I'm going to put forward two perspectives on why bad banks might be important in understanding the recession: an orthodox perspective; and a heterodox perspective.
Banks are financial intermediaries. A financial intermediary is a firm whose (primary) business is borrowing and lending. (They intermediate between the ultimate borrowers and the ultimate lenders). That's an important job. The ultimate lenders could lend directly to the ultimate borrowers. But then each ultimate lender would have to collect information on the creditworthiness or profitability of the ultimate lenders. Information is a non-rival good. There is no point in several ultimate lenders duplicating the costs of collecting that same information. A financial intermediary can collect the same information just once, and act as agent to the ultimate lenders' principal. To ensure the agent acts more or less in the principals' interest, banks act as residual claimant, and for this they need capital, so banks' capital can take the first hit when their loans go bad.
If banks go bad, because a lot of bad loans caused a loss of banks' capital, they must raise new capital, or shift to less risky loans, or contract their balance sheets in proportion to their loss of capital. Raising new capital generally means banks must issue new shares. The same financial crisis that caused banks' loan losses may also cause a fall in banks' share prices. People's uncertainty over the value of banks' assets may further lower banks' share prices. If banks believe that their share prices are below their fundamental value, they will be unwilling to issue new shares to raise new capital.
I'm not 100% sure my above story makes sense, either theoretically or empirically. But let's suppose it does. So we have "bad" banks, that have only their remaining capital, are unable or unwilling to issue shares to raise more capital, and so face a perfectly inelastic supply curve of capital — they have what they already have, and cannot get more, at any "reasonable" price. They cannot expand their balance sheets to take advantage of what would otherwise be profitable opportunities, because each individual bank is capital-constrained. A fall in the interest rate on reserves at the central bank, which would normally give each individual bank the incentive to expand its balance sheet, even if it meant raising more capital by issuing new shares, will now have no effect. Because banks' balance sheets are capital-constrained. (See my previous post.)
So what. Why does this matter? That's what I'm trying to understand. If someone says "we can't get a recovery until bad banks get fixed", why is that?
If we view banks merely as financial intermediaries, then I find it hard to see why bad banks would really matter much, under present circumstances.
Sure, good financial intermediaries are important for the efficient allocation of the flows of savings between competing borrowers. They will make sure savings flow to the places where they earn the highest (risk-adjusted) return. A country with good financial intermediaries, doing this job well, will have a Long Run Aggregate Supply curve moving rightwards more quickly than an otherwise identical country with bad financial intermediaries, because the (risk-adjusted) return on savings and investment will be higher.
But the current economic crisis does not exhibit the symptoms of a problem with the AS curve. We have symptoms of excess supply of goods and labour, and falling prices. That suggests a fall in Aggregate demand, relative to Aggregate Supply. So even if bad banks have caused to LRAS curve to shift left (or move rightwards at a slower pace), that is not the current problem. We have a fall in AD, and current output and employment is demand-constrained, not supply constrained. We have a general glut.
Why should bad banks cause AD to fall?
Banks borrow short, safe, and liquid; and lend long, risky, and illiquid. And they earn their income on the spread between the interest rates. Bad banks will mean higher spreads, because capital-constrained banks are unwilling to expand their balance sheets to exploit and hence reduce those spreads.
Different people and firms face different costs of funds, or opportunity costs of funds. The whole 3D picture of the yield curve (across time, risk, and liquidity) will affect consumption and investment demand. "The" interest rate that determines consumption plus investment demand will be some sort of weighted average of the whole 3D curve. For a given interest rate set by the central bank, at the short, safe, liquid, end of the spectrum, the greater the spread(s) the higher will be "the" rate of interest which determines consumption plus investment demand. So bad banks increase the spread between the central bank rate and "the" interest rate, and so reduce Aggregate Demand, for any given rate set by the central bank. Bad banks could force the central bank rate down to zero, and still leave insufficient AD.
The above represents my best attempt to represent the "orthodox" view of why bad banks are (partially) responsible for the current recession. I think there is some truth in that orthodox view. I have proposed it myself in a previous blog post. And by "orthodoxy" here I mean the Neo-Wicksellian consensus that prevails in central banks, as well as academia, and views the monetary policy transmission mechanism as operating solely via interest rates. [And yes, Post-Keynesians, you are absolutely orthodox in that regard: horizontalist Neo-Wicksellians minus microfoundations. Sorry. I couldn't resist a little dig at your heterodox self-image ;-)].
But is that orthodox consensus the whole truth?
Financial intermediaries are useful (to reduce information costs) but not essential. A lot of lending and borrowing is direct, via stock and bond markets, and does not go through financial intermediaries. And banks aren't the only financial intermediaries either. I have often been a financial intermediary myself, when I both borrow and lend at the same time. (OK, sure, I miss on the technical definition of "financial intermediary" because my primary business is being an economics professor, but so what?).
The textbook definition of a bank is: a financial intermediary, some of whose liabilities are media of exchange. Banks create money, in that outdated viewpoint. The fact that people have chequing accounts at banks, and those chequing accounts are the most important means for people to buy and sell everything else, is what makes banks special, and important. Currency is the only alternative. And it's an outdated viewpoint because in the current orthodoxy the quantity of money is demand-determined. Monetary policy is interest rates, and interest rates cause aggregate demand, and if they also cause money, that is just as an aside.
Against that orthodoxy, the heterodox view argues that general gluts are always and everywhere a monetary phenomenon; the proximate cause of an excess supply of goods is always an excess demand for the medium of exchange. And the quantity of money (qua medium of exchange) is supply-determined, in a way that is quite distinct from any other good. It's a view arising from the confluence of disequilibrium monetarist and Keynesian streams.
Money is an asset (and usually a liability too), but is different from every other asset because everybody regularly both buys and sells money whenever they sell and buy anything else. That's what it means when we say that money is the medium of exchange. There is only one way to hold more land than you are holding now, and that is to buy more land. There are two ways to hold more money than you are holding now. One way is to buy more money (i.e. sell more other things); the second way is to sell less money (i.e. buy less other things).
