Orthodox Monetary Theory:

A Critique from Post-Keynesianism and Transfinancial

Economics∗

By Dante A. Urbina
Complutense University of Madrid

ABSTRACT

This article seeks to perform a critique of orthodox monetary theory based

on the money multiplier approach according to which the central banks can
control the money supply exogenously and therefore maintain the system sta-
bility based on that. After explaining in somewhat greater detail the specific
formulation of this approach, it is criticized by demonstrating, from the Post-
Keynesian approach, that the money supply is an endogenous variable and that
the causality goes in the opposite direction to what is raised by conventional
theory. Also, from the approach of “transfinancial economics”, it is demonstra-
ted that the growing presence and importance of virtual money, convert the
money multiplier theory in almost irrelevant as explanatory framework.
Key words: Money multiplier–endogenous variable–virtual money
JEL–N10, G21, F4

Monetary theory is one of the most complex and interesting topics in the field
of economics. This obviously is correlated with the crucial importance of a good
management of monetary policy because a bad management of it may aggravate
existing crisis or even create them where none existed.

In this regard, what it tells us orthodox economic theory, based primarily on the
∗
Published: Urbina, D. (2016). Orthodox Monetary Theory: A Critique from Post-
Keynesianism and Transfinancial Economics. In: Debesh Bhowmik (Ed.) International Monetary
System: Past, Present and Future. Regal: India.

1
money multiplier approach, is that the money supply is exogenously determined by
the Central Bank starting from an initial amount of money which is multiplied by
virtue of that private banks are required to maintain a minimum of money in their
vaults in proportion to the reserve rate which is determined by the Central Bank.
Thus, since it is assumed that banks need to an excess of deposits before lending and
based on this is performed the secondary emission of money, the monetary authority
will only have to issue an initial amount of money and determine the reserve rate
to establish the total money supply in the economy and maintain a reasonable
stability of the financial system. Not required, therefore, greater institutional design
interventions or financial regulation to ensure the system stability.

Basically that’s what raises the orthodox approach to be criticized from the Post-
Keynesian perspective and the “transfinancial economics”. But before doing so, let
us see a more detailed formulation.

1. The money multiplier theory

As is known, the object of the money multiplier theory is to explain how the money
supply is determined in an economy. For this, the scheme starts from the so–called
“high–powered money” or monetary base (M0 ), which is the sum of value of all
banknotes and coins in circulation in the economy (CU ) plus the value of bank
reserves (R), that is:
M0 = CU + R (1)

Likewise, in addition to deposits held by private banks in the Central Bank (Dc),
also tend to keep a quantity of cash in their vaults (DB). This money will also be
accounted as part of bank reserves and, therefore, total bank reserves are given by:

R = Dc + DB

Now, let us analyze the balance of a private bank. The bank receipts deposits and
provides loans. A fraction of the deposits received are stored in the form of bank

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reserves and this is called “reserves – deposit ratio” which is represented as:

R
rd =
D

From which it follows that:

R = rd .D

This last relationship is determined by the Central Bank because it establishes the
level of reserve requirement that all private banks must hold as a fraction of their
deposits. These banks may also hold additional reserves if they wish as a precaution.

So, the money supply (M1 ) is the sum of currency in circulation plus demand deposits
in the banking system, that is:

M1 = CU + D (2)

The difference between the monetary base and money supply is deducted directly
from equations (1) and (2). Both include the circulating money, but M0 includes
only reserves of private banks, whereas M1 includes all bank deposits.

Getting the money multiplier expression from here is relatively simple. Be the “cir-
culating money – deposits ratio”:

CU
cd =
D

We divide equation (2) by equation (1):

M1 CU + D
=
M0 CU + R

After we divide each of the terms of the second member of the expression by the
value of deposits:
M1 CU/D + D/D
=
M0 CU/D + R/D
From where we obtain:
M1 cd + 1
=
M0 cd + r d

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Finally, by φ = (cd + 1) / (cd + rd ), we obtain that:

M1 = φM0 (3)

Equation (3) tells us that the money supply is a direct multiple of the monetary
base. The proportionality factor is given by φ, which is precisely the “money multi-
plier” (see: Larraín and Sachs 2004, p. 613–615).

