August 30th, 2013
in Op Ed
by Steve Randy Waldman, Interfluidity.com
There has been a recrudescence of blogospheric argument on the nature of commercial banks, whether they are best considered “financial intermediaries” not unlike mutual funds or insurance companies, or whether they are something different, in particular, whether their ability to issue liabilities that are near-perfect substitutes for base money renders them special in macroeconomically important ways. See e.g. Cullen Roche, Winterspeak, Ramanan, and Paul Krugman.
If banks are mere intermediaries between savers and borrowers, it may be reasonable to abstract them out of macroeconomic models and simply focus on the preferences of borrowers and savers and the price mechanism (interest rates) that ultimately reconcile those preferences, perhaps with “frictions”. If banks are special, if they have institutional characteristics that affect the macroeconomy in ways not captured by the stylized preferences of borrowers and savers, then it may be important to model the dynamics of the banking system explicitly.
Paul Krugman says banks are not special, most recently citing James Tobin’s famous paper on Commercial Banks As Creators of Money:
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.
I want to unpack this just a bit. First, please don’t misunderstand the argument. Tobin’s, and by extension Krugman’s, point is not the facile argument sometimes made, that loans don’t meaningfully create deposits because a bank needs to fund the loan when the deposit created by a loan is spent or transferred. That is true of an individual bank, but not of the banking system as a whole, the object to which Tobin correctly devotes his attention. It is an entirely uncontroversial fact that when the banking system net-increases its lending it creates new deposits, regardless of whether an individual lender’s balance sheet expands permanently or ephemerally.
Tobin’s argument was that this mechanical capacity of the banking system to “create new money” by net-lending ultimately doesn’t matter very much, because the non-bank private sector has a preferred portfolio of assets, of which bank deposits are a single component, and the net-lending of the banking system is constrained and ultimately determined by the non-bank sector’s desires. If the banking system somehow ramped up its lending in ways that create more bank deposits than the non-bank sector wished to hold, the nonbank sector would pay down bank loans until its preferred portfolio was restored. This is a perfectly coherent view, a view fully cognizant of the mechanics of bank lending and deposit creation, under which there is nothing fundamentally important about banks. Everything that matters is captured by the portfolio preference of nonbanks, so a macro modeler might reasonably ignore the details of the banking system and simply model the portfolio choice of the nonbank sector.
However, that a view is coherent doesn’t mean that it is accurate. The weakness of the Tobin/Krugman view is that common Achilles Heel of macroeconomic models, aggregation. In order for banks not to matter, it must be reasonable to model the non-bank private sector as if it were a unified actor with preferences independent of the behavior of the banking system. It’s easy to offer plausible accounts under which this would not be the case.
Suppose, for example, that banks lend primarily to cash-starved agents, and that cash-starved agents spend primarily to cash-rich agents. (I am including bank deposits as in my definition of “cash” here.) Should the banking system “exogenously” increase lending, the effect would be first a transfer of cash and an increase in debt to the cash-poor, and then a transfer of cash to the cash-rich as borrowers spent their loans. Suppose that the cash-rich then find themselves holding more bank deposits then they prefer to hold. Mechanically, they have absolutely no ability to redeem the deposits for other assets. The only way that deposits in aggregate are reduced is when loans are repaid to the banking system. But the cash-rich have very few loans to repay! Unless they pay off the loans of the cash-poor, taking losses to uphold the collective preferences of a putative nonbank private sector, bank deposits are as inescapable to cash-rich as base money is to the private sector as a whole.
If the real world looks anything like this, then commercial banks do indeed have something quite analogous to a central bank’s printing press. Net-expansions of the banking system’s balance sheet provoke an inescapable injection of deposits into the aggregate portfolio of the cash-rich. The price of bank deposits, like base money, is pegged to unity. If deposit balances come to exceed the desired allocation in portfolios of the cash-rich, the imbalance cannot be resolved by falling prices. Instead, a “hot potato” effect must take hold: prices of other assets might be bid higher until deposits are restored to their desired small share of the aggregate portfolio. Credit expansion would lead to asset price inflation (much more than to ordinary price inflation, as the consumption plans of the cash-rich need not change in real terms, so there is no impetus to bid up the prices of goods, services, or labor). As a stylized fact about the world, bank-credit-expansion-leads-to-asset-price inflation seems pretty solid. [1, 2]
This is just one account among a potentially infinite many under which the Tobin/Krugman “banks don’t matter” view would be insufficient, despite its theoretical coherence. It would be nice, from a tractability perspective, if the nonbank private sector could be modeled as a single agent with portfolio preferences independent of the behavior of the banking system. But I think the weight of the evidence suggests that the world is more complicated than that. I think we will need to account explicitly for the behavior of the banking system in order to capture important features of the macroeconomy.
 The account I’ve provided is a simplification. Implicitly, I’m presuming a banking system that holds no assets other than base money and loans to customers. In the real world, bank balance sheets may hold all sorts of assets. For the persnickety, lets generalize the tale. Deposits may be redeemed not just by repaying loans, but by purchasing any sort of asset off the consolidated banking system’s balance sheet. Repaying a loan is a special case of an asset purchase: a borrower buys up her own obligation to a bank. But deposit holders who are not borrowers can shed deposits in the real world by, for example, purchasing Treasury securities held by banks. Does this meaningfully change the story? Given a modest credit expansions, maybe. Given a large credit expansion, definitely not. Let’s go through it.
