Towards a New Paradigm in Monetary Economics
Cambridge published it in 2003.
Summary
Greenwald and Stiglitz argue that standard monetary economics, which analyses policy through the quantity of money and the transactions demand for it, describes the wrong mechanism, and that monetary policy operates through the supply of credit and the condition of bank balance sheets.
Their argument rests on information asymmetry in lending. Because lenders cannot observe borrower quality or effort, credit is rationed rather than cleared by price: raising the interest rate worsens the pool of borrowers through adverse selection and changes their behaviour through moral hazard, so lenders hold rates below the market-clearing level and ration instead. From this it follows that the relevant transmission channel is the willingness and capacity of banks to lend, which depends on their net worth, their risk perception and their regulatory position, rather than on the money supply.
The implications they draw are substantial. Monetary policy works by changing bank net worth and lending capacity, not by changing the quantity of transaction balances. Contractionary policy operates asymmetrically, since restricting credit works faster and more powerfully than expanding it. Banking crises are severe because the destruction of bank net worth removes the information capital embodied in lending relationships, which cannot be replaced quickly. And a monetary expansion may fail entirely if banks are unwilling to lend, which anticipates the post-2008 experience.
The book is technical and written for economists. Its framework has been substantially vindicated by subsequent events, though it has not displaced the standard treatment in policy or teaching.
Key takeaways 7
- Credit is rationed rather than cleared by price, because raising interest rates worsens the borrower pool through adverse selection and moral hazard.
- Monetary policy operates through bank lending capacity and net worth rather than through the quantity of money or transaction balances.
- Contractionary monetary policy works faster and more powerfully than expansionary policy, because restricting credit is easier than compelling lending.
- A monetary expansion can fail entirely if banks are unwilling to lend, which makes the money supply an unreliable policy instrument.
- Banking crises are severe because they destroy the information capital embodied in lending relationships, which cannot be rebuilt quickly.
- Bank net worth determines lending capacity, which means capital regulation and asset prices affect the real economy through a channel standard models omit.
- Firms rely on bank credit because equity issuance is costly under asymmetric information, which is why credit conditions rather than interest rates determine investment.
Who should read it
Economists and macro investors who want the credit-channel account of monetary transmission that post-2008 experience largely confirmed.
About Bruce Greenwald
Robert Heilbrunn Professor Emeritus of Finance and Asset Management, Columbia Business School; former director of the Heilbrunn Center for Graham and Dodd Investing
Value Investing: From Graham to Buffett and Beyond is the canonical modern restatement of the Columbia value framework, and Competition Demystified is its standard companion on barriers to entry.
Columbia Business School, Heilbrunn Center for Graham and Dodd Investing
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