An excess demand for land cannot cause a general glut of newly-produced goods, even though a desire to spend part of your income to buy land counts as desired "saving" according to standard definition. If everyone is trying to save in the form of land, so everyone wants to buy land, and nobody wants to sell, what happens? They fail, of course. Unable to spend their income on land, unless people decide to save their income in the form of money, they must decide to spend it on something else instead. Absent an excess demand for money, an excess demand for anything other than newly-produced goods must be frustrated, and people change their plans and decide to buy newly-produced goods instead. The inexorable logic of Say's Law dictates there cannot be a general glut that way, unless people desire to save in the form of money.
If people decide to save more, and save in the form of money, they might try to buy more money (i.e. sell more other things, like labour). They will fail of course, in a general glut, where all goods (like labour) are in excess supply. But an individual can never fail to to sell less money (i.e. buy less goods) and get more money that way. Each individual can succeed, but in aggregate they must fail (if the total stock of money is not increased). But the result is a fall in goods bought, and a fall in goods produced, and a fall in labour demanded.
A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of the medium of exchange.
So where do banks come in? Banks create money. Sure, the central bank creates currency, but most people buy most things not with currency, but with the money created by commercial banks. We pay by cheque, or debit card, or ATM from our chequing account.
Forget currency (mainly, I admit, because I can't really get my head around where it fits in). Assume that all money is bank money. The commercial banks are the central bank's agents for creating money. Normally, when the central bank wants to create more money, it shifts the supply curve of reserves (shifts a horizontal supply curve down, or shifts a vertical supply curve right, or anything in between), and individual banks respond to this incentive of a lowered supply-price of reserves to expand their balance sheets, supplying more money on the liability side (and supplying more loans, buying more bonds, computers, whatever, on the asset side).
But even if banks want to supply more money, how can the actual stock of money increase, unless people want to hold more money? For any other asset, you cannot sell more unless people demand to hold more. If banks were land banks, they could not sell more land unless they persuaded people to want to own more land, by lowering the price of land, or raising rents, or whatever. But money is different. And it's different because it is the medium of exchange.
When a bank makes a loan, it does so by crediting the borrower's chequing account $100 in return for an IOU for $100. The borrower may ask about the interest rate on the loan. But he will not ask about the interest rate on his chequing account. Nearly all borrowers borrow money because they want to spend it, not because they want to keep it in their chequing accounts. Individual banks increase the interest rate on chequing accounts not because they want to persuade people to accept more loans, but only because they want to attract more deposits so they don't have to borrow as much from the central bank.
If the central bank increases the supply of reserves, and banks respond by increasing the supply of loans, the money supply expands, regardless of whether those borrowing from the bank demand a greater quantity of money. Banks really are like helicopters, in that they can increase the quantity of money held without needing to creating a demand to hold more money. For any other asset, if you wanted people to hold more, without getting them to want to hold more, you would have to give the asset away, for free. Throw it out of a helicopter.
Now commercial banks certainly don't give away money for free. But they can "force" people to hold more money even when people don't want to hold more money. Each individual borrower accepts money in exchange for his IOU, because he can get rid of that money by buying something. But in aggregate they can't get rid of the money they don't want to hold. One person's spending of money is another person's receipt of money. But their attempts to get rid of that money are what gets us out of the recession, by eliminating the general glut of other goods.
Central banks got rid of their fleet of helicopters when currency got replaced by demand deposits as the primary medium of exchange (again, I admit, I'm unclear on where currency fits into my picture). They contracted out helicopter operations to the commercial banks. They wanted the commercial banks to create the excess supply of money at current levels of income, leading people to want to spend that excess so we can escape any general glut. But now the banks' helicopters won't fly, because banks lack the capital to expand loans.
It ain't the loans what matter; it's the money creation that goes along with loan creation what matters. That's why (bad) banks matter. Bad banks won't create money.
Update: I wrote this post partly as a follow-up to my previous post on banks, and partly as a response to a post by Scott Sumner that was sort of a response to that post.
Worthwhile Canadian Initiative 
“Forget currency (mainly, I admit, because I can’t really get my head around where it fits in). Assume that all money is bank money. The commercial banks are the central bank’s agents for creating money.”
And, “Central banks got rid of their fleet of helicopters when currency got replaced by demand deposits as the primary medium of exchange (again, I admit, I’m unclear on where currency fits into my picture).”
This is why we disagree so much. Back to a mortgage. When someone buys a house, does he/she get the mortgage and eventually and usually pay with a check (demand deposit)?
Think about an economy with all currency and NO currency denominated debt. What would it look like?
“Forget currency (mainly, I admit, because I can’t really get my head around where it fits in). Assume that all money is bank money. The commercial banks are the central bank’s agents for creating money.”
Is it more accurate to say “The commercial banks are the central bank’s agents for creating currency denominated debt with an interest rate attached and repayment terms attached.”?
“Central banks got rid of their fleet of helicopters when currency got replaced by demand deposits as the primary medium of exchange (again, I admit, I’m unclear on where currency fits into my picture).”
Assuming you want to increase the amount of the medium of exchange, should you increase demand deposits (currency denominated debt) or currency?
“If the central bank increases the supply of reserves, and banks respond by increasing the supply of loans, the money supply expands,”
I thought people said supply of loans was determined by capital. Is it the central bank increases the supply of reserves, interest rates come down, and demand for currency denominated debt (a loan) goes up (they are hoping for that)?
“Forget currency (mainly, I admit, because I can’t really get my head around where it fits in). Assume that all money is bank money. The commercial banks are the central bank’s agents for creating money.”
With legal tender laws, is currency used to make the interest payments on currency denominated debt whether gov’t (thru taxes) or private?
“But the current economic crisis does not exhibit the symptoms of a problem with the AS curve. We have symptoms of excess supply of goods and labour, and falling prices. That suggests a fall in Aggregate demand, relative to Aggregate Supply. So even if bad banks have caused to LRAS curve to shift left (or move rightwards at a slower pace), that is not the current problem. We have a fall in AD, and current output and employment is demand-constrained, not supply constrained. We have a general glut.