When we claim that “deposit balances come to exceed the desired allocation in portfolios of the cash-rich”, we are implicitly conjecturing some menu of other assets that become underrepresented. If all of those other assets are held on the banking system’s balance sheet and available for sale, then cash-rich agents can restore their preferred portfolio simply by redeeming excess deposits for the assets they desire until their desired allocation is restored.
However, unless the assets the cash-rich desire are illiquid loans to the cash-poor, there will exist a scale of credit expansion beyond which some or all of the desired assets become unavailable for purchase from bank balance sheets. A creative solution to this problem is for banks to try to transform illiquid loans to the cash poor into substitutes for the assets the cash-rich desire. That’s one explanation (in addition to regulatory arbitrage) for the securitization boom of the early 2000's. But as we’ve seen, the strategy has its limits. Unless we posit perfect alchemy, there will be some scale of credit expansion beyond which cash-rich agents cannot restore balance to their portfolios by purchasing assets from the banking system.
Realistically, the scale of credit expansion beyond which portfolio balance cannot be restored by direct redemption of deposits need not be very large at all. For example, cash-rich agents typically desire to hold much of their wealth in corporate equities, which commercial banks hold in small quantities if at all. Following an injection of deposits provoked by lending and spending, cash-rich agents will be unable to restore their desired allocation of stocks except by bidding up share prices.
A common, but foolish, dodge of these problems is to pretend that the only assets in the world (besides loans) are base money, bank deposits, and Treasury securities, and then to presume that the banking system will always carry a sufficient inventory of Treasury securities and base money to restore balance through deposit redemption. This is stupid for the obvious reason that private-sector portfolio allocations contain stuff other than Treasuries, base money, and bank deposits, and for the less obvious reason that accommodating unlimited redemption implies that the banking system may borrow in unlimited quantities from the state.
For the super-persnickety, bank deposits can also be redeemed by purchasing services, rather than assets, from the banking systems. That is, cash-rich agents could get rid of excess deposits by doing stuff that caused them to increase their bank-fee expenses. It is unlikely they’d find this a very appealing way to restore portfolio balance, however.
 Readers might complain that I am misrepresenting Tobin a bit here, in that I’ve attributed to him the view that an overabundance of deposits will be remedied via loan repayment or asset purchase, while Tobin explicitly allows for a price-adjustment mechanism as well:
Given the wealth and asset preferences of the community, demand for bank deposits can increase only of yields of other assets fall [and therefore prices of other assets rise]. The fall in these yields is bound to restrict profitable lending and investment opportunities available to the banks themselves. Eventually the marginal returns on lending and investing, account taken of the risks and administrative costs involved, will not exceed the marginal cost to the bank of attracting and holding additional deposits.
Tobin draws a sharp contradistinction between deposits and base money:
Once created, printing press money cannot be extinguished, except by reversal of the budget policies that led to its birth. The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies. For bank created money, however, there is a mechanism of extinction as well as creation, contraction as well as expansion. If bank deposits are excessive relative to public preferences, they will tend to decline; otherwise banks will lose income. The burden of adaptation is not placed entirely on the rest of the economy.
Tobin wants to conclude that bank deposits differ from the obligations of other private financial intermediaries in degree rather than in kind. But, on the facts he accurately and perspicaciously observes, he might as easily have argued that bank deposits differ from base money in degree rather than in kind. After all, the economy adjusts to the issuance of no other private-sector asset by shifting prices and yields of across the full spectrum of financial assets. That sort of adjustment implies a “hot potato” effect sometimes. It seems arbitrary for Tobin to claim that for the “‘hot potato’ analogy” to truly apply, bidding up of other assets must be the only conceivable means of private-sector adjustment to its issuance. Since bank deposits behave sometimes or partially like “hot potatoes”, since they uniquely share the quality of being pegged to a price of unity with a government guarantee, they arguably share as much resemblance to base money as they do to “ordinary” financial assets. Tobin makes much of the fact that there is a limit to profitable issuance of deposits, that eventually yields on lending and deposits must converge, but there are limits to profitable issuance of base money as well, the state’s capacity for seignorage is not inexhaustible. The state must contract the supply of its money and obligations when private sector demand for them falters, or risk hyperinflation and political collapse. Banks and states have surprisingly similar financial structures, and modern banking systems inevitably include states at their core.
I think a lot of assumptions that foreshadow current disagreements surrounding banking are embedded in Tobin’s phrasing:
“Given the wealth and asset preferences of the community…[t]he fall in…yields is bound to restrict profitable lending and investment opportunities available to the banks themselves.”
Tobin presumes a unified financial community and rational profit-seeking banks. People (like me) who think a detailed understanding of the institution of banking should be at the heart of macro modeling contest both of those assumptions. We think that there is no homogenous “community”, but segmented populations whose socially problematic interactions are often mediated via financial institutions. We think that banks do not always or even usually behave in ways that can be characterized by a well-behaved infinite-horizon profit maximization problem. Instead, for a variety of reasons ranging from agency problems, political influence, faddishness, and mere error, we view bank behavior as special and complex. So we find it convenient to model banks specially, or to examine expansions and contractions of credit as if they were exogenous, rather than presume that other aspects of our models neatly determine what banks will do.