Summary of Stiglitz on Monetary Policy

After the Global Financial Crisis, there has been a lot of re-thinking about Monetary Policy, as one might expect. In fact, in light of the magnitude of the failure, re-thinking efforts have been much less than proportional. There are many, many, different strands of thought, and personally, I do not have clarity on what needs to be done. Furthermore, the situation is rapidly changing, so that a solution for today would not be a solution for tomorrow.  The fundamental problem is private sector creation of money, and nobody wants to discuss this elephant-in-the-room. But there may be a good reason for this unwillingness — with the financial sector is firmly in control of the US Government, and the Euro area, it does not seem politically feasible to think about radical alternatives. The goal of this post is just to summarize a paper of Stiglitz expressing his post-GFC thoughts on Monetary Policy — without much in the way of comments and discussion. The full paper itself is linked at the bottom of the post.

Summary of Joseph Stiglitz paper on monetary policy:

  1. In response to GFC 2007-8, massive programs of QE (quantitative easing) have been launched all over the world. While these actions may have prevented another Great Depression, economic growth and employment has not been restored to pre-crisis levels.

History of Evolution of Thinking at Central Banks

  1. Monetary policy had been based on the quantity theory of money (QTM) MV=PQ, which posits a stable relationship between the quantity of money, and the GNP. However, starting in the 1980’s this equation became unstable – Velocity fluctuated erratically, and none of the measures of money showed any stable relationship to important real and nominal variables like the GNP, and even the interest rate.
  2. This failure of QTM should have prompted a deeper investigation of monetary theory, and reasons for its failure, but it did not. [Stiglitz is unaware of the research of Richard Werner, which explains the failure, and provides and alternative: The Quantity Theory of Credit]
  3. Instead of investigating WHY the quantity of money failed to have stable relationships with macroeconomic variables, Central Banks shifted to the use of interest rates as the main instrument for monetary policy.
  4. Post Crisis experience has led the problem that interest rates have hit 0%, but the economy has not responded in the manner expected – cheap credit should have led to borrowing for investments, stimulating production, and borrowing for consumption, stimulating demand and lifted the economy out of the recession. However this has not happened.
  5. In light of this experience, current thinking is that monetary policy has become ineffective because we have hit a liquidity trap at 0% interest rate. We cannot take it down further. Some efforts are being made to create negative interest rate policy in the hopes of breaking through the liquidity trap.

Stiglitz’s proposed solutions:

  1. The key variable which drives the economy is the supply of credit to investors and consumers. This supply, provided by private banks, does not respond in a systematic or mechanical way to either the quantity of money produced by the central bank, or the interest rates. This problem does not have much to do with 0% interest rate floor. What we need to do is to target the flow of credit directly, if we want to have an effective monetary policy.

Errors of conventional theories, models, and policies.

  1. Conventional macro models assume perfect information and liquidity, which makes banks unnecessary. Using a more realistic model with liquidity constraints, credit rationing and asymmetric information, Greenwald & Stiglitz (G&S) show that credit provision by banks depends on their net worth, perceptions of risk, and the regulatory framework.
  2. In abnormal situations like post-GFC, these other factors which affect the provision of credit by banks, can overwhelm the normal channels by which monetary policy operates, rendering it ineffective. To restore effectiveness, Central Banks must go outside the conventional channels, and utilize macro and micro prudential regulations.
  3. Even if Central Banks succeed in increasing supply of credit provided by private banks, this may fail to have desired effects of stimulating production and consumption. This happens when credit is provided for non-productive activities like lands and stocks, which increases their prices without creation production or consumption. Cheaply available money can flow to harmful speculative activities, instead of productive investment.
  4. Lowering interest rates to fight recession creates a jobless recovery (as observed in USA). Lower costs of capital lead firms to substitute machines for labor.

The problem is that we are asking too much from a single instrument. But most governments have eschewed using this broader set of instruments.

