Keep Banks Out of Macro?
Scott Sumner says we should keep banks out of macro. I Think that’s a very strange comment coming from a monetarist or even any economist. Whether he knows it or not, monetary policy works primarily through the banking system via the Fed’s ability to influence interest rates. When the economy is too hot the Fed increases the cost of overnight borrowing thereby reducing the spread at which banks make money in an attempt to tighten the supply of loans. Of course, there’s no such thing as easing the supply of loans because the idea of a “supply of loans” is a confused concept since banks are only capital constrained in their ability to make new loans. So, it’s not like they have a big supply of loans on shelves that are waiting to fly off them. Healthy banks make loans when creditworthy customers walk in their doors.
Anyhow, getting back on track – the Fed has some control over money. After all, it has monopoly power over the overnight rate. But this is merely one piece of the money supply puzzle. The real control of the money supply rests with borrowers demanding loans and the rate at which banks set those loans (of which the overnight rate is an important influence). But the Fed is not the omnipotent entity that most presume. And this cuts right to the core of the problem with Sumner’s statement – modern macroeconomists don’t really know what money is. Nor do they seem to care. If more macroeconomists understood that money is credit they’d care more about banking.
To me, banks are like the circulatory system in the human body. They’re the primary means through which money (most of which is issued by banks in a modern monetary system) is issued and circulated. When the banks aren’t working or consumers aren’t borrowing the system seizes up. If the human body doesn’t have a consistent flow the body dies. The major organs can’t operate otherwise. An economy is no different. Banks are not just a crucial piece of the entire monetary puzzle. They are, arguably, the most important piece. To claim that they should be kept out of macro is patently absurd.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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Looks too me that Mr Sumner does not understand the importance of credit or put it simply the credit transmission mechanism to the “real economy” that banks play. Is he living in the “real world”? What an absurd comment.
Best,
Martin
“When the economy is too hot the Fed increases the cost of overnight borrowing thereby reducing the spread at which banks make money in an attempt to tighten the supply of loans.”
Aren’t you talking about pre-ZIRP days? With fed funds near zero the Fed can only do monetary policy through the markets via asset prices,no?
“Fed Monetary policy actions are transmitted to the economy via the trading accounts of the Primary Dealers and the markets. That’s how money begins its path to reaching bank reserves and economic activity. The dealers are the transmission mechanism. The markets are the transmission mechanism from the dealers to the economy. The Primary Dealers get the cash first. They are the only deciders of how to distribute it”
http://soberlook.com/2012/09/mainstream-economists-do-not-understand.html
IOER is now a de facto Fed Funds Rate. To tighten IOER would go up.
Great, I posted yesterday hoping you might comment on this. I thought it was funny too, but totally consistent with his previous ideas. Sumner’s basically a neo-classical, right? He’s got that one main difference: the central bank should target NGDP growth rather than inflation… and his explanation that 2008 was REALLY caused by “tight money” … and his idea that “all the Fed has to do really is SAY they’re targeting NGDP and that’ll have the desired effect” idea. But basically he’s neo-classical… and that’s where he and Krugman, and Nick Rowe agree: No need to engage in “Banking Mysticism” (i.e. thinking of banks as anything but an intermediary). The loanable funds model is the right one, so please stop all this noise about the banks having any special roll. “Loanable funds” is perhaps why Sumner is dead set against the “balance sheet recession” idea. He just doesn’t believe that private debt levels have anything to do with the recession… and he doesn’t believe in bubbles… to him, I guess, the market is always rational, although it can experience “shocks.”
Perhaps what it really is, as Adam K has referred to in his comment in your “Dorks” article, or what Steve Keen has said over and over, and what Fullwiler referred to in the “floor” article you posted recently… these guys had to absorb IS/LM and loanable funds back when they were undergrads in econ 101… they internalized that and that forms the core of their intuition, and they’re not going to give that up… they’re going to defend these ideas against all comers, and the idea that “banks matter” is a direct threat to those foundational ideas.
Either that, or he doesn’t want to learn how banks and banking works. He’s already admitted that he doesn’t understand them very well.
Perhaps it’s a combination of both… perhaps they worry… and can guess, from the schooling Fullwiler gave Krugman on bank mechanics, for example, during the Krugman/Keen debate, that those mechanics they resist learning would make their house of cards fall apart. They simply have faith that “banks don’t matter” and that loanable funds is the correct model… and they know a big chunk of their world depends on that, so they react viscerally to anything that looks like a credible threat to their faith.
