This is the foundation of endogenous money theory, a concept central to post-Keynesian economics. Unlike mainstream economics, which sees money supply as something the central bank controls from the top down, the Post-Keynesian view argues that money is created from the bottom up by commercial banks making loans. In other words, money is not just injected into the economy at the whim of central banks but instead expands or contracts based on demand for credit.
22 When Monetary Policy fails – The Reality of Endogenous Money and The Liquidity Trap
When people imagine money, they often picture it as something the central bank controls directly, printing it, distributing it, managing how much is in circulation. This is a comforting thought because it suggests that someone, somewhere, is in charge. But what if that’s not really how money works? What if, instead of being created by the central bank, money is actually created by the banking system itself?
Take, for example, the housing market. When banks issue mortgages, they are not simply handing out money that already exists in some vault. They are creating money by lending it into existence. Each time a bank approves a mortgage, new money is injected into the economy. When housing booms occur, it is not necessarily because central banks are printing too much money, it is because banks, responding to demand, are issuing more and more loans. This is how modern economies function: money is created when people borrow and disappears when people repay their debts.
Now, this raises a crucial question: if money creation depends on the willingness of banks to lend and people to borrow, what happens when neither side is willing to play their part?
This is exactly what happened in Japan in the 1990s and again globally after the 2008 financial crisis. Both were classic cases of what economists call a balance sheet recession, a situation where households and businesses, instead of taking on new debt, focus on paying off their existing loans. This means that even when interest rates are cut to zero, borrowing does not increase because no one wants to take on more debt. As a result, the normal mechanisms of monetary policy break down.
Japan offers a striking example of this. After the bursting of its real estate and stock market bubbles in the early 1990s, Japanese households and companies were left drowning in debt. The Bank of Japan (BoJ) responded by cutting interest rates to near zero, expecting businesses and consumers to start borrowing and spending again. But they didn’t. Instead, they focused on paying down their existing debt. This created a vicious cycle: spending remained weak, businesses saw no reason to invest, wages stagnated, and economic growth ground to a halt.
The situation in Europe after 2008 was eerily similar. Countries like Spain and Ireland had experienced massive property booms fuelled by easy bank lending. When the financial crisis hit, these economies collapsed under the weight of private debt. The European Central Bank (ECB) slashed interest rates, but just like in Japan, borrowing did not pick up. Households were too burdened by debt to take out new loans, and banks, facing their own financial troubles, were reluctant to lend.
This is where quantitative easing (QE) came into play. When interest rate cuts proved ineffective, central banks decided to go further by buying financial assets, mostly government bonds, to flood the banking system with money. The idea was that by increasing liquidity, banks would lend more, businesses would invest, and economic activity would recover.
But something unexpected happened. Instead of stimulating broad-based economic recovery, most of this newly created money stayed in financial markets.
To understand why, consider what QE actually does. When central banks buy government bonds, they inject money into the financial system, but that money often ends up in the hands of investors, hedge funds, and large corporations, rather than in the pockets of ordinary people. As a result, QE has been far more successful at inflating stock prices than at boosting real economic activity.
Take the United States after 2008 as an example. The Federal Reserve pumped over $4 trillion into financial markets through QE, and the result was a historic stock market rally. Corporate profits soared, asset prices skyrocketed, and the wealthy, who own most stocks, saw their wealth increase dramatically. But for the average worker, wages remained stagnant, job security was weak, and economic inequality worsened.
The same pattern repeated itself in the UK, where the Bank of England (BoE) launched its own QE programme. Property prices in London surged, stocks rose, and banks recovered. But ask the average Briton whether they felt the impact of QE in their daily lives, and most would say no. The money, instead of trickling down, had pooled at the top.
This has led many Post-Keynesian economists to argue that QE is fundamentally flawed, not because it fails to inject money into the system, but because it injects money into the wrong parts of the system. If the goal is to stimulate demand, why not bypass the financial sector and put money directly into the hands of those who will spend it?
This question has led to discussions about more radical alternatives, such as “People’s QE”, the idea that instead of using QE to buy financial assets, central banks could directly fund public infrastructure projects, distribute money to households, or even cancel existing debts.
And then there’s negative interest rates, another extreme policy that central banks have experimented with in recent years. In a desperate attempt to push banks to lend, central banks in Japan, Denmark, Sweden, and the Eurozone have cut interest rates below zero, effectively charging banks for holding excess reserves. The logic is simple: if keeping money in the bank costs them, banks will be forced to lend more.
But has it worked? The evidence so far is mixed. While negative interest rates have lowered borrowing costs, they have also hurt savers and retirees, whose pension funds and savings accounts now yield next to nothing. In countries like Germany, where people traditionally rely on bank savings rather than stock investments, this has led to growing resentment. In Japan, where negative rates were introduced in 2016, businesses and households still remain reluctant to borrow, and economic growth remains sluggish.
What all of these cases reveal is that monetary policy has limits. Interest rate cuts, QE, and even negative rates cannot force people or businesses to spend if they don’t want to. This is the central flaw in conventional economic thinking, the belief that if you make money cheap enough, the economy will naturally recover.
This brings us to a critical conclusion: if monetary policy alone is not enough, what else should be done? If cutting interest rates and injecting money into financial markets has not worked for the average household, what alternatives exist?
Who Really Pays for Economic Mistakes?
When central banks and governments step in during a crisis, their actions are not always as fair or effective as they might appear. Take quantitative easing, for instance. It is often introduced when interest rates are already near zero and traditional monetary policy no longer works. The idea is to inject money into the financial system to encourage lending and investment. In theory, this should support growth and jobs. But in practice, much of this newly created liquidity ends up flowing into financial markets and asset prices rather than into people’s wages or small businesses.
The result is a widening gap between those who own assets and those who do not. House prices, shares, and corporate values rise, while ordinary workers see little improvement in their pay or living standards. Inequality grows quietly, not because people stop working hard, but because the system itself channels new money toward wealth rather than work.
And when inflation finally picks up, as it often does after these policies, the same institutions that fuelled the boom respond by raising interest rates. They say inflation is “out of control”, as if it were an unexpected storm rather than a consequence of earlier decisions. The burden then falls on ordinary households. A typical family in the United Kingdom, for example, might find themselves paying hundreds of pounds more each month on their mortgage, not because of something they did wrong, but because of a cycle of policy mistakes made elsewhere.
When stability eventually returns, those at the top tend to recover first. Asset prices rise again, and the wealthy become wealthier. Meanwhile, the public is left to cover the cost, both financially and emotionally. This pattern raises a deeper question about accountability. When policies go wrong, no one steps forward to say, “We failed to govern wisely.” Instead, responsibility is quietly shifted onto citizens.
If we are serious about building fairer and more resilient economies, then our systems of economic governance need to change. Stability cannot come at the expense of equality. Policy should not reward speculation more than production or treat households as shock absorbers for decisions made far above them. We need institutions that are transparent, accountable, and designed to serve people, not just markets.