This is the model proposed by neoclassical macroeconomics. According to this model

the initial intervention of the Central Bank, by determining the monetary base and
the reserve requirement, is enough to make the financial system remains reasonably
stable without requiring major interventions because in this scheme is argued preci-
sely that banks require an excess of reserves before they can lend, that these reserves
are initially generated by an expansion of the monetary base which is created by
the government, and that a sequence of bank deposits by recipients of fiat money
creates credit money that is a multiple of the initial injection of money.

2. The money supply: endogenous or exogenous?

We start the critique by addressing the central methodological point that has been
emphasized from the Post-Keynesian approach, that is, determine whether the mo-
ney supply is an endogenous or exogenous variable. As seen, the orthodox theory
raises that this is an exogenous variable that is created by the Central Bank. Thus,
having several measures of monetary aggregates ranging from the narrowest like M0
to the broadest like M3, one of the main implications of orthodox monetary theory
is that broader measures of the money supply (M1, M2, M3, etc.) will always be in
line with the dynamics of the monetary base M0, which is strictly controlled by the
Central Bank.

However, the empirical evidence disagrees. For example, in his article “Debunking
Macroeconomics”, the heterodox economist Steve Keen presents an interesting eco-
nometric analysis establishing, in the period 1990–2012, the correlation between
changes in M0 and M3 and the real economic dynamic (considered in based on the
level of unemployment in reverse). Here the graphs presented by Keen:

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Graph 1: The Correlation of M0 Change and Unemployment has the “Wrong” Sign

Graph 2: M3 Change and Unemployment are strongly negatively correlated

As can be seen from the graphs, the correlation between M0 and economic activity
is weak and has the wrong sign, while the correlation between M3 and economic
activity is strong and has the correct sign. From this discrepancy Keen infers that
the cause of the financial crisis of 2008 has more to do with the action of private
banks in an environment of deregulation than with any specific monetary policy

5
of the Federal Reserve (Central Bank of the United States). Thus, we see that the
total money supply can exhibit a significantly different behavior than that provided
exogenously by Central Bank. And this is demonstrated even more clearly if we look
at the correlation between M0 and M3. Keen writes: “The correlation between chan-
ges in M0 and changes in M3 is (. . . ) strongly of the wrong sign for the pre-crisis
period from 1990–2008 (−0,55), and only barely positive for the post-crisis period
(+0,14)” (Keen 2011, p. 160).

And this is just one of the many empirical evidences in this regard. In fact, in
his book Horizontalists and Verticalists, the Post-Keynesian economist Basil Moore
(1988, Chapter 7) provides a more comprehensive and detailed empirical support
for the theory of endogenous money supply by showing, based on the Granger–Sims
test, that causality in the process of money creation actually goes in a direction
which is opposite to the direction proposed by the orthodox macroeconomists and,
consequently, the monetary base would be a dependent variable (endogenous) ins-
tead of a causal variable (exogenous).

Nevertheless, as Moore himself claims, a mere econometric test, no matter how

strong it is (as occurs in this case), cannot prove by itself a relevant economic truth
because it takes causality in a purely instrumental sense (predictive) and not in a
sense of content (explanatory). Therefore, we still require a consistent theoretical
basis to establish the theory of endogenous money supply. And that is what we shall
see.

3. From the “money multiplier” to the “money divider”

In his Treatise On Money Keynes argued that economists should not accept the idea
that “in the banking system, the initiative starts from the depositor and the banks
can not lend more than what their depositors have previously entrusted to them”
(Keynes 1930, p. 46). Thus, to properly understand the process of money creation,
it is necessary to first understand the true nature of the process of generating credit.

In a capitalist economy like ours, the most important individual demand for credit
comes from companies. Indeed, the entire current “industrial capitalism” depends

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crucially on the existence and development of the “financial capitalism”. Thus, com-
panies “borrow funds from banks, in the short term, to meet their capital needs (...)
because they must pay to the factors of production, especially labor, before receiving
revenues from sales of goods and services produced, because the production and sale
takes time” (Moore 1988, p. 373).

And here is where the crucial question emerges: where do the funds that banks lend
to companies come from? It would be naive to pretend that they come deterministi-
cally from the private savings and associated reserve requirements because obviously
this does not would be enough to explain the observed large economic expansions.
Therefore, to sustain the process of “economic development”, other method is requi-
red which, as Schumpeter has pointed, “is the creation of purchasing power by the
banks. It is always a question, not of transforming purchasing power which already
exists in someone’s possession, but of the creation of new purchasing power out of
nothing” (Schumpeter 1912, p. 82).