  1. Using aggregated macroeconomic models hides the distributional effects of monetary policy. Stimulus using monetary policy hurts the poor and the laborers, and enriches the wealthy, leading to increasing inequality.


  1. Conventional theories of how money works, which are the basis of monetary policy today, have been discredited. The transmission channel for conventional tools – interest rates, Open Market Operations, Reserve requirements – is very weak, and can be interrupted or disrupted by outside factors.
  2. Managing a complex economic system requires as many tools as one can manage; the single minded focus on short term interest rates as the instrument and inflation as the target substantially limits the possibilities for effective interventions by the Central Bank.

PART 2: Creation of a RADICAL New System which circumvents all of these problems.

  1. The total amount of credit creation should be directly under government control. This credit can then be allocated or auctioned to banks – banks can no longer create credit, unless they acquire/purchase the right from the government. In turn, the government can put conditions on allocating credit to banks to ensure that it is lent out for productive investments only, and not for speculation. Electronic money can ensure that the system works, since all money and credit creation can be monitored.
  2. In open economies, fluctuations in the exchange rates and in balance of payments create tremendous costs. These can be managed by a trading chit system which stabilizes the trade deficit or surplus at a pre-determined level. Every exporter is issues a trading chit equal in value to his exports. Every importer must acquire trading chits in order to be able to import. Since the value of export chits necessarily equals the value of import chits, this system will have exactly balanced trade with no surplus or deficit. If economic conditions dictate running a deficit, the government can issue 20% extra chits, over and above export earnings – this would stabilize the trade deficit, and hence also the exchange rates. This is of tremendous value in stabilizing the economy.

POSTSCRIPT: At the time I wrote this, I was not aware of Richard Koo’s work on balance sheet recessions. This issue, heavy debt liabilities, seems of central importance, and has been completely ignored by Stiglitz, and many other authors (though not Mian & Sufi: House of Debt). See the 10m Video: Koo: Balance Sheet Recessions or read the RWER paper by Koo: The World in Balance Sheet Recession



  1. “The fundamental problem is private sector creation of money, and nobody wants to discuss this elephant-in-the-room.”

    I do. I have. And I have taught millions about bank credit worldwide with an animated movie, Money as Debt (2006), that PREDICTED the debt crisis.

    Also, I have repeatedly given this author the answer he seeks and he ignores it, claiming he has more important work to do, like write yet another article about the miserable failings of the OTHER economists.

    The article above aptly illustrates why economists are so universally INCOMPETENT. As with all such thinking by economists, not one moment ‘s thought is devoted to what happens to bank credit money, some of it in existence for 30 years, BETWEEN the time of its creation as principal debt-to-a bank and the time of its required repayment.

    NONE of the reforms mentioned above will solve the problem because none of them even recognize the problem!!!
    The problem is MULTIPLE SIMULTANEOUS PRINCIPAL DEBTS of the SAME MONEY. Money is created as principal debt to a bank and is subsequently RE-LENT multiple times while still owed to the bank that created it.

    P of money in existence < P of principal debt (much less, perhaps 9%)
    Digging Deeper into Debt-Money
    The Bank of England's confessional isn't the whole story

    "… just consider what might happen if mortgage holders realised the money the bank lent them is part of an invisible trap, a game of musical chairs designed by the bankers in which losers are mathematically predetermined to default whenever the creation of new debt to banks slows down, for any reason. The only way to keep the music playing is for all of us as a whole to go further and further into debt to banks forever."

    How to Turn 9 Trillion Dollars of Unpayable Principal Debt into 9 Trillion Dollars of New Funding (PDF)

  2. “The fundamental problem is private sector creation of money, and nobody wants to discuss this elephant-in-the-room.”

    The problem is deeper than this, much deeper.

