Towards a More Stable and Sustainable Financial Architecture – A Discussion and Application of the Quantity Theory of Credit

Abstract

Thanks to the banking crisis, there has been a greater awareness that leading economic theories and models, as well as influential advanced textbooks in macroeconomics and monetary economics may have been amiss when they neglected to include banks in their analyses. Economists are now labouring to include banking in their models. However already sixteen years ago a paper was published in this journal which presented probably the simplest possible framework that incorporates the economic consequences of banking into a macroeconomic framework: The ’Quantity Theory of Credit" (QTC, Werner (1997)). It resolves a number of perceived ’anomalies" in macroeconomics and finance, can be used to explain and predict banking crises, and carries a number of policy implications about how to enhance financial stability and deliver sustainable growth. Unlike many better known and far more complex models and theories, it has fared well during the turbulent period since it was proposed. In this paper QTC is revisited and a number of questions that have been raised in the profession concerning it are discussed. It is then applied to the following questions: how to detect and avoid banking crises; how to deliver sustainable and stable economic growth; how to end post-crisis recessions quickly – such as those in many European economies – while minimising costs to the tax payer; and finally, what a financial architecture would look like that has a higher chance of delivering the latter goals on a regular basis. (E41, E52, E58)