One more for the Banking School. This is a thought-experiment to help us clarify our thinking about banks.
If banks bought houses, instead of lending people the money for people to buy houses, what would be different? Not much.
But we students of money and banking would avoid some common mistakes, like confusing the demand for money with the demand for loans. And we would see that financial intermediation has no necessary connection with money.
Suppose there were some prohibition (motivated by religion or politics or whatever) against banks charging interest on loans. But no prohibition on banks charging rent on houses they own. So banks stop making loans and start buying houses instead.
The asset side of banks' balance sheets would be diffferent: banks would own lumpy and illiquid houses instead of lumpy and illiquid mortgages on houses. Banks might need higher capital ratios, because houses are normally riskier than mortgages on houses. But the liability side of banks' balance sheets could be exactly the same as now. Some of the things on the liability side, like chequable demand deposits, could still be used as money, just as they are now.
People would pay rent to the bank, instead of paying interest to the bank. So banks would earn rental income from their assets instead of interest income. The revenue side of their income statements would look a little different, but banks would still make their living from the spread between the low yield on their liquid liabilities and the high yield on their illiquid assets.
So not much would change.
But it would be a lot simpler to teach money and banking.
Instead of: 1. me promising to repay a loan from the bank; 2. the bank crediting my chequing account for the amount of the loan; 3. the bank debiting my chequing account when I buy the house; 4. and the bank crediting the house seller's chequing account, — we can skip all but the last step. The bank buys the house by crediting the house seller's chequing account. Period. What happens to the money after the house seller gets it is exactly the same in both cases. And that's the important part. That money keeps on circulating around the economy. Until the bank sells a house, which destroys the money it had previously created.
It is very easy for students of money and banking to get confused between the demand and supply of money and the demand and supply of loans of money. It would be very hard for students to get confused between the demand and supply of money and the demand and supply of houses. But the two would nevertheless be related: the demand for houses by banks would be exactly the same as the supply of money by banks. (You can define them both as stocks, or both as flows, whichever you find more convenient.)
But an excess supply of money by the non-bank public wouldn't necessarily mean an excess demand for houses by the non-bank public. There are lots of other things you could buy if you wanted to hold less money.
If people wanted to hold more money, a good monetary policy would try
to ensure that this resulted in banks wanting to hold more houses. Otherwise we would get recession and deflation, as people tried to hoard money.
And
if people didn't want to hold more money, a good monetary policy would
try to ensure that banks didn't want to hold more houses. Otherwise we would get boom and inflation, as people tried to spend away the excess money.
If banks both bought and sold houses, and announced a price (or price/rental ratio, or rental yield) at which they were willing to buy or sell unlimited quantities of houses, we know that the housing market would always clear. The stock of houses demanded by the non-bank public at the price set by banks would always equal the stock of houses they actually owned. If the non-bank public had an excess demand for houses, they would immediately buy them from the bank. If the non-bank public had an excess supply of houses they would immediately sell them to the bank. But that wouldn't mean the stock of money demanded by the non-bank public would always equal the stock of money they actually owned. The market for houses is not the same as the market for money. The market for houses is just one of the many markets for money.
But if banks bought houses, instead of lending people the money to buy houses, then banks, strictly speaking, wouldn't be banks. They would act almost exactly like banks, but we wouldn't be allowed to call them "banks". Because banks, by definition, are financial intermediaries whose liabilities are used as money. And a financial intermediary both borrows and lends, and the "banks" in my thought-experiment don't lend. They buy houses instead. They create money not by making loans, but by buying houses.
But if the "banks" in my thought-experiment act like banks, but don't meet the strict definition of being banks, maybe we should change the definition? Does a bank that is left holding the houses when all its mortages default, but is still a going concern because it has adequate capital, suddenly stop being a bank, by definition? That isn't a very useful definition.
Maybe we should change the definition to: a "bank" is anything that creates money. What it spends that money on is immaterial. It could buy houses, buy financial assets backed by houses, or it could just give it away to charity, or by dropping money out of a helicopter.
What should our slogan be? "Loans create deposits!"? Maybe. "Buying houses creates deposits!"? Maybe. "Creating deposits creates deposits!". Better. "Creating money creates money!". Yep, that's it.
The one truly important and puzzling thing about banks is that people are willing to use their liabilities as a medium of exchange. But that's equally important and puzzling about any thing that creates money, whether it's a financial intermediary or not.
