Godley's View of Credit and Banking

Godley (1996) is the paper that truly launched the SFC approach. The paper appeared as a Levy Economics Institute working paper where Godley had been working for three years. Papadimitriou had been getting a bit worried because until then Godley had produced hardly anything for the Institute. The reason was that he was setting up the empirical model of the US economy while simultaneously trying to write an academic paper that would show, with the help of simulations, how to synthesize a theory of credit creation with that of income determination. The paper was certainly a revelation to all those interested in monetary economics that came to read it.

Godley was most preoccupied with understanding the functioning of the economy as a whole. Godley (ibid.: 14) had been groping ‘to show how the whole system fits together and cast banks in a realistic role’. Godley was putting together a monetary flow analysis, linking monetary income and expenditure with a flow demand for credit, and a portfolio analysis, that explained the various demand functions for financial assets, including the demand for a stock of money. Godley’s 1996 paper reconciled an approach based on flows of credit with the more traditional Keynesian portfolio approach. He integrated the two views, showing formally, with a fully integrated model that could be simulated, how flows and stocks would gradually change in line with each other through time. Godley’s models could simultaneously determine the stocks of money or securities held by households and the flows of credit, investment, and income, as well as the stocks of private and public debts. The same integration had already been achieved in Godley and Cripps (1983), but the integration was only partial, the difference being that most of that book assumed that all financial assets held by households were retained in the form of bank deposits. In addition, Godley (1996) formalized the appearance and the treatment of capital gains.

As Godley points out on a number of occasions, he himself owed his formalization of portfolio choice and of the fully consistent transactions-flow matrices to Tobin. Godley was most particularly influenced and stimulated by his reading of the paper by Backus et al. (1980), as he writes in Godley

(1996: 5) and as he told us verbally several times. The discovery of the Backus et al. paper, with its large flow-of-funds matrix, was an eye-opener which helped Godley to move forward, by providing both a role for the banking sector and getting into sectoral flow-of-funds analysis, allowing him to build what he called a transactions-flow matrix, where all rows and columns had to sum to zero.

However, as explained in Godley and Lavoie (2007a: 493), despite their important similarities, there is a crucial difference in the works of Tobin and Godley devoted to the integration of the real and monetary sides. In Tobin, the focus is on one-period models, or on the dynamics of adjustment from an arbitrary distribution of assets to the desired portfolio composition, for a given income level. By contrast, in Godley and Cripps and in further works, Godley is preoccupied in describing a fully explicit traverse that has all the main stock and flow variables as endogenous variables. As he himself says, ‘[T]he present paper claims to have made...a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition’ (Godley 1997: 48). Tobin never quite succeeds in doing so, thus not truly introducing (historical) time in his analysis, in contrast to the objective of the Godley and Cripps book.

Another major difference between Tobin and Godley is their views about the role of banks. Again, this is discussed in detail in Godley and Lavoie (2007a: 497-499). In most of Tobin’s writings, banks are veils that provide households with a greater variety of asset choices. By contrast, in Godley’s view, banks play a distinct and essential role, since bank credit allows the expansion of economic activity. Godley’s banks are Kaldorian, responding to the financial needs of their creditworthy clients. This is linked to Godley’s view of the production process, which is similar to that of the French and Italian monetary circuitists, in particular those of his long-time friend Augusto Graziani. Within this framework, bank loans act as a necessary buffer for the fluctuations in inventories. The link between inventories and bank loans is preserved all the way from Godley and Cripps (1983) to Godley and Lavoie (2007a).