtDWC= New Debt generated for households by the banking system
ddtDΠC= New Debt generated for firms to consume by the banking system
ddtDFI= New Debt generated for firms to invest by the banking system.

(aggregate expenditure)Ye=W+ ΠD+ ΠR + δ⋅(ddtDWC+ddtDΠC+ddtDFI)

(aggregate income)Yi= W+ ΠD+ ΠR

YE−YI=δ⋅(ddtDWC+ddtDΠC+ddtDFI)

So, in this set of equations, what allows households and firms to spend more than they earn
(collectively) is debt generated by the banking system (as it allows for credit creation). However, he
now has to reconcile the fact that there seem to be two different drivers for expenditure to be
greater than income; money and debt. To do this, he draws on the Post-Keynesian concept of
‘endogenous money’, where money creation is endogenous (i.e by the private sector, rather than
through the actions of the central bank).
For members of the ‘Circuit School’ of Post-Keynesians, the banking sector can create money
precisely because it can expand it’s balance sheet on both sides, creating deposits (a liability)
alongside it’s assets. However, these deposits can also be traded, as a medium of exchange, and can
therefore serve as money. Given that an expansion of credit takes place when banks lend money
out to the private sector, there is also an expansion of money. On the assets side of the balance
sheet, the bank holds a loan. However, the banking sector also holds the collective deposits of the
private sector as it’s liabilities. In these circumstances, an expansion of new debt through the
banking system leads to an increase in the money supply.
This allows Keen to say that:-

ddtM(t)=ddtD(t) => The rate of money growth is equal to the rate of debt growth

M(t)=ddtD(t)=M(0)+D(t) => The Money Supply is equal to fiat money (produced by the central bank)
and the debt in the second period.

Y(t)=V(t)⋅M(t)=V(t)⋅integ(ddtD(t))=> Keen uses one of the traditional equations in monetary theory

(the quantity theory of money, or Y=MV) to demonstrate that Output is equal to the rate of debt
growth multiplied by the velocity of money.

Y(1)=Y(0)+v(1)⋅ΔD(1)

This allows Keen to demonstrate that the rate of money growth are equal to the rate of debt
growth. Absent exogenous changes in the money supply by the central bank, debt-financed changes
in expenditure cause changes in income by creating new money. This is because lending from private
banks generates deposits (on the liabilities side). Given that these deposits are ‘media of exchange’,
a debt-financed expenditure effectively creates new money.

This is shown above. As the bank produces credit, it also produces deposits which can be used as
media of exchange. Therefore, cash borrowings from the bank (Cash) and credit borrowing from the
bank (Card) both create money. Keen also makes the point that orthodox economic theory draws a
straight causal chain from reserves to lending. For the orthodoxy, banks are limited by their deposits,
and can be constrained by increasing ‘reserve requirements’.

Keen completely rejects this view, claiming that the orthodoxy have reversed the salient causal
relations. Reserves do not lead to lending, banks lend and find reserves after the fact. He quotes the
ECB, demonstrating that reserve requirements are ‘backward-looking’, that is to say, that they look
at the deposits and reserves of the banks in the previous period, after banks have conducted lending
operations.

We already have a theory of how changes in money growth change output. As we show that private
debt can be a source of money growth, Keen therefore demonstrates the centrality of private debt
to output growth.

3. Lavoie’s Critique of Keen

Marc Lavoie responds to Steve Keen’s paper by arguing against his claim that ‘private debt has been
ignored as a driving force in macroeconomic cycles’, other than by Minsky (1969),Keynes (1937) and
Schumpeter (1932). Furthermore, he consistently accuses Keen of obfuscation and overstatement,
claiming that “There is nothing new here, except an odd use of T-accounts”. For Lavoie, most Post-
Keynesians accept that bank credit “has a role to play in expanding and contracting aggregate
demand’, but Keen’s equations needlessly complicates the issue. Lavoie’s critique is in 3 parts.

Firstly, Lavoie demonstrates that Steve Keen’s theoretical ancestors, Minsky, Keynes and
Schumpeter may not have been saying what Keen interprets them to be saying. Lavoie begins with a
critique of Minsky’s equations which relate money growth with ex post and ex ante income, shown
in Steve Keen’s paper. For Lavoie, Minsky(1975) is simply tautological. What he says is that
investment today (ϒQ) is greater than saving yesterday (u(1- α)D), and that this gap is financed by a
demand for money and a demand for bonds. Given that investment and saving have to be equal (as
an accounting identity), stating that investment today is greater than saving yesterday is identical to
stating than investment today is greater than investment yesterday. Holding all else equal, this also
means that output today is greater than output tomorrow. The “novelty”, for Lavoie, consists only in
the statement that new investment is financed by a random variable (the change in money growth).
This is shown below:-

ϒQ=∆M + u(1- α)D

∆M, which is the key variable here, is considered by Lavoie to be simply an expression of the fact
that investment can be financed by a change in money balances. Given that we assume a traditional
Keynesian tradeoff between liquid money and illiquid bonds, a change in money balances is usually
equal to an analogous change in the demand for bonds. Therefore, this is analogous to saying that
‘excess’ investment is funded by the sale of bonds, which decrease money balances. Rather than
pointing to the ability of investors to ‘increase output by credit, as if from nowhere’, it seems to
revert to the old view, which Minsky and Keen paradoxically attack, that Investment is ‘financed’ by
saving.