    1st – The middle class in particular expect and demand security in jobs ‘plus’ security in assets, not giving it any thought that the incomes of both flow in opposite directions. The younger generation do not see owning a home and a portfolio as some ‘dream’ anymore, they see it is their duty, and that if they aren’t buying a home and accumulating financial assets they are somehow letting their family and society down. The more assets accumulated the greater the credit creation necessary which must always put downward pressure on job security.

    2nd – As a result of the first, every economic agent must compete against each other for access to that credit; all economic activities must be formed under debtor/creditor contracts which must be enforced.

    It’s not so much ‘credit’ that is the problem, it is the purpose of and the intent behind what sort of credit we are creating. Even if money was solely issued by the central bank without interest, if each economic agent intends to enforce their legal relations and seize property of the defaulting party then this is no different to usury.

    The real problem is usury in the form of enforcing agreements and seeking damages (seizing property) when a party defaults. The real evil lies not in creditors charging interest but in borrowers being driven by emotions entering into agreements based on predicting a future they can’t predict and putting their livelihoods at risk.

    There is no law that says we all must go into legally enforceable debt, and yet we all act as if there is such a law!

  3. lobdillj said:

    Neither Stiglitz, nor either of the two previous commenters make any sense at all IMO. Here’s the guy who makes sense: . Modern Monetary Theory is the answer. See Kelton and Wray as well.

  4. “Modern Monetary Theory is the answer”

    The answer to what exactly?

  5. Michael Hudson is one of my heros and has made penetrating analyses of the modern financial system. I am surprised to learn the he endorses MMT. The following article in RWER provides a clear critique:Modern Money Theory and compares it with New Currency Theory A comparative discussion, including an assessment of their relevance to monetary reform
    Joseph Huber
    Paul Grignon: There are seven different schools of thought about money mentioned in this article above, of which two are compared in detail. ALL of them agree that the current system is bad and leads to crises, which is also what your theory of recursive re-lending does. I think we can all agree with Lord Mervyin King, Governor of Bank of England, who said that of all the possible monetary systems we could imagine, ours is the WORST. Further ANALYSIS of WHY the system is bad does not seem to be needed. What is needed is a NEW system. In this dimension, I believe that Islamic concepts win hands down. There is to be no trading of debt, no interest based lending. Loans are ONLY for social welfare purposes – there are NO business loans at all. Business Finance ONLY occurs through partnerships of various types. All lenders must particpate in risks of doing business in order to be able to benefit from a share of the profits. Regarding your producer credits, Islam has something similar called ISTISNA’, which has been used and is highly recommended way to stimulate the economy and create local finance — effectively creates money between the consumer and producer without government or banks. None of the reform proposals that I have seen go far enough in this direction.

  6. David Harold Chester said:

    Without interest being paid on loans there would be no incentive for investment. A company that has money invested in its durable capital goods, during productive activities will often manage to make a return on its invested capital (in addition on its land as rent and on its labor as wages) and some of this interest or dividend should be returned to the lender of the investing money. So I find that the Islamic style of money management will not be successful.

    • David,
      No offence to you personally, but I think your way of thinking sums up the whole problem. You, like just about everyone seems to be convinced that we all must operate under the one economic system. Why?

      If Asad wants to operate under an Islamic style of resource management, and provided he doesn’t wish to impose it on the whole planet, then why should he be prevented from doing so based on what you or anyone else want? The same goes for Paul Grignon and anyone else who has their own model. Are we all saying that unless we find proof on a planet in some distant galaxy that multiple economic models can co-exist that we should never even entertain the idea? Would the light bulb had been invented if the inventor said I’m not going to invent a light bulb until I see one in action?

      I’m starting to wonder if people are really trying to solve the problems we are facing or whether they are in fact addicted to the chemicals our brains produce whenever we get into debates about economics or politics.

  7. David Harold Chester said:

    How would the Islamic system work in practice? By tradition the Arab traders were once able to profit from the sale of their goods which they introduced from abroad, and if that is not a return due to interest (and the other two things) I don’t know what it is. I am not being personal but my doubts have not been answered.