I believe Stiglitz has said something similar to this. Recessions happen with problems on the AS side, while depressions happen with problems on the AD side, almost always currency denominated debt problems.
I’m going to add consumer currency denominated debt.
Why should bad banks cause AD to fall?”
because the people (the lower and middle class experiencing negative real earnings growth) couldn’t make the interest payments leading to defaults and should not be borrowing. It was bad bank lending behavior.
It is not the banks that need bailed out. It is the lower and middle class.
Another point. If lower interest rates don’t get excess savers to spend, excess debtors to go further into currency denominated debt, and people who were excess savers but aren’t anymore because of work hour cuts or wage income cuts to go further into currency denominated debt, what should happen?
Too much: “When someone buys a house, does he/she get the mortgage and eventually and usually pay with a check (demand deposit)?” Yes.
“Think about an economy with all currency and NO currency denominated debt. What would it look like?” Horrible. No pension plans. But OFF-TOPIC!
“Is it more accurate to say “The commercial banks are the central bank’s agents for creating currency denominated debt with an interest rate attached and repayment terms attached.”?” No.
“Is it the central bank increases the supply of reserves, interest rates come down, and demand for currency denominated debt (a loan) goes up (they are hoping for that)?” Quantity demanded of loans goes up. Yes.
“With legal tender laws, is currency used to make the interest payments on currency denominated debt whether gov’t (thru taxes) or private?” No. We usually pay by cheque.
Now, back off a little please. Let someone else attack me!
No attack here, generally I thought that was pretty good.
Just one question, which might be a dumb question, but here goes anyway – if someone doesn’t want to hold currency what alternative do they have that might keep the money from showing up as a bank deposit. For example, I could buy stock, but then whoever sells me the stock has the money in their bank account.
Seems like the money created by the loans is a hot potato that gets passed around from bank account to bank account, but is always in one bank account or another. Is there somewhere else it could go that isn’t occurring to me?
And if not, in what sense do ‘ultimate lenders’ really choose to lend, lending would equal borrowing as an accounting identity, but it wouldn’t really have any explanatory meaning.
Declan: Thanks.
Your “hot potato” metaphor is exactly the same metaphor that “disequilibrium monetarists” use to describe the same process. There is nowhere it can go. Unless someone pays off a bank loan. But then the bank, if nothing else has changed, will just make a loan to someone else. They can’t get rid of the hot potato, but in their attempts to get rid of it, by buying stuff or lending it, they cause output and income to rise, and/or prices of goods and assets to rise, until income and prices rise enough that the demand to hold money rises enough, that they decode they want to hold it after all. And that’s the new, happier, equilibrium.
You lost me on the last bit, I’m afraid.
Assuming the CB does not intervene, if banks (or most banks) have insufficient capital, do they switch from supplying money to demanding money? The bank itself can satisfy it’s demand for more money by selling less money (contracting credit), with the secondary effect that contracting credit can create a recession. Which causes everyone else to demand more money, so they sell less money and keep it in their bank accounts – which helps satisfy the banks demand for more money.
Patrick:
I’m not quite sure what you are saying. I’m going to give two different answers, for two different interpretations:
1. Suppose a bank has insufficient capital, and wants to get more. A banks capital represents its wealth, or net worth. Or shareholders’ equity. It’s what it owns (assets) minus what it owes (liabilities). If a bank borrows (demands money?), that doesn’t increase its capital (unless it borrows by issuing new shares). It just increases its assets and liabilities by an equal amount.
2. If a bank has insufficient capital for its current assets and liabilities, and doesn’t or can’t get more, it might call in loans, or sell assets. That contracts its balance sheet, and reduces the supply of money at the same time.
I was imagining a bank that had barely sufficient capital to start with. So it won’t call in loans, but won’t make new ones either. It won’t contract, but can’t expand.
NR: In the first part of your post, you get everything precisely backwards. I guess that’s what happens when you start with “Banks are financial intermediaries”.
You and I actually agree when you say “A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of the medium of exchange.” I think your definitions are screwy and stick with the common sense definition of saving as “income you do not spend”.
You lost me with how banks can make people who don’t want to take out more loans take out loans. And the Govt (albeit not the banking sector) still has massive fleets of helicopters they could fire up on Monday.
Also, please note how a falling economy, with collapsing AD, impacts even a well capitalized bank’s desire to lend.
Thanks for the response Nick. What I meant at the end of my comment was, if banks create money by lending, and that money has nowhere to go but back to the bank as a deposit, then the view of the bank as intermediary doesn’t make much sense to me. The ‘ultimate lender’ has no agency – they have money so the money sits in a bank. They don’t choose to lend it, and they won’t stop lending it if interest rates on deposits get too low. They can’t do anything (in aggregate) but lend their money.
The decision makers are the borrower and the banker. If they are both willing, then the money supply expands, if either of them is unwilling or unable, then money supply is static (or decreases as existing loans get repaid).
The person who has a deposit in the bank is just a bystander. The depositor could give their money to a potential borrower directly (in return for a promise of interest payments in the future), but this wouldn’t have the same effect as borrowing from a bank, and to the extent that it replaced bank lending, it would have a negative impact of money supply.
Nick: Mises has a great passage on this precise subject.
Winterspeak: I’m glad to see your response.
“In the first part of your post, you get everything precisely backwards. I guess that’s what happens when you start with “Banks are financial intermediaries”.”
I thought I was being very orthodox there. Nothing especially original. Just textbook money and banking, minus the money! Perhaps it’s that last part (“minus the money”) you object to. So do I.
“You and I actually agree when you say “A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of the medium of exchange.” I think your definitions are screwy and stick with the common sense definition of saving as “income you do not spend”.”
Yes! I thought we would agree there. But you and i must be about the only people who do (I exaggerate slightly). “My” definition isn’t mine. It’s the standard keynesian national income accounting textbook definition of “saving”. I agree it’s not a useful definition in this context.
