Banks are Special: the Ins & Outs of Money

I was going to drop the back and forth with Paul Krugman, but then he dangled this delicious treat in front of me and like any good little puppy I just had to jump up and bite at it.  So, here I go back to snapping at the big dog.  I apologize to Dr. Krugman’s ankles in advance, but this point is the crux of our entire discussion so I think it’s crucial that we cover this point thoroughly.

Dr. Krugman’s piece yesterday on banking showed a substantial step towards the Post-Keynesian & the endogenous money position that banks create money endogenously.   Dr. Krugman says:

“All the points I’ve been trying to make about the non-specialness of banks are there. In particular, the discussion on pp. 412-413 of why the mechanics of lending don’t matter — yes, commercial banks, unlike other financial intermediaries, can make a loan simply by crediting the borrower with new deposits, but there’s no guarantee that the funds stay there — refutes, in one fell swoop, a lot of the nonsense one hears about how said mechanics of bank lending change everything about the role banks play in the economy.”

So we’re now both on the same page that “loans create deposits” and that this can be done simply by marking up the borrowers account.  But we’re still not seeing the importance of banking the same way and I think part of the confusion stems from the Tobinesque view of banks.  In the Tobin world banks are basically just financial intermediaries who act as deposit acceptors in order to satisfy portfolio allocations.  But that view severely downplays the fact that banks are the primary creators of money in our system and this money they create (inside money because it is created inside the private sector) rules the monetary roost.  Stick with me here.

The expansion (and at times contraction) of inside money (money created inside the private sector by banks as a result of a loan that creates a deposit) is one of the key determining factors in how investment is financed, how you buy your home (in most cases) and how the economy expands and contracts.  And its creation is not constrained by central bank reserves or deposit holdings and it does not get “multiplied” as almost all mainstream textbooks theorize (Tobin understood this as previously discussed and the Federal Reserve has recently discussed this point).  This is what the endogenous money view is all about!  And in order to understand it you have to realize that this isn’t the case merely inside of a “liquidity trap”.  It is always the case!  All the crisis did was expose the actual way banks always operate.  It is not a special, unique or temporary event.  Banks always make loans independent of their reserve or “multiplier” position.  Loans always create deposits and this loan creation process is absolutely crucial in understanding how the monetary machine works.  

But what about their role as financial intermediaries?  Well, the Tobin view is somewhat incomplete and puts banks in the wrong perspective.  In Monetary Economics Wynne Godley and Marc Lavoie provide a much more realistic view of banks and explained why the Tobin view was not entirely accurate:

“In other models that attempt to integrate bank behaviour to a full-fledged macroeconomic model, specifically that of Brainard and Tobin (1968) and Tobin (1969), banks are essentially agents operating in financial markets who do nothing but make an asset choice exactly like the asset choice of households and conducted according to the same principles. The role of banks is thus nothing more than to extend the range of asset and liability choice open to households. Tobinesque banks are treated like financial intermediaries. Their main function is not to create loans which make possible the expansion of production and the financing of inventories. Their main role rather is to allocate assets and to decide whether they are prepared to take on any additional liabilities. This view of banks is a rather artificial one, and it leads Tobin (1969: 337) to make some strange constructions, such as a deposit supply function which describes ‘the quantity of deposits banks wish to accept at any given deposit rate’, or to argue that the rate of interest on loans adjusts to clear the credit market…We are proposing something entirely different here. (p. 334).”

…

“In G&L models, banks are creators of credit-money, and they play an essential systemic role. This must be contrasted to the role of banks in most of Tobin’s models. Banks in his models are presented as a simple veil, that provide households with the opportunity to enhance their choice of assets. As is clear in Brainard and Tobin (1968), banks, like households, are assumed to make portfolio asset choices, based on rates of return, among free reserve assets, loans and government bills. Loans play no special role in this approach – they have no priority – and banks could as well be a non-banking financial institution.2 This impression is reinforced by a reading of Tobin (1982a), where bank loans are omitted altogether from the formal model. When banks are mentioned, it is claimed that the ‘traditional business of commercial banks is to accept deposits…and to acquire assets of less liquidity and maturity….Other intermediaries likewise transform their assets into forms better tailored…to the preferences and circumstances of their creditors’ (1982: 193).3 Backus et al. (1980: 265) also formally describe banks as pure intermediaries, but they do concede that, more realistically, bank loans play.  a special role in monetary production economy, admitting that ‘banks regard business loans as a prior claim on their disposable funds, and meet these demands at the prevailing rate, only later adjusting this rate in the direction that brings loan demand closer to the bank’s desired supply’. This ‘more realistic’ accommodating bank behaviour is more in line with the role of banks in G&L models, which to some extent resemble the banks described by Fair (1984: 72).”

So now I hope we’ve reached a moment of true clarity.  Banks are indeed special.  In fact, they’re beyond special.  They are the oil in our monetary machine.  As I like to say, inside money “rules the monetary roost”. Inside money is the dominant form of money in circulation today and it is the tool that is used at the point of sale in most modern economic transactions.  Outside money, or government money (cash, coins and reserves) is a facilitating form of money.  Cash and coins primarily serves to allow inside money customers to draw down bank accounts for convenient transactions.  And reserves serve primarily to smooth out the interbank settlement process.  The reserve system is a support mechanism designed around the inside money system.  It is not the center of the monetary universe as most economists depict.

When understanding the crisis and why the economy broke down this understanding was central to what was going on because once the engine stopped running due to a lack of oil (the de-leveraging) then the car broke down.  Thus, the IS/LM model which is quantity centric, was never going to help understand the crisis because it couldn’t help us understand how the bank lending mechanism was broken after the credit bust.  But more importantly, this is not a temporary event.  Banks are not temporarily failing to “lend out” reserves.  This is always the case.  All the crisis did was expose the operational reality of the banking system as being unconstrained by reserves.  And perhaps most importantly, banks are not just mere intermediaries in the system who can be removed from a realistic economic model.  They are the oil in the engine and one of the most crucial components of the monetary machine.   And yes, you can omit the oil and its circulation from your economic model, but don’t be shocked when your own model breaks down as a result.

To see this entire back and forth from start to finish please see here:

Cullen Roche: The Failure of the IS/LM Model in Predicting the Crisis

Paul Krugman: Banks and the Monetary Base

Cullen Roche: Banks and the Monetary Base – A Friendly Response to Paul Krugman

Paul Krugman: The Monetary Base, IS-LM, And All That

Cullen Roche: Economath: economics – IS/LM – Krugman Cross = Win

Paul Krugman: Banks as Creators of “Money”

Related:  Understanding the Modern Monetary System

Understanding Inside Money & Outside Money

* Big thanks to Carlos Mucha for the Godley & Lavoie quotes.  

** I should add that outside money can certainly influence the price of inside money, but this does not mean that the creation of new inside money is necessarily dependent on the amount of outside money.  The central bank must accommodate the inside money system’s needs for reserves at all times.  And it must do so in a manner that would not create systemic instability.  After all, the Fed’s primary job is to oversee stability of the payments system. 

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