    Surely, today, the Islamic business people would either all join companies having investment abroad, or they would no longer be able to compete with the rest of the world. Arab business at home has always been inclined to be private and separate but also it would be very slow to grow without proper stimulation of the kind that requires interest (which might be expressed using other notation.

    • “How would the Islamic system work in practice?”

      That is up to those who will operate under it. It’s shouldn’t be yours or mine or anyone else’s concern (unless they attempt to impose their model on everyone, which is what political capitalism and political socialism are both guilty of).

      ” or they would no longer be able to compete with the rest of the world”

      on what grounds must we “all” compete? Competition is a child of capitalism and should be left to those who enjoy competition. I am not aware of any true islamic style arrangement that involve competition, on the contrary, it is based on the investor taking an actual interest in the results because he has accepted that if the venture fails (such as a crop failure) he also loses.

      “Perhaps I should add that mankind as a natural phenomenon has reached the stage of evolution where his society has now arrived at the stage where capitalism is a part of it that cannot be avoided”

      I totally agree. Capitalism is a product of humans gradual move away from forced slavery and feudalism to accepted legal bondage, i.e. we impose legally binding obligations on one another at risk of jail or losing property when we can’t keep our promises. Society is far too large and populated to rid itself of capitalism and the contract. To get rid of capitalism is like saying, we should invent an education process but without kindergarten and primary school. How would people grow unless they suffer the frictions that the market economy forces us to experience?

      But this does not imply nor assume that none of us can work toward moving above the legal contract even if individually or as small legally isolated groups. Our legal systems are more than adequate to enable multiple economic models to co-exist. Why should I be a capitalist if I don’t want to be, and at the same time, if i don’t want to be a capitalist, why should I stop others from being capitalists?

      “My model for our free-world society”

      Let me ask you this? Can you operate under the model of yours without political change? Can you operate it with just one other person, or a group of persons (and if so how?), or can you only operate it if the whole system is changed (and if so, why?)? If the latter, what if I don’t want to operate that way? Where does that leave me?

  8. David Harold Chester said:

    Perhaps I should add that mankind as a natural phenomenon has reached the stage of evolution where his society has now arrived at the stage where capitalism is a part of it that cannot be avoided, no matter how it might be disguised using other notations.

    My model for our free-world society is given in a short working paper SSRN 2865571 “Einstein’s Criterion Applied to Logical Macroeconomics Modeling.” This model might be quite distasteful to many experts who think they can get away with words alone that are unsupported with diagrams and mechanisms for accurate analysis about how our social system works–but they are sadly mistaken. It is time to better explain about ourselves in our society which implies that macroeconomics needs to be properly re-written..

  9. David Harold Chester said:

    I am confused by the suggestion that our social system with money could have evolved in some other way or even that it could be governed to work differently that generally what it does in the capitalist system. If as in the Islamic way there is no interest then I for one would try to borrow as much money as I could, without fear of having to face a financial penalty for delay in its return. Since every other business person would do the same, the resulting chaos would get nothing done because the criterion for directing competitive money-borrowing to the right place would cease to exist!

    Just as animals compete to be the dominant male when it comes to selection of the most fit for reproduction, so too the human animal needs to control and direct his competitive spirit, to apply to the best means for efficient production of goods and services. Evolution does not stop with biological change, indeed we may still be evolving there too!

    • “I am confused by the suggestion that our social system with money could have evolved in some other way or even that it could be governed to work differently that generally what it does in the capitalist system.”

      That is true to a point. If money is allowed to be lent at interest then it is capitalist based money. When it is not permitted to be lent at interest then you may have a different system, but, and this is a big but, if traders using this non-interest bearing money still enter into legally binding contracts with pre-determined terms and conditions (such as I will lend you my 100 coins to invest in your tomato business but you must pay me back 200 coins once your harvest is finished, and if you do not I will seize your house and land) and with the intent to enforce those contracts and to seize property of the defaulting party then it is still capitalism. Even if “interest” was banned, those who are naturally competitive will find others ways to extract more from others, especially from those who are less competitive by nature, as long as they can find people willing to enter into contracts with them.