“Also, please note how a falling economy, with collapsing AD, impacts even a well capitalized bank’s desire to lend.”
Yes, because it makes some otherwise good loans go bad. Absolutely. I forgot to include that bit. It’s an important deviation-amplifying feedback loop. But it isn’t essential to my story, and I need to keep my story as simple as possible.
“And the Govt (albeit not the banking sector) still has massive fleets of helicopters they could fire up on Monday.” Filled with currency? Or bank money? I want to leave fiscal policy out of it, because it’s hard enough keeping my head straight as it is.
“You lost me with how banks can make people who don’t want to take out more loans take out loans.”
You misunderstood what I was trying to say. They want to take out the loans, but they don’t want to hold the loans as money. They want to spend it. Each individual can spend the money and stop holding it, but in aggregate someone’s got to hold it. So in aggregate, they are forced to hold more money than they want to hold.
Declan: OK. I understand you better now. I think you might be right, and making an important point. But need to think about it some more. It’s late here.
Hi Nick
Regarding the “hot potato” issue, I’m with you on the point that buying any asset or good/service just “moves the money around.” But, are you assuming there are no time deposits, money market accounts, money market funds, and the like, which enable individuals to simply relabel existing deposits as less liquid, interest earning balances while remaining on the same bank’s balance sheet? Or, are you assuming those things are “money,” too?
Jon: “Mises has a great passage on this precise subject.”
Do you remember where? It’s so long ago I read Mises on money, I can’t remember it all. Wonder if that’s one of the places I got these thoughts from? It wouldn’t surprise me.
Scott: Hmmm. I don’t want to call those things “money”, because they aren’t media of exchange. Dunno. I have to think about that one.
“It’s late here.”
Indeed, I hesitated to make my comment since I was worried it might keep you up!
Scott’s question is similar to what I had in my mind when I wrote my first comment – does it matter if money goes into, say, a money market fund instead of just a deposit? Does that give people an alternative to bank deposits – or just make the bank more comfortable knowing that its deposits are tied down for a little longer? I can’t quite get my head around that.
Is there a difference between price inflating with currency and price inflating with currency denominated debt?
“They want to borrow” or do they? I thought they wanted to save. The bank can lower the price of money to encourage it, but they can’t lower it to zero or they won’t be able to profit. Capital impairment will increase their desired profit margin. Many would like to borrow if they didn’t have to repay, but banks can’t lower it below their expected risk and expect to profit. If they can’t lower rates enough between the zero bound and their margin to increase lending how can they create money? How do they push on the string?
Combining Scott’s and Winterspeak’s points, it might be helpful to separate out the act of pricing claims with the act of expanding balance sheets. Any entity that expands its balance sheet is adding to demand.
But in order to expand your balance sheet you need someone else to price your obligation. Here banks play a role in performing idiosyncratic credit analysis as households cannot supply uniform accounting information as in the financial markets.
So it might be more accurate to call banks “appraisers”, or “price-setters”, because of their ability to price claims on a mark-to-model basis, due to their government backing. That is the only special thing about banks (and playing golf rounds with the Treasury Secretary:P). Once a price is assigned to a claim, your immediate purchasing power is increased by the same amount in exchange for a long term liability. However the claim is priced, the effect on increasing demand is the same.
I think the key issue here is the desire of borrowers to de-leverage, and some evidence of this is that net household borrowing began to rapidly shrink in 2007, prior to Bear or Lehman failing. This means shoving more money to banks is not going to boost aggregate demand. Moreover, the only difference between a “bad bank” and a “good bank” is in the capital structure and underwriting discipline. All that can be fixed by government administratively, and fairly quickly (given the political will) whereas getting household borrowing restarted is harder to do.
“It ain’t the loans what matter; it’s the money creation that goes along with loan creation what matters. That’s why (bad) banks matter. Bad banks won’t create money.”
So you have an exclusive cause and its effect…and the effect matters but the cause doesn’t. Rather meaningless distinction, no?
“A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of the medium of exchange.”
No. Savers can just sell their money income for other financial assets. The financial asset sellers aren’t net savers — the buyers are.
Great post.
Why isn’t the second view orthodox? Isn’t it obvious? Lol.
The connection to currency is redeemability. Of of the zero maturity assets are redeemable in currency.
Connecting up the 3D interest rate structure and monetary disequilibrium isn’t very hard. When you hit the zero nominal bound, efforts to reduce nominal interest rates lower creates monetary disequilibrrium.
At a negative nominal interest rate, currency is better than other assets, and an excess demand for currency develops. All the other zero maturity assets are redeemable, and so the excess demand for currency generates an excess demand for them. Their quantities drop. So, excess demand for money in general. Reduced expenditure.
If the nominal interest rates on all money (including currency) can go negative, (passively adjusted with the rest,) then this isn’t a problem. Low, perhaps negative nominal interest rates don’t cause an excess demand for any sort of money. But at the same time, market interest rates on the short safe stuff can fall, which allows that whole 3D structure to adjust.
Capital constrained banks (ignoring redeemability into zero interest currency) are consistent with monetary equilibrium. They can shift both liaiblity composition to increase in quantity of money. They can shift their asset composition to reduce the capital constraint. (Collect on risky assets and buy safe ones.) And finally, they can lower the interest rates they pay on monetary liabilities. This reduces the demand for money, adds to profitability, and fixed the capital problems.
Having money redeemable in zero interest currency messes this up. The Central Bank has to expand the quantity of zero interest currency to meet any excess demand or else the entire banking system is going to end up with an excess demand for moeny. They can’t fix it buy lowering their interest rates paid on money if that makes currency better than deposits. Excess demand for currency.
If the reason for the excess demand for currency is the zero nominal bound, where people are demanding currency because clearing the markets for short and save assets would make them have negative yields (so that currency is better,) then having the central bank expand the quantity of currency by purchasing those very assets in excess demand at the zero bound fixes nothing. More currency, yes, but less of those securities on the market.