The interesting thing though is it seems like Krugman may have evolved slightly since those debates. And Nick Rowe always accepted that banks could create money out of thin air… he just believed that because the CB targets inflation (not an interest rate) in the long term, that means that (somehow… I still haven’t figured out his logic on this… it has something to do with his “hot potato” idea) that the CB then ultimately has control over the supply of base money, and thus Krugman is closer to being right than Keen and Fullwiler. I would be interested to see if David Glasner comments on this Sumner article… Glasner seems pretty mainstream neoclassical, but he doesn’t accept Nick’s “hot potato” and he does accept the endogenous money concepts common to MR, MMT, and Keen (though he claims he doesn’t understand the rest of the “post-Keynesian” ideas).
As Mike Sax has pointed out though, and as Sumner has stated outright, he (Sumner) is done with interfacing with people that don’t share his most basic articles of faith (loanable funds, rational expectations, etc…. i.e. the fundamental principals of neo-classical orthodoxy).
Cullen, during the Keen/Krugman debates about “banking mysticism” and aggregate demand, Nick Rowe came to Krugman’s defense, saying (unlike Krugman at the time) that while he agreed with the “MMT” concept that banks can create money out of thin air, he ended up supporting Krugman’s position in the end. Here’s one of his “banking mysticism” articles, and what I take to be a key sentence from it:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/03/banking-mysticism-and-the-hot-potato.html
“In Canada, over a longer horizon, the supply of reserves is perfectly elastic at 2% *inflation*. It is perfectly *in*elastic with respect to the rate of interest (except at very short horizons).”
What does Rowe mean here in this sentence? What exactly does he mean by “elastic” and “inelastic?”
I’m curious, because I think that might lie at the heart of why neo-classicals, while they may reluctantly accept some aspects of how banks actually work, still cling to the loanable funds theory in the end (which justifies them ignoring banks in their models).
BTW, his next article (just hit the next button at the top right) is also on this subject.
Confused? This was an addition (response) to a comment I made that’s “awaiting moderation.” I’m not referring to Scott’s next article, but a related one.
Or perhaps it’s something else that Rowe says here that explains his beliefs: That the central bank asymmetrically participates. The central bank does NOT agree to accept “bank money” at par, he says. But that’s false, right? If a bank creates a loan/deposit, that loan can ultimately be used as collateral, not just in dealing w/ other banks, but in obtaining reserves from the Fed (at least to cover reserve requirements). I think we went through all this with Romeo Fayette months ago in your “Yes Mr. Neoclassical..” article. He also seems to ignore, that w/ no reserve requirements, the “reserves” from the CB don’t really need to exist except temporarily… ultimately they can ALWAYS be borrowed (except for brief overdraft events) on the inter-bank market. And that’s exactly the situation in his native Canada!
It is fitting into Sumner’s ideology: his prescriptions only work if the economy has no banks and all the base money immediately flows into the economy and asset prices. But when banks are present this is not the case. The base money the Fed creates is created by swaps, not helicopter drops. So understanding banking is really crucial to the viability of his models, but he claims he can afford to not understand banking. Krugman has done the same. It is basically an article of faith they make: “let’s assume we can describe the economy and impacts of the monetary policy without talking about banks, please?”
Recently Sumner described the CB control of the price level in presence of IOR as setting the prices of reserves.
“Presumably he cuts the IOR, which reduces the demand for bank reserves, and this reduces the value of bank reserves. So far so good. Bank reserves are a medium of account, so if their value falls then the price level rises.”
http://www.themoneyillusion.com/?p=18700
He forgot that the CB by changing IOR changes the price of reserves with respect to bonds not goods, so it is interest rate setting not price level setting – so it can only move the price level if the demand for credit is very response to rates, unlike now.
Cullen, here’s one of Sumner’s responses to a commenter, which I think is very telling, and REALLY highlights the difference between MR and a prescriptive philosophy like MM:
“Gregor, I agree that in the real world banking problems can be a leading indicator of NGDP decline. But I’d like to change the world so that monetary policy was less inefficient, so that monetary policy prevented banking problems from impacting NGDP.”
So Scott’s not so concerned with reality… he’s more concerned with how things will be once he can “change the world.”
Sounds about right. He’s fitting his ideal world (ideology) into his reality. Which is why his reality is largely irrelevant.
Hey Cullen, … I think this comments section might not be working quite right either. This post should appear at the bottom, not indented. Check the time stamps.
Credit Banks just create a “asset” and extract the capital or fossil fuel flow……………
You will find when the capital is gone – there was no need for the credit banks at all.
They just extract capital – over a long enough time period its becomes pretty obvious.
Obviously they will recommend the max extraction of capital so as to maximize their profits.
For this reason they should be kept out of Macro.
Any increase in the real productive capital base is against their interests as any real effort to increase net capital will subtract from the assets they use as a conduit for farming the fiat / running down the capital base.