Worthwhile Canadian Initiative 
Nick,
I realise you like thought experiments, but I think there are better ways of dealing with the “student confusion” to which you refer than the “banks buy houses” thought experiment: i.e. I prefer trying to accurately describe the REAL WORLD. So here goes.
Banks do two things: first, intermediate between borrowers and lenders, and second, create money for day to day transactions.
While it might seem that money is created when a bank lends money into existence for the benefit of a borrower, in fact the loan must be largely covered by depositors, bondholders and shareholders and the latter lot are by definition willing to deposit for relatively long periods (except to the extent than banks do maturity transformation). And money in deposit accounts, quite rightly, tends not to be counted as money (though practice varies from country to country, and varies with the term of deposit accounts).
I.e. I disagree with your claim in relation to the money apparently created when a bank lends that “That money keeps on circulating around the economy. Until the bank sells a house, which destroys the money it had previously created.” What you refer to there is not really money: it’s a loan.
Next, the charge made by banks can be divided into, 1, administration costs and 2, genuine interest (i.e. a reward for forgoing consumption).
Banks charge borrowers for both. In particular they charge genuine interest because banks have to pay interest to long term depositors, bond holders etc. In contrast, there is no reason for banks to charge genuine interest for the creation of day to day transaction money or what might be called “genuine” money because the bank does not forgo consumption when creating genuine money, and nor does anyone else.
Typo: 3rd paragraph: “the loan must be largely covered by depositors, bondholders” should have been “the loan must be largely covered by LONG TERM depositors…..”. Doh.
Is the bank truly creating new money? Doesn’t the bank sooner or later have to find lenders prepared to provide the money used to buy the houses ?
In a simple model it would have to borrow first and then buy the houses later , and it could only do this if could find an interest rate where it could borrow cheaper than the ROI on the rent it got on the houses it bought.
In a model where the CB targeted interest rates then the banks could buy houses first knowing that the CB would eventually create enough money to provide sufficient deposits cover the loans. Some of this money would come from people depositing the money they received when they sold the houses to the banks, and the rest from money created by the CB by buying enough assets to make the banks books balance. The banks would buy houses (and the CB create new money) until the ROI on rents was equal to the rate they knew the CB was targeting (plus a markup for bank profit).
So the banks “create” money only to the extent that others are prepared (sooner or later) to put it in bank deposits and not spend it. It is the CB that truly creates money by buying other assets for new “outside” money.
“Banks might need higher capital ratios, because houses are normally riskier than mortgages on houses. But the liability side of banks’ balance sheets could be exactly the same as now.”
Let’s take that to the limit. What if the capital requirement for houses is 100%?
“Maybe we should change the definition to: a “bank” is anything that creates money. What it spends that money on is immaterial.”
What if the bank starts buying assets that go down in value?
“But we students of money and banking would avoid some common mistakes, like confusing the demand for money with the demand for loans. And we would see that financial intermediation has no necessary connection with money.”
This is exactly why monetary policy is inefficient IMO. People demand more money but they don’t demand more credit and maybe even wish to develerage. Therefore it doesn’t matter if you reduce the rate on lending people don’t want to borrow more which makes the broad money supply expand at insufficient pace which means growth, demand and inflation are below ideal levels. To solve this the CB needs to break the unnecessary link between lending and monetary policy. The CB can directly affect broader money interest rates or quantity in order to pursue its policy aims by effecting or placing funds into accounts of public directly.
“The one truly important and puzzling thing about banks is that people are willing to use their liabilities as a medium of exchange. But that’s equally important and puzzling about any thing that creates money, whether it’s a financial intermediary or not.”
I’d say using demand deposits as MOE is about 1 to 1 convertibility to currency. I’d say that 1 to 1 convertibility also makes demand deposits medium of account (MOA).
“The one truly important and puzzling thing about banks is that people are willing to use their liabilities as a medium of exchange. But that’s equally important and puzzling about any thing that creates money, whether it’s a financial intermediary or not.”
People use bank liabs as a medium of exchange because they can deposit and transact in commercial bank deposits. If People could directly deposit and transact in base money then people would use base. People are also misled to a large extent into believing that commercial bank liabs are US dollars which they are not, they are just claims on US dollars.