The central bank wants to fix the problem, it must buy riskier and longer term assets that are not in excess demand at the zero bound. Notice this changes the 3D shape. The central bank is taking more risk.
Anyway, I think what you call heterodox is the core. But the orthodox stuff is more or less correct too. They must be. It is often two ways of looking at the same thing.
Nick I guess I was describing option 2, so I wasn’t playing by the rules.
Nick wrote: “But then each ultimate lender would have to collect information on the creditworthiness or profitability of the ultimate [borrower].”
I find the Treasury Direct market to be a good model. The Treasury loans direct to citizens bypassing the ‘intermediaries’. Economists need to get off their tushes and start thinking along the line that many/most loans serve public purpose, are simple enough, and therefore don’t need an intermediary.
http://www.treasurydirect.gov/
Nick wrote: “Forget currency (mainly, I admit, because I can’t really get my head around where it fits in).”
Most everyone has an ‘accounting’, including Nick.
Currency is the tangible form of the Fed’s ‘medium of exchange’ and the foundation of their accounting. Take that same currency and put it in a bank and it becomes reserves. Take it out of a bank and it is called cash.
Cash/Reserves are ultimately the only thing to pay taxes with, BofA bank money just won’t do, Ford/Walmart/HomeDepot nonbank money won’t do either. Neither will Nick’s ‘medium of exchange’.
“Different people and firms face different costs of funds, or opportunity costs of funds.”
Exactly and what monetary policy needs to avoid in order to retain ‘independence’. Most ‘risk’ analysis is used to screw certain classes of citizens.
Why not allow any citizen to offer a Treasury Security to the Fed in exchange for Fed funds at the current rate?
Winslow: “Currency is the tangible form of the Fed’s ‘medium of exchange’ and the foundation of their accounting. Take that same currency and put it in a bank and it becomes reserves. Take it out of a bank and it is called cash.”
That’s the accounting at the back of my mind. It is exactly as if each bank has a wad of currency sitting in the Bank of Canada, as reserves. But then there’s the question of people’s choice as to whether to hold money in the form of currency or in the form of demand deposits. That’s not the same thing.
Bill: Thanks!
What I call the “heterodox” view was never really “orthodox”. As you know, it’s a distillation of Yeager, Clower, and “disequilibrium monetarists” like Laidler. Always a minority taste, but it seems to never have been properly understood, because the Lucas revolution swept away the brief flowering of general disequilibrium theory in a monetary exchange economy. So everybody forgot this stuff (if they ever learned it, which few did). I never know how to categorise it. Is Yeager a monetarist? Not really. And Clower is much more Keynesian. Everybody talks about monetary economies, but nobody stops to think about what makes the medium of exchange so special. And those special features only get revealed when markets are in disequilibrium (non-market clearing).
So I called it “heterodox”. Partly also, I confess, to gently tease Post Keynesians, who I think don’t always realise just how orthodox and mainstream they are, in at least this respect. They are part of the “establishment”, in many respects (though not of course in all).
“Anyway, I think what you call heterodox is the core. But the orthodox stuff is more or less correct too. They must be. It is often two ways of looking at the same thing.” I can’t figure out if there is a fundamental difference, or if they are just two ways of looking at the same thing. Duck/rabbit. What makes me suspect they are different is that I see no way to capture the fact that money is a medium of exchange within the orthodox perspective. It’s implicit within the orthodox perspective, of course, because there can’t be an excess supply of goods otherwise. But is the orthodox view fully consistent with the role of money as medium of exchange?
Your discussion of currency makes sense within the orthodox view. Just another asset, into which all other assets are redeemable, which happens to have a 0% nominal yield. But it’s also a medium of exchange. And it’s hard enough getting my head around the weird properties of just one medium of exchange, let alone two. Plus, as far as I can tell, the stock of currency really is (nowadays, in Canada) demand-determined, while the stock of demand deposits is supply determined. Banks helicopter demand deposits, but the Bank of Canada doesn’t helicopter currency. Dunno.
Wicksell’s nightmare: “So you have an exclusive cause and its effect…and the effect matters but the cause doesn’t. Rather meaningless distinction, no?”
‘Twas but a rhetorical flourish! But loans don’t cause money, because the expansion of loans and the creation of money happen in the same act at the same time.
“No. Savers can just sell their money income for other financial assets. The financial asset sellers aren’t net savers — the buyers are.”
Sure. Someone who buys a financial asset with part of his income is saving. But that doesn’t disprove what I said, about only the desire to save in the form of money can cause an excess supply of goods.
RSJ: Sorry. You lost me in that comment.
Lord: “The bank can lower the price of money to encourage it,…” You mean lower the interest rate on loans? (We need to be really careful here to distinguish loans from money, and what we mean by “price”.)
If a bank’s capital constraint is binding, that means that if it had more capital it would find it profitable to expand loans at current rates of interest on loans. If it weren’t profitable to expand loans anyway, then the capital constraint cannot be binding, by definition.
Scott and Declan: the simple model at the back of my mind was one where banks’ only liability was chequable demand deposits. If banks offer (say) term deposits as well, then an individual can extinguish his demand deposit by switching it to a term deposit. It’s just as if he paid off a bank loan. I expect the effect on the supply of money depends on what the bank does next. If it does nothing, the supply of money contracts. If it responds by creating a new loan (or just buying something), then the money supply does not contract.
“most people buy most things not with currency, but with the money created by commercial banks. We pay by cheque, or debit card, or ATM from our chequing account”
And credit cards? A credit card effectively creates a (bank?) loan and a deposit in another bank as it is used, but what about the quantity effect of the undrawn credit line?
Rebel: I think credit cards don’t count, because you still have to pay the bill by cheque at the end of the month. It’s just a way of postponing payment.
Nick,
Credit cards or lines of credit don’t count, but spending with credit cards (or lines of credit) does, as it creates a loan and a deposit for the bank issuing the card, and the deposit is debited and credited to the bank at which the recipient of the spending banks. The reserve account of the credit card issuer is debited and the reserve account of the spending recipient’s bank is credited. Paying down your credit card decreases the loan (on the credit card issuer’s balance sheet) and debits your own deposits, while your bank’s reserve account is debited while the credit card issuer’s reserve account is credited.