I don’t think Scott means “kept out of macro” in the sense that we should be rid of the banks, or even that they matter NOW, but won’t always (“when the capital is gone” as you state), I think he means “kept out of the theory of macro entirely always and forever because they don’t matter now and they will never matter!” which I believe is a terrible idea if you want to accurately describe reality. But it sounds like Scott’s purpose isn’t to describe reality, it’s to “change the world” to comport with his idealized macro economy. And bringing in banks just messes up his vision.
Except Central Banks he likes them. Especially ones headed by Chuck Norris
Right! … and especially when they’re filled with piping hot potatoes!
BTW, I don’t see why Scott should be threatened by including bank models if he really believes his existing models are accurate. If Scott’s models are correct, then bringing in an accurate model of the banks should only marginally improve the fidelity of his model, … which he could then point out, and thus make a powerful argument for using his simpler, cleaner model.
He probably suspects, however, that it might not work out like that!
BTW, I posted pretty much the same comment (above) on Sumner’s site, and he replied:
“Tom Brown, I have no objection to explaining the monetary failures in terms of changes in the credit markets, my fear is that people will start arguing that banking instability causes macroeconomic instability.”
I’m not sure what that means though.
Cullen would you mind expanding on your thoughts below? thanks
“The coin has exposed another option to leaving the banks in control. It’s a debate we should all see coming because the rest of the world is slowly coming around the realization that the real debate is about govt self financing vs a system that is controlled primarily by private banks.”
To me, the coin is a super interesting discussion. It’s an invaluable concept to MMT because it illustrates that we’re not THAT far from achieving a MMT world of govt self financing. The only roadblock is that oligopoly. And I can guarantee you one thing. If you’re a bank CEO, lobbyist or consultant who understands all the things being discussed in this comment section, the coin scared you sh$tless because it was a brief glimpse into the world where modern banking dies at the hands of govt self financing.”
Cullen has done a lot of posts on this coin. Look back over the last couple of months.
“In fact, macroeconomists grossly overrate the importance of banking.”
That statement is patently absurd. Either he cannot comprehend the notion that “financial crises” are not de facto discussions of banking or he is comically ignorant of the literature.
He doesn’t believe that private debt levels had anything to do with the crisis. For him there was nothing wrong with the “Great Moderation” under Greenspan where those levels rose steadily. He does admit that an “exogenous shock” started the collapse off (that would be the housing “bubble” and poor lending standards, etc… he puts “bubble” in quotes because he doesn’t believe in bubbles and thinks the market is always rational). He says what really caused the problem in 2008 was the reaction of the Fed: i.e. overly tight money!
BTW, that “overly tight money” argument is pretty much the same conclusion that Milton Friedman and Anna Schwartz came to regarding the Great Depression in the 1930s… although there I think they at least had a bit more evidence for that being a strong contributing factor. Friedman is one of Sumner’s heroes.
Friedman and Schwartz’s argument was a little more nuanced than a simple case of tight money; and I think Sumner is probably aware of that (I hope…). They specifically highlighted the failure of the Fed to fulfill its expected (at least by the market) role as “lender of last resort” and head off the wave of bank failures from ’31 to ’33. They also raked the Fed over the coals for focusing on nominal rates (and therefore feeling monetary policy was loose) while simultaneously allowing the real interest rate to spike to around 11 percent in an environment of widespread bank failures and rampant unemployment. They were correct on both accounts. That certainly does not mean there were not other factors involved, but Friedman and Schwartz were mostly right.
Actually the circulatory analogy is stronger (in some ways) than you might realize Cullen.
The heart gets all the love in the talk about the circulatory system. It is the pump and when it stops we all know the outcome but few non medical people have dug deeper into the whys of our circulatory system…. its purpose and what drives it. Turns out, the heart is a servant for the cells of the body. It responds to THEIR wishes. The cells gives the directions, the heart tries to respond. “Hey I need to run!!” Yells the leg muscles. “Coming right up sir, 10 liters a minute of blood!!”. “Hey I really need to concentrate on this problem guys” yells the brain. “At your service sir! How much blood do you need? Ill take some from the skin and muscles right now cuz they are at rest”
All kinds of hormonal and neural signals are sent to the heart from the various organs that give the heart instructions as to where to send the blood and how much.
So in our economy the money system responds (or should respond) to the demands of the consumers/producers.
Another analogy that I think works. We have 6-7 liters of blood in our body (the stock of blood) but we can have up to 20 liters a minute flowing through our vessels. We cant simply add to the stock of blood and think the flow will be increased, it doesnt work that way. SImilarly, I think monetarists think that a certain level or stock of money translates automatically and in and of itself to more flows through the economy.
An economy of just banks is not a healthy one just like blood vessels and a heart can not by themselves make up a human.
You write: “Similarly, I think monetarists think that a certain level or stock of money translates automatically and in and of itself to more flows through the economy.”