Nick,
When you say “money”, I find it hard to tell whether you are talking about transaction accounts or about bank liabilities generally. You have told me before that you usually mean transaction accounts, as that is the medium of exchange. But the statement “the demand for houses by banks would be exactly the same as the supply of money by banks” suggests you are thinking about the totality of bank liabilities.
The problem is that money defined as transaction accounts behaves in a certain way, and money defined as total bank liabilities behaves in a way that is related but different. Conflating the two definitions actually seems to me to be one of the big sources of confusion over banks as creators of money.
Mike,
You say, “If People could directly deposit and transact in base money then people would use base.” First (a minor point) people actually do “transact” in base money when using physical cash (dollar bills).
Second (a more interesting point) I suggest people also to some extent transact in base money when doing book-keeping type money transactions (check and plastic card transactions). To illustrate….
Suppose I sell $X of government debt, and the proceeds of that sale is the only money I have. I can’t DIRECTLY transact in it, as I don’t have an account at the central bank, but to all intents and purposes I can: in effect my commercial bank would act as go-between or agent for me when I wished to pay someone some of my base money.
Moreover it would be possible to totally displace commercial bank created money with base money, which is what advocates of full reserve banking want to do. Commercial banks’ reserve ratios would need to be gradually raised to 100%, while the government/central bank machine spent freshly created base money into the economy to replace the commercial bank money being withdrawn.
Ralph: “I prefer trying to accurately describe the REAL WORLD.”
I don’t. I prefer trying to accurately EXPLAIN the real world. And in order to explain the real world, we need to find out which bits of the real world are important and which aren’t, and which bits of the real world would change if we changed other bits of the real world.
In the real world, banks both borrow and lend. They sell their own IOUs (borrow) and buy other people’s IOUs (lend). But what would change if banks only borrowed, and did not lend. They bought houses instead of other people’s IOUs. Not much. Which means that banks’ lending isn’t very important.
“I.e. I disagree with your claim in relation to the money apparently created when a bank lends that “That money keeps on circulating around the economy. Until the bank sells a house, which destroys the money it had previously created.” What you refer to there is not really money: it’s a loan.”
The money that banks create is a loan. It is an IOU, signed by the bank. It is a loan to the bank by whoever owns that IOU. Banks borrow when they create money.
Ron: let’s put it this way. People must be willing to use the money created by banks. They must find it more convenient in some cases to use commercial bank money rather than only using shells, or central bank money. Commercial bank money must be able to compete with central bank money.
TMF: “Let’s take that to the limit. What if the capital requirement for houses is 100%?”
Then people wouldn’t be able to borrow money from the bank to help them buy a house.
TMF: “I’d say using demand deposits as MOE is about 1 to 1 convertibility to currency. I’d say that 1 to 1 convertibility also makes demand deposits medium of account (MOA).”
But you or I or any solvent person can issue IOUs that are 1 to 1 convertible into money. But nobody uses my IOUs as money.
Mike: I agree that there is something peculiar in or monetary system. Linking the supply of money with the market for loanable funds is as peculiar as linking the supply of money with the market for houses, or the market for precious metals.
“If People could directly deposit and transact in base money then people would use base.”
Currency is sometimes more and sometimes less convenient than chequing accounts. Central banks don’t produce chequing accounts (except for commercial banks and the government), but commercial banks are (usually) prohibited from issuing currency. They have divided up the market between them, and don’t allow direct competition.
Nick Edmonds: there are companies that own houses (more usually apartment buildings) that they rent out to tenants, and they finance those purchases of houses by issuing shares and bonds (that don’t circulate as money). To the extent that banks finance their purchases of houses by issuing long term non-monetary liabilities, banks are no different from those companies. (What’s the correct name for such companies?)
“You say, “If People could directly deposit and transact in base money then people would use base.” First (a minor point) people actually do “transact” in base money when using physical cash (dollar bills). ”
Obviously, but it is very inconvenient to transact in physical unless your talking about relatively small face to face transactions when compared to electronic pmt systems that exist for commercial bank deposits. People cant deposit their US dollars directly at a CB like commercial banks can. They just take your base if you deposit with them and give you claims on USDs in your account.
“Suppose I sell $X of government debt, and the proceeds of that sale is the only money I have. I can’t DIRECTLY transact in it, as I don’t have an account at the central bank, but to all intents and purposes I can: in effect my commercial bank would act as go-between or agent for me when I wished to pay someone some of my base money.”