So, spending with a credit card raises deposits. Paying down the credit card reduces deposits. That’s just accounting.
Best,
Scott
Nick,
I was just making the point that as far as demand is concerned, there is no difference between a customer taking out a loan from a bank and a business selling a bond to the credit market. Both boost demand by the same amount (assuming that the proceeds from both are spent to purchase output, and not to purchase other financial claims). So there is nothing special about banks in this regard.
The special thing about banks is that they serve households who would otherwise not get access to the credit markets, and of course banks have certain government backing that allows them to avoid market pricing.
This simplifies the assumption a bit, so you don’t need to get into discussions about whether money market funds “count” or whether other financial assets count. You don’t need to try tease out whether an increase in some monetary aggregate increases effective demand or not, etc. If you assume that financial claims are liquid (a reasonable assumption), then you can treat all financial claims equally, regardless of maturity. In that case, only new issues (or net borrowing) add to demand, and demand is increased by how much the new issues are priced, independently of the instrument or whether the obligations are priced by a bank or a market maker.
In that case, instead of saying “A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of the medium of exchange.”, you would say “A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of financial assets, as opposed to tangible assets”. Then you can look at the imbalance between the desire to accumulate financial assets and the willingness to incur financial liabilities generally, with the possible role of government to fill the gap by issuing liabilities.
Well said, RSJ!
Thanks Scott,
I guess the only difference (maybe not a real difference?) I have with MMT is that I don’t want the government to always supply all the net financial liabilities needed to fund private sector net financial assets. Even if doing so would not cause inflation and would achieve full output.
In some cases, the private sector can desire to accumulate too many financial claims, in which case my preferred resolution would be to try to change the underlying structural issues so that the private sector desires to accumulate the “right amount” of net financial assets — specifically whatever is needed to fund real productive investment needs modulo a leverage multiple (which should be constant over the business cycle).
Ideally, if productive investment is growing by 3%, then deficit spending should be 3% of GDP. Over time, that number should decrease as a result of increasing productivity. Obviously this will vary over the cycle as that leverage ratio changes, but if the numbers get too far out of whack from this, then you are no longer funding investment, but growing consumption in excess of wages or a current account imbalance.
In this case, I would try to address these structural imbalances via other levers rather than just funding private sector net financial asset desires in unlimited amounts. As an example, if I was emperor of Japan in 1990, and the private sector wanted to accumulate, say 1.5GDPs worth of NFA to pay for all the excess real estate debt, then I would first put the banks into receivership and cause mass debt write-offs, at which point, you wouldn’t need to deficit spend so much, but just enough to help recover from the shock of the write-offs. The reduced debt burdened on households would be a more effective demand boost, it would work faster, and it would solve an underlying structural problem more quickly than 2 decades of falling prices and enormous public works. If I was emperor of the U.S. in 2008, I would do the same. I’m not sure what the most popular MMT decision algorithm is in these cases.
“A general glut is caused not by an excess desire to save, but by an excess desire to save in the form of financial assets, as opposed to tangible assets”
– not true in the case of an excess desire to save in the form of existing (as opposed to new) tangible assets
Scott: On credit cards. What you say seems to make sense to me. But at the same time, when you pay by credit card you still have to pay again, when you pay off the credit card. What’s different about paying by cheque (or debit card) is that when BMO customer deposit $100 of cheques drawn on TD, and TD customers deposit $101 cheques drawn on BMO, the $100 cancels, and BMO only needs to transfer $1 reserves to TD. I’m not as clear on this as I should be.
But what I really want to respond to is the other argument in the comments above: a 3-way argument between anon, RSJ+Scott, and me(+Winterspeak). I think it’s important. And, I think I’ve got my head clear on it too!
First off, anon’s position is exactly the orthodox position. It’s what the textbooks say, and what we teach and learn in economics classes. It’s what I teach. But I think it’s wrong!
Let me restate anon’s position: take a closed economy, and one with no government, for simplicity. We divide all goods (real and financial) into two groups: newly-produced goods, and the rest.
Cd + Id =Y means that the demand for newly produced consumption goods plus the demand for newly produced investment goods = the output of newly produced goods. It’s a (semi-) equilibrium condition (“semi-” , because it ignores the supply side). And if Cd+Id is less than Y, then firms reduce Y, and you get the general glut of excess supply (assume the output firms and workers want to produce and sell, Ys, is constant).
We can define desired saving as Sd=Y-Cd, and re-state the semi-equilibrium condition as Sd=Id.
According to the orthodox view (anon’s view), an excess of desire to spend your income on anything other than newly-produced goods causes a general glut. It could be money, it could be other financial assets, or it could be real goods (like land and antique furniture) that are not newly-produced.
Here’s why I think the orthodox view is wrong. Suppose we start in equilibrium, then suddenly everyone wants to cut consumption of newly-produced goods and buy land. There is an excess demand for land. Even if the price of land is fixed, so you can’t eliminate the excess desire to save in the form of land by a rise in land prices, people will want to buy land but won’t be able to. Unable to buy land with their income (because nobody is willing to sell), they will change their plans on saving in the form of land. They start looking at second-best alternative plans.
If their second best alternative plan is to go back to wanting to buy newly-produced consumption goods, there’s no general glut.
If their second-best alternative plan is to buy more antique furniture, that creates an excess demand to buy antiques, so they can’t buy antiques, and I repeat my argument above.
I can run exactly the same argument against RSJ and Scott, if people desire to save in the form of financial assets (except money), instead of land, or antiques. Either the price (interest rate) on financial assets adjusts, until desired savings equals investment again, or it doesn’t adjust. If it doesn’t adjust, we just get an excess demand for financial assets, so people can’t buy financial assets, and have to change their plans, and consider a second-best alternative. Repeat.
It’s only if they desire to save in the form of the medium of exchange (money) that we get a general glut. If people can’t “buy” more money (sell more other goods) because there’s an excess demand for money (excess supply of other goods), they can always “sell” less money (buy less other goods.