Yes, perhaps that’s the “hot potato” they talk about. Some neo-classicals/monetarists have retreated a bit from this, and claim that the “hot potato” really only applies to physical cash, but then you’ll note that both Krugman and Sumner keep pointing out that physical cash exceeds electronic reserves at least in normal non-ZLB times. Fullwiler does a good job of debunking this “physical cash is special” argument here:
http://neweconomicperspectives.org/2013/01/understanding-the-permanent-floor-an-important-inconsistency-in-neoclassical-monetary-economics.html
Of course Cullen debunks that all the time too!
Yep ,its between Chuck Norris and hot potatoes for most tired analogy.
I wish my comments “awaiting moderation” would get out of quarantine… I summarize a theory repeated elsewhere (Steve Keen, Adam K) that neo-classical econ 101 (taken when they were youths) sets them up to make their entire world-view dependent on having faith in principals which are very shaky when examined in the light of day (i.e. the “loanable funds,” “quantity theory of money,” “rational expectations,” IS/LM, etc. theories). Looking at banks too closely directly challenges these foundations (esp. “loanable funds”).
Not an analogy per se, but also getting tired of “in the long run”. ;-}
Bruce Lee already kicked Chuck’s ass.
http://pragcap.com/thoughts-on-the-michael-woodford-paper
As Keen says, we’re a credit economy, so only flows and the perception of credit quality matters. We haven’t been a monetary exchange economy since debt/GDP < 1 (whenever that was!).
Nice Greg. Thanks!
I know Scott Sumner is supposed to be a “smart guy”, and Nick Rowe too, but the two of them are just so dense to the real world I can barely read them anymore.
I stopped paying attention to Scott when he claimed Japan had inflation 100x ours because 100 Yen = 1 dollar. I pointed out that the Yen was more like a penny but he persisted…. moron
I have to admit, I’ve seen some jaw droppers over there, but also a lot of stuff that I don’t understand (I assume because I don’t have the background to understand it). So what is it about them that seems to be getting people’s attention (i.e. Bernanke, congress, etc.)?
Is this an “emperor has no clothes” situation?
I liked this comment too, BTW, on Sumner’s site from “Geoff”:
“You guys are all arguing over definitions. It’s nothing but semantic quibbling.”
Policy makers and influential people like Bernanke and Woodford pay no attention to Sumner, the latter stated as much openly.
Keep the academics out of macro?
I am an academic (non-economist though) and I am in macro.
I am not leaving so get used to seeing me around.
This is a fertile field since the crash and a great opportunity to make a huge impact on economics. Besides, I love a good intellectual challenge
Then how about “Keep the economists out of economics?”
I would prefer Cullen spend more time helping us understand other economists and less time selling his own theories. Sumner may have erred in using a bit of hyperbole in the title of his article, but Sumner is no dope.
I agree he’s no dope, but I don’t think that was hyperbole in his title. I think he really believes that. And until recently (and perhaps still) you’d have a lot of folks agree w/ him.. Monetarists, Market Monetarists and neo-Keynseians (Krugman, Rowe, Christensen, Nunes, DeLong, Cochraine, etc)
They call it “Banking Mysticism” to believe that banks are important in macro.
Interesting that the Economist just had an article saying that banks need to be incorporated into Macro models:
Economics after the crisis
New model army: Efforts are under way to improve macroeconomic models
Jan 19th 2013
http://www.economist.com/news/finance-and-economics/21569752-efforts-are-under-way-improve-macroeconomic-models-new-model-army
That’s the article Sumner was responding to. He says so the top of his article.
Sorry, my bad, I hadn’t read Sumner’s article.
Scott’s cool. Fed policy was contractionary. If there is a better reason to target nominal-gDp (rather than just prices), you would think it would be because of limited upward & downward price flexibility (the hallmark of a healthy competitive economy). But what seems more intractable is closing the “output gap”.
The time it takes to catch up to the trend rate of real-gDp income streams seems much longer than “transitory” pricing. The downside to unemployment, federal, state, & local deficits, etc. all seem more important (harder to reverse).
Real gDp:
2008-04-01 13310.5 peaked
2011-10-01 13441.0 caught back up
Gross Domestic Product:
2008-04-01 14415.5 peaked
2010-07-01 14576.0 caught back up
Personal Consumption Expenditures: Chain-type Price Index (PCEPI)
2008-07-01 110.235 peaked
2009-12-01 110.290 caught back up
If the CB would have operated with a different target, the recession wouldn’t have been as deep.
Actually Bernanke never eased. The Fed couldn’t. The IOeR policy effectively emasculates its “open market power”. Otherwise POMO’s could have pushed the roc in MVt up faster (despite a balance sheet recession).