If people want to pay with their deposits held at the CB directly then allow it in the same way people make payments with commercial bank deposits. The central bank should be more accesible to all in providing depository services should they require them becuase the CB is the safest institution and deposits and payments are highly systemic. There is no benefit to intermediating in payments or deposits.
“Moreover it would be possible to totally displace commercial bank created money with base money, which is what advocates of full reserve banking want to do. Commercial banks’ reserve ratios would need to be gradually raised to 100%, while the government/central bank machine spent freshly created base money into the economy to replace the commercial bank money being withdrawn.”
Allow people to directly transact and deposit base or commercial bank deposits. Whichever is superior will be the largest component of broad money. There is no need to be restrictive just allow healthy competition.
Nick Rowe
If the central bank allowed deposit taking and payments alongside the private banks it should be beneficial due economies of scale and scope plus the depository and payments system is systemic so people can access the safety of the CB if needed.
Ron: “So the banks “create” money only to the extent that others are prepared (sooner or later) to put it in bank deposits and not spend it. It is the CB that truly creates money by buying other assets for new “outside” money.”
If the velocity of circulation of their money were infinite, neither commercial banks nor central banks would be able to create strictly positive stocks of money.
Mike: maybe. But lots of people have made similar arguments for nationalising lots of industries, and the results haven’t always turned out so well. Historically, some governments have managed central banks very badly. Why would we expect them to do better with commercial banks?
TMF: “What if the bank starts buying assets that go down in value?”
Exactly the same as happens now when the bank buys assets that go down in value. Houses go up and down in value, relative to deposits; mortgages on houses go up and down in value, relative to deposits. That’s why banks have capital reserves.
Nick Rowe
“Mike: maybe. But lots of people have made similar arguments for nationalising lots of industries, and the results haven’t always turned out so well. Historically, some governments have managed central banks very badly. Why would we expect them to do better with commercial banks?”
Im not suggesting anything be changed with banks. All Im saying is make the depository system of the central bank accesible to anyone if they want to use it. I’m not suggesting full reserve banking or nationalized banking.
Mike: understood. But compare it to the question of whether government should get into the business of producing cars, rather than just producing roads and running bus services. (OK, not the best analogy.)
I love this post. I had to make a similar scenario in my head before I understood how QE works. With QE central banks don’t buy houses but they can buy things such as MBS or corporate bonds that are a little bit more tangible (IMO) than government bonds. I figure the more aggressive QE is, the wider the selection of assets bought by central banks have to be, and the more chance they have to dip into pools of things that are tied to or backed by things that are tangible. They can even buy gold and quell the fear of those that think money should backed by more of it! 🙂
These scenarios always lead me to wonder how much of the market, central banks have to replace, that is how much stuff do they have to buy, before we can reach a sensible GDP target. Also how can they choose what to buy in order to distort the free market the least possible? When QE consists of buying mostly just houses (or MBSs) aren’t you favoring the housing sector over other sectors?
Nick Rowe
“Mike: understood. But compare it to the question of whether government should get into the business of producing cars, rather than just producing roads and running bus services. (OK, not the best analogy.)”
I hope I understand the question. The gov could probably produce cars relatively competitively if it wanted but arent we then loading the gov with too many responsibilities? If we overload the gov then it becomes less effective at everything becuase it cant focus and becuase of diseconomies of scale amongst other things.
But the CB already produces money and already provides deposits to some institutions. Deposit taking is a simple and systemic activity and it isnt much of a greater burden than the one it already has to extend deposit taking to the public. Also if performed by an independant central bank it wont be overburdening the gov becuase the CB is separate. The cb could be made even more independant too by making governers or commitee publicly elected.
Benoit: thanks!
(Inflammatory aside: over the years, Market Monetarists like me have taken a lot of heat from critics who accuse us of “not understanding banks” or “ignoring banks”. But why aren’t those critics the ones writing posts like this, asking the deeper questions like whether it really matters whether banks are or are not financial intermediaries? All they ever seem to do is fuss around with balance sheets. I accuse those same critics of not understanding money. They ignore the differences between money and all other goods: the fact that money has many markets and other goods have one. They say nothing about why people are willing to use money as a medium of exchange, and that that creates a demand for money that makes banks possible. They get confused between money and credit. How can they understand banks if they don’t understand money? End of rant!)