It is only an excess desire to save in the form of money that causes a general glut. An excess desire to save in the form of other financial assets (RSJ and Scott), or real goods that are not newly-produced (anon), will only cause a general glut if it leads to an excess desire to save in the form of money.
By the way, anon: since you are commenting here, and clearly know some economics, why not give yourself a real fake name? Every Tom, Dick, and Harry calls himself “anon”. 😉
Nick:
You claim that the quantity of currency is demand determined. I understand, of course. Currency is printed and issued in responses to withdrawals of currency from reserve balances at the central bank. Banks generally withdraw currency from those reserve balances to meet currency withdrawals from depositors.
Why not make interest on reserve balances at the central bank -5%? We can imagine all the nominal interest rates in the economy falling–checkable deposits, short government bonds, long bonds, whatever.
What is the problem? I think you end up with a demand determined quantity of currency equal to total wealth and the nominal interest rate at zero.
If you won’t put up with that, then the illusion of passive demand determined currency breaks down.
I favor privatized currency. Without other changes, that makes reserve balances the sole monetary base. But under current conditions, where banks have the right to withdrawal currency from reserve balances, then currency is key.
That it seems demand driven is nothing more than an artifact of interest rate targeting. All money is “demand driven” if we say the central bank changes the quantity to keep an interest rate on target. Or, for that matter, anything else.
The central bank does choose the quantity of currency. And that drives everything else. If they are so lost in their policy tool that they don’t see that, then it is just self-delusion. But a clear eyed vision of what is going on doesn’t mean that the quantity of currency doesn’t have to adjust if they are going to use their instrument.
It is even true if they are using explicit loans, what we used to call discount rate policy. There is a shortage of loanable funds at the rate unless they change the currency they control.
All of you accounting folks–
when people save by purchasing already existing financial or tangible assets, what does the seller do with the money they receive?
You are assuming that their desired money holdings–currency or balances in checkable deposits increase.
Your model has the amount of money people hold passively adjust to everything else.
Monetarism is based on the notion that it doesn’t just passively adjust. It might well adjust, but for a reason. And so, the quantity of money and the demand to hold money is the key.
The straw man version of monetarism is that the demand to hold money is constant, so that changes in the quantity of money result in a proportional increase in spending. But that is a straw man. All we ask for is an explanation as to what is happening to either the quantity of money or else the demand to hold money. How is it that the demand to hold money rises to match the increase in the quantity of money?
If the non-govt sector has a desire to accumulate financial assets, the only way the entire sector can do this on balance is via government deficits. That’s the only way to for there to be a NET increase in financial assets held by the non-govt sector, BY DEFINITION.
Others are talking about a desire to save by some people that’s offset by a desire to spend by those that eventually find themselves with the balances. Right now, though, the private sector as a whole has been attempting to deleverage (and, of course, the desire to save doesn’t have to result in a transaction to purchase financial assets, as savers can simply hold deposits or relable them as time deposits, though I doubt that’s more than a portion of what’s going on in practice). The non-govt sector can’t really do that in real time (again, by definition) aside from the effects automatic fiscal stabilizers (such as lowered income leading to lower taxes paid, etc.) that raise the deficit. The other option is to have a change in relative prices or interest such that the desire to deleverage on the whole ceases or is even reversed, which is obviously the preference of neoclassicals. From the MMT perspective, that approach might possibly work temporarily (or it might not), but overall it ignores the lessons of Minsky.
meant to say change in prices, not relative prices.
Nick,
Regarding credit cards, that is an increase in the money supply and a purchase. Like any spending on credit, it may or may not be paid off “at the end of the month.” To the degree that it is, yes, you’re right in the accounting sense (though the spending happened, for sure).
But, in the aggregate, credit card debt incurred within the month often (usually) is not paid off at the end of the month. Indeed, it’s not until you get recessions (generalizing here) that in the aggregate you might see aggregate credit card debt outstanding actually decline.
NR – “Here’s why I think the orthodox view is wrong. Suppose we start in equilibrium, then suddenly everyone wants to cut consumption of newly-produced goods and buy land. There is an excess demand for land. Even if the price of land is fixed, so you can’t eliminate the excess desire to save in the form of land by a rise in land prices, people will want to buy land but won’t be able to. Unable to buy land with their income (because nobody is willing to sell), they will change their plans on saving in the form of land. They start looking at second-best alternative plans.”
–why necessary to assume there’s not a market clearing price for the money price of land? why can’t there be a market clearing price for excess demand for existing assets? agree if you assume not, then the money alternative becomes the source of the glut – but why assume that?
BW – “when people save by purchasing already existing financial or tangible assets, what does the seller do with the money they receive? You are assuming that their desired money holdings–currency or balances in checkable deposits increase. Your model has the amount of money people hold passively adjust to everything else.”
–same question; that’s what a market clearing price means – satisfaction with the money result
SF – agree as a government response to a glut; separate issue from NR’s question about the source or nature of gluts
Nick,
Thanks.
“It ain’t the loans what matter; it’s the money creation that goes along with loan creation what matters. That’s why (bad) banks matter. Bad banks won’t create money.”
I had been looking without success for a way of putting that thought. You have found the formulation I will henceforth quote.
In return, I will try to suggest how currency fits in. Think ex-ante. The forward monetary variable in the light of which we economic agents make our choices of prices to offer at/expect to accept, plan quantities to offer/buy and amounts to save/dissave is expected MV. Expected MV turns out to be the stock of all assets multiplied by the likelihhood of their being used to settle transactions in the coming period. A perfectly illiquid asset (if one exists) would have a likelihood of zero. A highly illiquid asset class like real property may have a likelihood of (roughly) the order of 0.0001. A time deposit for a year may have a likelihood around 0.1 – it is a thousand times more likely to be used in settlement of a trans action than real property. A high denomination note may have a likelihood of 2.0. A coin may have a likelihood of, say, 100 or 500. The key is that all asset classes may expect to be used in the settlement of transactions to some degree, and to that degree they enter into the expected MV. Currency is just one such asset class.