Secondly, Lavoie critiques Keen’s ‘credit monetarism’. Traditional Monetarism a la Friedman looks at
the equation of exchange (MV=Y) popularized by Irving Fisher and Alfred Marshall. Keen changes this
into a means of connecting money growth and debt growth through the theory of ‘endogenous
money’. However, his equations depend on the assumption that the rate of turnover of new money
(which is equal to the rate of turnover of new debt) is measurable.

Y(1)= Y(0)+ v(1)*(d/dtD(1))

(Note: Here, (1) is a time subscript. Keen is saying that output in time t+1 depends on the sum of
output in time t and velocity in time t+1 multiplied by the change in debt between time in t and t+1)

As shown above, Keen equates his ‘rate of turnover’ of new money with ‘velocity’ in the monetarist
framework. Lavoie makes the point that velocity has historically been notoriously difficult to
measure, and more often than not, becomes identified after the fact to ‘plug the gap’ in any writing
of the equation MV=Y. This reduces Keen’s equation to tautology, where any gap between the
change in debt and output being plugged, almost by definition, by any changes in velocity.

Thirdly, Lavoie accuses Keen of having misread Schumpeter’s quote, “From this it follows, therefore,
that in real life total credit must be greater than it could be if there were only fully covered credit. The credit
structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.” Lavoie
claims that Schumpeter merely refers to the ability of bank credit to ‘increase purchasing power’,
rather than aggregate demand increases through the change in debt. While Lavoie accepts Keen’s
point that, “credits create deposits”, and his exposition of endogenous money, he does not agree
that Keen can use the change in debt as a variable to ensure that aggregate expenditure can outstrip
aggregate income.

Marc Lavoie sets up two alternative equations, from Godley and Cripps (1983) and Godley and
Lavoie (2007), which demonstrate his restatement of the relationship between output (Y) and debt.

Y=FS + I
Y=FS+ D
I=D

For Lavoie, debt does not necessarily directly finance expenditure, as much as it finances production,
and allows the payment of debt. Whenever there is a debt-financed purchase of a consumption-
good, consumers purchase goods, drawing down inventories, and allows firms to pay down debt.
Although it may appear that output can be driven by debt-finance, this is not the same saying that
the ‘change in aggregate demand=change in debt’. Although the change in ‘production’, through
inventories is equal to the change in debt, aggregate expenditure is not equal to the change in
inventories. The difference between the two is equal to the change in profits.

4. Palley’s Critique of Keen

Thomas Palley’s critique of Keen rests on the fact that Keen gets the intuition right, but the direction
of causality wrong. Firstly, Palley critiques Keen for ignoring the fact that his ‘Keynesian’ model
ignores the ‘central Keynesian problematic’, the issue of injections and leakages. Given Keen’s
equation for debt, shown below:-

Y(1)=Y(0)+d/dtD(1)*v(1)

At any point, for Keen, output is determined by output of the previous period multiplied by the
velocity times the change in debt. If you follow the equations back far enough, it follows that, other
than at t=0, expenditure which is NOT debt-financed plays almost no role. However, Keynesian
macroeconomics recognizes all kinds of changes in expenditure which are not debt-financed. Palley
brings up the pertinent examples of money hoarding by corporations, the increase in which clearly
represents a decrease in aggregate expenditure.

Secondly, Palley expands on Lavoie’s critique of Velocity. For Palley, the concept of velocity is
completely ill-defined. Given that velocity is simply the rate of turnover of money, it is unclear which
transaction ‘velocity’ is supposed to represent. Is velocity the rate of turnover of consumer credit? Is
it the rate of turnover for business credit? For Palley, it is unclear how the rates of turnover across
different types of expenditure are equal, as Keen seems to assume by speaking about ‘velocity’.
Another issue, for Palley, is the relationship between credit, aggregate demand, and velocity. Given
that there are different kinds of credit, and these have different effects on aggregate demand (and
therefore, different kinds of velocities. However, “a dollar created by consumer credit is the same as
a dollar created by business lending”. This indicates that there should only be a single velocity of
money for different velocities of credit.

Furthermore, Keen’s equation provide a means for the determination of output, gives us no
mechanism for the distribution of output between consumption and capital goods. Contra Keen,
Palley presents a more nuanced macroeconomic framework, where debt does not increase one-for-
one with aggregate demand, but is only one of the many factors which help to determine aggregate
expenditure.

Summary

Keen aims to demonstrate, contrary to orthodox macroeconomic theory, that private debt is a large
driver of macroeconomic fluctuations. In doing this, he effectively presumes that non-debt financed
expenditure is not of any great importance in determining aggregate expenditure. He also makes use
of the concept of velocity, using it as a credit accelerator, despite the numerous problems with that
concept in the monetarist literature. Furthermore, he has been accused of misunderstanding his
antecedents, such as Keynes and Schumpeter, grafting onto them faulty ex post and ex ante analysis.
Furthermore, Keen ignores the fact that, in his equations, fiat money growth can generate output
growth. An increase in fiat money would change the rate of growth of money (and therefore, the
rate of growth of debt), and would therefore increase output. However, this ignores the fact that
changes in the monetary base have a highly idiosyncratic impact on output, far more complicated
than the simplistic picture that Keen shows there (Pollin, 2012).

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