When banks are expanding, that favours those goods that banks buy. But when banks are contracting that disfavours those same goods that banks now sell. But I am less concerned with the effect of changes in money on the markets for those particular goods. I am much more concerned about the effects of changes in the markets for those particular goods on money. Because something that affects money will affect all markets.
Mike: I think those are the sorts of questions to ask. But I’m not sure how simple the deposit-taking business really is, and whether the government would do it well or screw it up. But we are wandering too far off-topic now.
Nick,
Call them PropCos. To make that work, I have to have a way in which the public can easily switch between money and PropCo shares. After all, if I want to transfer part of my balance with the bank from a transaction account into a deposit account, it’s very easy. So we could imagine that each bank has affiliated PropCo. Whenever, one of its customers wants to make that switch, the bank then sells some housing to the PropCo in exchange for shares and sells the shares to the customer. We could then say that “the demand for houses by banks would be exactly the same as the supply of money by banks” with money meaning transaction account balances. Banks’ “demand for houses” here would have to specifically refer to the houses they held directly, excluding those held in PropCos.
I find that a difficult concept to relate to banks in the real world. It seems to imply that banks’ demand for asset is equal to a bit they determine themselves plus a bit equal to the amount their customers want to hold in non-transaction accounts.
Nick Edmonds: couldn’t PropCos just have a chequing account at the central bank to handle transfers of deposits between PropCos in exactly the way that real world banks do? Or they could keep small reserves of central bank currency, and pay them out to those wishing to withdraw their deposits, which is much the same, except less convenient, and vulnerable to muggers. PropCos are just like open-ended mutual funds, except the own houses rather than shares.
The important difference is whether or not the liabilities of PropCos, banks, whatever, are used as media of exchange.
“What should our slogan be? “Loans create deposits!”? Maybe. “Buying houses creates deposits!”? Maybe. “Creating deposits creates deposits!”. Better. “Creating money creates money!”. Yep, that’s it.”
And don’t forget the ever popular, “Banks don’t buy houses out of reserves.”
Mark: Ha, yes! I had forgotten that one. But of course an individual bank does buy houses out of reserves, because the seller of the house is unlikely to bank with the bank that bought the house, and even if he does, the person he buys stuff from probably won’t. It’s only the banking system as a whole that doesn’t buy houses out of reserves, and even that depends on how the central bank responds, and the public’s desired Currency/Deposit ratio.
BTW, Scott Sumner said somewhere, IIRC, that central banks aren’t really banks. I’m now beginning to think that commercial banks aren’t essentially banks either, because it doesn’t matter whether or not they are financial intermediaries, just as it doesn’t really matter what the central bank holds on the asset side of its balance sheet.
“if people didn’t want to hold more money, a good monetary policy would try to ensure that banks didn’t want to hold more houses. Otherwise we would get boom and inflation, as people tried to spend away the excess money.”
But a rational banker would always follow good monetary policy, just like rational apple farmers would always follow good apple policy. Bankers, like farmers, would be throwing away profits if they failed to provide the public with the right amount of the stuff they produce. Of course, an irrational banker might lose assets and thus cause his money to lose value, but it would be a topsy-turvy world if bankers could cause booms by behaving irrationally.
Nick, I like this post. I like to think that perhaps I partly inspired it. 😀
… since you wrote “I think I agree with that…” after I commented on your “Banks are special…” post that I like to think of banks in aggregate paying for everything in the private non-bank world (salaries, office supplies, dividends, donuts, electricity, loans, etc) by crediting banks deposits, and that I like to likewise think of them accepting payment for everything (principal, interest, points, fees, CDs etc) by debiting bank deposits. That way you skip all the (mostly unenlightening) reserve accounting details.
On the next layer out, the CB does exactly the same thing.
Do you think your thought experiment here supports your view of MOE vs MOA and also your view that the Law of Reflux does not hold (very much) for bank deposits, and whether the hot potato effect (HPE) applies to bank deposits? Are there any testable implications of that which a talented guy like Sadowski could find evidence for in the data? I believe that you still have a disagreement with Scott Sumner and David Glasner over MOE vs MOA, the Law of Reflux and the HPE, correct? Are there testable implications to their view vs your view regarding these issues (which I see as all being related)?