(This ex-ante view also seems to help when considering how small changes in the expected liklihood of big asset classes being used in settlements of transactions affect monetary conditions. It brings into the picture the unused credit lines (including those of credit cards) and the credit created between non-financial economic agents (my supplier gives me a credit limit at his warehouse, my publisher pays me six weeks in arrears, etc.). But all that is for another occasion.)
Credit card debt isn’t an increase in the quantity of money.
Lines of credit, however, impact the demand for money.
The supply of money isn’t the same thing as nominal expenditure.
Nearly all spending is funded out of current income. People earn income and spend it.
Credit shifts funds between debtors and creditors. Lenders spend less and borrowers spend more. Repayment means debtors spend less and creditors spend more.
Most credit is not created by banks. Most expenditure is not financed by loans.
Now, checkable deposit issuing banks do make some loans. But treating all spending as if it were due to an excess supply of money is blindness.
If there were no government, imbalances between the supply and demand to hold financial assets can be cleared through changes in prices and yields.
The only problem is with currency. With fixed nominal price, its relative price can only change through changes in the price level. With a zero nominal yield, its yield can only change through expected changes in the price level.
With deposits, they have a fixed nominal yield, and so their nominal quantity needs to adjust unless the prices of all the other goods are to change. Fortunately, the nominal yield on deposits can change.
There is never any need for the government to create more financial assets. Only if the government monopolized the issue of currency, keeps its nominal yield at zero, and makes it the medium of redemption for all the rest of the economy, do problems develop.
We can imagine a situation where the central bank owns all the private financial assets and there remains an excess demand for currency, and no one wants to sell any private securities to the central bank. But the notion that the government must create more financial assets because the private sector wants to hold more is mistaken.
anonTDH: “–why necessary to assume there’s not a market clearing price for the money price of land? why can’t there be a market clearing price for excess demand for existing assets? agree if you assume not, then the money alternative becomes the source of the glut – but why assume that?”
Agreed. We are on the same page. We can imagine a hypothetical case where the government has price controls on land, so there could be an excess demand for land. But even in that case (I argue), that would not cause an excess supply of newly-produced goods (unless it spilled over into an excess demand for the medium of exchange). (Notice, by the way, I am contradicting Walras’ Law when I say that). But if the price of land adjusts to market clearing, we can’t get the excess demand for land anyway. And I would make the same argument for financial assets (except money). Whether or not the interest rate adjusts to get rid of the excess demand for financial assets, it can’t create an excess supply of newly-produced goods (unless it spills over into an excess demand for the medium of exchange).
On the same point: Scott: “If the non-govt sector has a desire to accumulate financial assets, the only way the entire sector can do this on balance is via government deficits. That’s the only way to for there to be a NET increase in financial assets held by the non-govt sector, BY DEFINITION.”
Agreed. It’s an accounting identity (in a closed economy). But suppose the government does not create a deficit to satisfy the private sector’s demand for financial assets. Will that cause an excess supply of newly-produced goods, and a recession? (If those financial assets are not money). I say “no”, unless it creates an excess demand for money.
Similarly, if the non-govt sector has a desire to accumulate land, the only way the entire sector can do this on balance is via government sales of land. That’s the only way to for there to be a NET increase in land held by the non-govt sector, BY DEFINITION. But suppose the government decides not to sell land. Will that cause an excess supply of newly-produced goods, and a recession?
Bill: I think you were writing too quickly, and meant to say:
“With CHEQUABLE deposits, IF they have a fixed nominal yield, [DELETE and so] THEN their nominal quantity needs to adjust unless the prices of all the other goods are to change. Fortunately, the nominal yield on deposits can change.”
Now, the nominal yield on deposits can change, and if it changes by the right amount, and in the right direction, that will eliminate any excess supply or demand for deposits. But will it? My head’s not clear on that.
Suppose there’s no currency. All money is bank deposits. Start in full equilibrium. Then the central bank increases the supply curve of reserves. Banks expand loans and deposits. There is an excess supply of deposits hot potatoing around the economy. If banks raised their interest rates on deposits, that would eliminate the excess supply of deposits. But would banks do this? As far as I can see, the only reason an individual bank would have to raise the interest rate on deposits is if it wanted to gain reserves (take them away from other banks). But I don’t see why individual banks would respond this way if the original shock that displaced us from equilibrium were an increased supply of reserves.
I’m still puzzled.
David: Thanks! (But you had better fix my grammar first!)
But I don’t think your way of looking at the spectrum of liquid/illiquid assets works. Apart from money, no other asset is ever used to settle a transaction. If I have land, and want a house instead, first I sell the land for money, then I use the money to buy a house. It’s always the medium of exchange, on one side of all transactions.
Even though there’s only a difference in degree in the liquidity/transactions cost of all assets, with a spectrum with land and houses at one end, and the medium of exchange at the other, that difference in degree becomes a difference in kind (Clower? Yeager?). The asset that is most liquid (has the lowest transactions costs) behaves qualitatively differently from all the others. It gets used in ALL exchanges.
“Credit card debt isn’t an increase in the quantity of money”
Yes it is, unless it is a non-bank like a department store issuing the credit. In that case, you’ve created a receivable but–true–no deposits. Please show me with balance sheets how money isn’t created when someone spends with a bank issued credit card. Good luck.
“Credit shifts funds between debtors and creditors. Lenders spend less and borrowers spend more. Repayment means debtors spend less and creditors spend more.”
Wrong. Many (most, even) lenders do not use any funds to create a loan. For example, whether you are a bank, a department store, or a supplier of materials to a business, no “funds” are used. For the bank, the loan creates a deposit . . no prior funds necessary. For the department store, the loan is a receivable . . . no prior funds necessary. For the supplier, the loan also creates a receivable. The lender does not necessarily spend less, and particularly in the case of banks, has no less “funds” available, and no more “funds” available when the loan is repaid (aside from less capital applied).