      ” If as in the Islamic way there is no interest then I for one would try to borrow as much money as I could, without fear of having to face a financial penalty for delay in its return.”

      First of all, you would not have access to Islamic finance because you would not be operating under the Islamic model from what I can gather. From your work (which I read the other night) there is nothing in your proposals which suggests you would be breaking from the contractual model. Provided you maintain the same relationship you formed with government when you applied for your tax file number (or whatever they call it in your country), then as far as government and everyone else is concerned, you have expressed your intent to operate under the capitalist contract model and you will forever do so until that relationship changes. From what I can gather, the Islamic model is not based on contract, it is based on surplus share arrangements (which is the same as my Custodian model).

      Thus, if a percentage of the population wanted to operate under the Islamic model, then the only way they are going to be able to do it is to change their relationship with government and for government to become the partner, at least initially until the sector grows large enough to function on it’s own (although government will still be a silent partner, just as they are a silent partner for all capitalists and economic agents). The finance that government would provide toward the functioning of the Islamic model would have to stay in that model. By the same token, no agent working within the Islamic model would be permitted to obtain capitalist finance. The two systems of property, legal relations, and finance, must be kept separate. Of course it also goes without saying, no entity operating under the Islamic system would own property for capital purposes, i.e. they would not be permitted to benefit from capital appreciation because such a phenomenon should only occur in the capitalist system along with the inherent risks that come with it.

      This is the way a mature and developed economy should work – multiple modes of production and distribution, which must include both a for profit sector (capitalism) and also a non-profit sector of almost the same size.

      If we imagine a triangle that represents that whole of society, then the bottom say 50% would be made up of economic agents who operate under the contract capitalist system. Another say 40% would operate under the non-profit models which would include the Islamic model, the Custodian model, etc, and the remaining 10% would be the government which facilitates all models. Each sector brings unique benefits to society that the other sectors can’t provide, that is why a mature economy should always facilitate multiple models.

  10. The Islamic Economic system is founded on the principles of cooperation and generosity, in direct opposition to the capitalist principles of competition and greed. Instead of the evolutionary jungle of cut=throat competition, it invites us towards civilization. As Polanyi has pointed out in the Great Transformation — ALL traditional societies were also based on these social principles for communities, and capitalism is strongly exceptional. Human beings can behave like animals, but they DO have the potential to improve, and to learn how to behave like human beings! Islamic teachings are meant to teach us how. For further clarification see: The TRANSFORMATION of human behavior as a central strategy for Islamic Economics

  11. I agree with you Asad, however, I also agree with David that we are passed the point of no return when it comes to capitalism. Capitalism will always exist until the earth as a whole experiences some huge calamity, and the reason is actually in what you said here:

    ” Human beings can behave like animals, but they DO have the potential to improve, and to learn how to behave like human beings! ”

    Without capitalism, and more to the point, without the imposition of it upon all of us, many of us would never have experienced the frictions we now experience as a result of it – in other words, capitalism is the sandbox which we first play in until we get so sick of the sand rubbing on our skins that we look for a way out. But just as a few of us leave the sandbox does not mean we pull up the sandbox, for every one that leaves, dozens more must jump in as they reach the legal age of majority; only those who have experienced the pains of a contract system and who has left the sandbox may guide a youngster to bypass the sandbox altogether.

    I learned a great deal regarding this education process, not to mention the basis of my custodian model from an economist by the name of Bijan Bidabad who wrote;

    “Economic- Juristic Analysis of Usury in Consumption and Investment Loans and
    Contemporary Jurisprudence Shortages in Exploring Legislator Commandments”

    maybe you have read this too?

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