Mike Sproul: suppose Martha Stewart suddenly became more popular, and people wanted to be owner-occupiers rather than tenants, so they could paint the walls in weird stripes. Profit-maximising banks would sell houses, and the money supply would fall. The question is: would banks also cut the interest rates they paid on deposits, so that the quantity of money demanded fell too by an exactly equal amount? Wouldn’t that depend on the central bank’s monetary policy?
Nick… and how about your disagreement with Mike Sproul? Any more to it than battling thought experiments (nothing against thought experiments… those are my favorite kind!)? Again I’m wondering is there a consequence that we would check for in the data to each view to lend support to one view over the other? What are the implications we can check for?
Tom: thanks!
This thought-experiment is designed to make it clearer that the Law of Reflux is wrong. It is very hard for people to get confused between “the quantity of houses demanded by the non-bank public always equals the stock of houses they hold” and “the stock of money held by the non-bank public always equals the stock of money they hold”.
How to test between the two approaches…that’s a question I keep mulling over, but don’t have a clear answer to yet. A better question would be: “How much does it matter empirically that the other side is conceptually wrong?” But normally you can only measure things like that empirically when you have two logically coherent viewpoints, so you can measure whether the data is closer to one or the other. But if the other side doesn’t even make logical sense…you can’t do that.
Nick, I don’t really buy this:
“If banks bought houses, instead of lending people the money for people to buy houses, what would be different? Not much.”
There are quite a few differences:
1) A mortgage declines in value every time a payment is made. Thus, the asset for the bank shrinks as does the customers deposit. The value of the house as asset does not shrink due to payments made. In fact, in your model the rent seems to be fully counted as income for the bank unlike a mortgage payment where some part is used to pay down principal! With that the money stock declines every time a payment is made.
2) The mortgage has fixed monetary value that only declines with payments by the borrower. The value of the house is set by market conditions and is not fixed.
3) At the end of the mortgage the borrower owns the house. In your case the bank owns the house indefinitely.
I personally don’t care about money but only about my combined monetary assets (plus all non-monetary assets, of course). A monetary asset is anything that is denominated in a fixed dollar amount. Just because I “lent” the money in my checking account to my bank does not mean I would not count it as my monetary asset anymore. Similar to any treasuries I may own. The combined monetary assets of the public go up when people take out loans and go down when they are being paid back or loans default. What part of those are considered “money” hugely depends on the definition you want to use but has very little application to the real world. I don’t feel any difference in my wealth if I have $1000 in cash, as bank deposit, a CD or a US treasury note.
Btw. Your thought experiment is not that far off from Islamic banking as you may know:
http://en.wikipedia.org/wiki/Islamic_banking
“But if the other side doesn’t even make logical sense…you can’t do that.” … Ouch! 😀
It sure sounds like you are saying that “the other side” here doesn’t even have a logical argument… Hmmm, that’s a tough one… after following SO many thought experiments between all of you going back over a year now… I’ve never had the impression that “the other side” was being completely illogical. Can you identify exactly where their logic breaks down?
Also, couldn’t we frame the empirical test JUST in terms of your view of the Law of Reflux? I.e. can’t we test the Rowe Hypothesis of “The Law of Reflux is Wrong” in terms of the data w/o regard to whether or not “the other side” is being logical or not?
Also say you were given unprecedented control over two small brand new nearly identical nations… such that you could use them for an experiment to test the Rowe Hypothesis. How could you devise an experiment to do that? I’m asking for the outlines of a thought experiment on how we could do an empirical test here I guess.
I like this thought experiment, but saying the market for houses is just one market vs. all markets for money is a gross simplification. Almost everything can be bought on credit, and in fact, total private credit market debt is 3-4x GDP so it is not a small market. So isn’t credit like money because there are many markets for credit? And if so, aren’t banks important? Sorry if I misunderstood the argument.
“Maybe we should change the definition to: a “bank” is anything that creates money.”
And how does it do that in the Western world? By making loans which create deposits. q. e. d.
“What it spends that money on is immaterial. It could buy houses, buy financial assets backed by houses, or it could just give it away to charity, or by dropping money out of a helicopter.”