The implications of this are devastating for orthodox monetary theory. Indeed, if
money is originated mainly as a byproduct of the new loans granted by the banking
system to companies that require financing without necessarily relying on specific
reserves for it, the money supply is endogenous and not exogenous. It is not surpri-
sing, then, that Alan Holmes, vice president of the Federal Reserve Bank of New
York, has been forced to accept that “in the real world, banks extend credit, creating
deposits in the process, and look for the reserves later ” (Holmes 1969, p. 73).

In this context, the ability of Central Banks to control the money supply and ensure
the stability of the system is quite low. Instead of that private banks are subject
to what is imposed by Central Bank, happens that Central Bank is subject to the
dynamics of the banks with all the errors involved in such discretion and the subse-
quent destabilization of the system.

Therefore, as Casquete (2000) has noted, it is not accurate to say that an increase
in reserves leads to an increase in lending, as claimed by the orthodox theory, but
rather the reverse: is an increase in credit what leads banks to seek an increase
in reserves. These reserves, searched later, only need to be a fraction of the credit

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generated and, if we look at the true nature of the process, we must abandon the
approach of the “money multiplier”, and replace it with the “money divider”, such
that:
M0 = dM1
1
d=
φ
That is, the monetary base is a fraction of the money supply: a subtle but necessary
distinction to avoid the mistake of orthodox economics to the consider the direction
of causality in an incorrect way.

4. Transfinancial economics and the implications of financial innovation

The above is enough to dismiss orthodox monetary theory, but there are still relevant
critical elements to analyze. The first of them comes from an innovative approach
called “transfinancial economics”. In the words of its founder, the British researcher
Robert Searle, the transfinancial economics “is a form of heterodox economics which
deals with mainly non-mainstream economic thinking” and its uniqueness and im-
portance comes from seeking to obtain all the theoretical and practical implications
of the recognition of the fact that “virtually all money exists as electronic or digital
data transmitted from one bank account to another” (Searle, 2014).

Now, if most of the money generated by the banks is virtual money, the money
multiplier theory loses all explanatory relevance because it could well occur that
the dynamic of virtual money may be disconnected regarding the initial monetary
base or reserves that are maintained by legal banking reserve. Searle himself has
recognized the relevance of this interpretation when, in a communication sent to the
author of this article on April 6, 2014, he said: “Yes, the reality is that virtually all
money exists as electronic data. A very tiny percentage of it is of course created by
the government as cash spent into the community. The rest of it is created [electro-
nically] by banks as repayable loans with interest. I know this sounds unbelievable,
but this does appear to be correct!”. In other words, if money can simply be created
by means of a “click” or by pressing a computer key is not imperative wait until

8
there are real reserves and the subsequent process can easily escape from the control
of Central Bank.

But that’s not the only thing that has escaped from the control of the Central
Banks. From the 70s technological changes have allowed to the banks more flexi-
bility in managing their assets and liabilities reducing the cost of making transfers
through the development of computer systems thanks to which is much easier to
overcome several of the regulations to which they were subjected.

Also have been designed sophisticated financial instruments, such as certificates of

deposit, which allow to banks obtaining funds far above what would be consistent
with their level of reserves and deposits. Thus, credit can be expanded by adjusting
the level of deposits later and, therefore, they cease to be a constraining factor.

All this is evident and important part of the real banking system. But it seems that
conventional economic theory is blind regarding this. Indeed, as Searle has said,
“mainstream neoclassical economics (. . . ) has little or no real understanding of the
importance of how money is created, and what it fully means in society and the
world” (Searle, 2014).

5. Conclusion

The money supply is an endogenous variable, not an exogenous variable, the direc-
tion of causality goes from the level of appropriations to the level of deposits and
not the reverse, the increasing presence of virtual money makes that the real le-
vel of banking reserve becomes unimportant as constraint, and financial innovation
provides increasing opportunities to circumvent the regulations and restrictions of
the monetary authority: all this constitutes a powerful cumulative case against the
orthodox monetary theory in general and the money multiplier theory in particular.
It is clear that the latter is a poor guide, if not harmful, regarding the management
and understanding of the monetary system, and to relying solely on this theory for
it is like trying to leave the forest having the map upside down. But the solution is
simple: you have to turn the map.

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