Maybe we could stick with the real world? There banks only buy financial assets backed by collateral. They don’t give money away for free (charity, helicopter). They also do not buy non-financial assets outright; There are regulations prohibiting that with good reason. Otherwise, banks could just buy up everything and charge the public an arm and a leg for using it. It would essentially give the bank’s owners the license to print money for their own enrichment.
jt26, I think what Nick means by “MOE” in this article:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/08/banks-and-the-medium-of-exchange-are-both-special-or-neither-special.html
Are (in part) bank deposits, which you are calling “credit.” So it looks to me like he’s saying exactly what you say in the last line of your comment, right there in the title of the post!
Odie, you write: “There banks only buy financial assets backed by collateral.”
I don’t think that’s true: when the banks in aggregate buy their employee’s time (pay their salaries) or pay dividends, their electric bill, interest on deposits, rent, computers and other office supplies, etc… they do so (again in aggregate) buy crediting bank deposits. They do so out of their capital, so capital constraints apply.
Tom,
But that is not money creation. They take that out of the capital their interest income earned. Their customer deposit liabilities will stay the same but their net worth will decline. If all assets of the bank will exactly equal all customer deposit liabilities it does not matter whether the bank has a balance sheet of 10 million, 100 million, or 1 billion it will have zero capital and may have to close if it does not find additional investors. That is the big difference to Nick’s thought experiment. There, the bank would create $100,000 which would increase the capital/net worth of the bank and it can then use it to buy a house. In essence, the bank’s owners print their own money.
Nick,
“This thought-experiment is designed to make it clearer that the Law of Reflux is wrong.”
If you mean by this that people can’t get rid of an excess supply of bank liabilities by repaying loans, I’d tend to agree with that. But I come back to this point that the quantity of bank liabilities is not equal to the quantity of the medium of exchange. It’s one thing in a world where banks have only houses (H) as assets and transaction accounts (M) as liabilities, so H = M. But a better analogy to the real world is H = M + D, where D is the other liabilities. So knowing H doesn’t tell us M; we need another equation (or maybe two more equations and another variable – an interest rate perhaps). And when we ask what, in the real world, determines the balance between M and D, it’s hard to believe that the demand for medium of exchange plays no role.
Odie, you write
“But that is not money creation.”
Sure it is. Every time a bank deposit is credited that’s creation of “inside money.”:
Click to access sr374.pdf
Likewise every time bank deposits are debited that’s destruction of inside money.
“They take that out of the capital their interest income earned”
Actually it doesn’t matter where they take it from, interest, retained earnings, etc. It could be shares they sold to investors, or even certain kinds of bonds they sell (sub-ordinated debt for example), or profits they obtain in any form.
“Their customer deposit liabilities will stay the same…”
The deposit liabilities on the aggregated banks’ BS do not stay the same. It’s easiest to see this if you consider that there’s just one commercial bank. They have two choices for transacting with the public: use physical cash or credit/debit bank deposits. Every time they credit a bank deposit they make inside money. Every time they debit a bank deposit they destroy inside money. Every time they use cash they use outside money. I would bet that mostly banks only buy and sell bank deposits with cash and very little else.
“There, the bank would create $100,000 which would increase the capital/net worth of the bank and it can then use it to buy a house”
Not true: that $100k would be a liability to the bank. If the house they purchase is worth $100k, they’ve not improved their capital position at all in the near term, although they’re hoping to improve it by collecting rent in the long term. Inside money is always a liability to the bank. The aggregated banks can and do print their own money in this sense… but every time they do they add to their liabilities.
More generally every time the aggregate banks buy or sell (because that’s the business they’re in… buying and selling), they put into motion a potential change to their capital position. If they sell stock or sub-ordinated debt they directly add to their capital position immediately. Same goes for making a bad loan, except that they undermine their position. Same goes for paying their electric bill: it just decreases their capital… but in that case it may well be worth it. Otherwise they hope that the trades they make improves their capital position over the long run.
Banks don’t hold mortgages now, for the most part. They securitize them. It makes for a better balance sheet.
In your example, I think to get a good fit, you need to have the banks securitize the houses and sell the securities. The risks gains and income would be tranched in entertaining ways. The banks would then be fulfilling their role as repackagers of risk. People who wanted to speculate in residential real estate would buy the equity tranches instead of buying houses themselves. Banks would want to get real estate off their balance sheets, because of its bad effect on their assets at risk calculations and thus their return on equity. Banks would, of course, make money as originators, servicers and trustees, as they do now.
Banks would also still make money from underwriting, trading and services. Taking deposits and making loans is only part a big modern bank’s business (or even less for a few).
Nick:
If Martha Stewart became more popular and houses were bought by people instead of banks, then at the first sign of tightness in the money market, people who wanted money would start offering other goods besides houses to the banks. Banks would buy cars instead of houses. No effect on the interest rate, the quantity of money, or anything else.
Tom:
My Paper “There’s No Such Thing as Fiat Money” lists 5 or 10 empirical studies of the quantity theory vs. the backing theory by Sargent, Calomiris, Bomberger and Makinen, Bruce Smith, Thomas Cunningham, Pierre Siklos, and one or two others. They all favored the backing theory. Fischer Black (of Black-Scholes fame) wrote a ‘conceptual’ paper favoring the backing view way back in the 1970’s.
Currently, my favorite thought experiment is an-old fashioned mint. If money is tight, people bring silver to the mint to be stamped into coins. If they have too much money, people will melt coins and the coins will reflux to bullion. The market automatically provides the right amount of coins, just like it would provide the right amount of silver spoons. The Law of Reflux works just as it should.
Now make one change. Instead of the mint stamping peoples’ silver into coins, the mint keeps the silver in a vault and issues paper (or electronic) tokens that circulate instead of the coins. The tokens are easier to carry and they don’t wear out. The Law of Reflux works just the same as it did with coins.
Now make another change. Instead of the mint only issuing 1-ounce tokens to people who bring in 1 oz. of actual silver, the mint starts issuing 1 oz tokens to people who bring in 1-oz. WORTH of land, wheat, bonds, etc. Once again, the Law of Reflux works just the same. If people want more money they bring in more land and get more tokens. If they want less money they redeem their tokens for land.
One last change: Suspend silver convertibility of the tokens, while maintaining bond convertibility, and still accepting the tokens for taxes, loan payments, etc. Nothing important would change, except that people would wrongly conclude that ‘not silver-convertible’=’unbacked’, and the crazy idea of fiat money would take hold.
Nick Edmonds, you write:
“If you mean by this that people can’t get rid of an excess supply of bank liabilities by repaying loans, I’d tend to agree with that.”
I’m a little surprised to see you write that in light of recent discussions at monetaryrealism.com. Or am I getting your position confused with that of Ramanan? Or JKH? Is there some differences between the three of you?
Also, it seems to me that loans can always be repaid, so there has to be a room for at least some reflux doesn’t there?
Mike Sproul & Nick Rowe:
We’ve got the makings of a great smack down event here… in one corner we’ve got:
“…and the crazy idea of fiat money would take hold.”
and in the other:
“But if the other side doesn’t even make logical sense…you can’t do that.”
Nick, do you have anybody else in your corner? David Laidler? Bill Woolsey?
Mike Sproul… thanks for the references… I’ll check them out. But in all fairness, can you think of any evidence which tends to support the null hypothesis over that of your backing theory hypothesis? Might that include the Somali “orphaned” bank notes? Something else?
Tom:
Well, in addition to Somali shillings there’s bitcoin, the Iraqi Swiss Dinar, and a few others I’m probably forgetting. Those cases are, of course, extremely rare exceptions to the rule that money is always the liability of its issuer, and backed by the issuer’s assets.
Possible explanations for those unbacked moneys are (1) People expect that it will be honored (i.e., backed) sometime in the future. (2) People value it as a curiosity, like baseball cards.
Tom,
If I give you a check of $1000 does that create any money? Even when our banks credit and debit our accounts respectively? I don’t think so. Same with interest income earned by the bank. Let’s say I make a $2000 mortgage payment. $800 are to pay down the principal, which reduces my debt liability and the bank’s mortgage asset by $800 each. $1200 does not reduce my debt liability. Instead it will be income for the bank which it will use to pay e. g. one of its employees by crediting its account. No money being created are destroyed there, simply shifting funds around. For those $1200 the bank’s deposit liabilities stay the same. (More maybe later)
Odie,
“If I give you a check of $1000 does that create any money?”
No, there’s not NET creation of money there.
“$1200 does not reduce my debt liability.”
I agree, because your mortgage and the deposit are different things. There’s two separate IOUs here: your IOU to the bank (the mortgage) and their IOU to you (your deposit). Again I’m thinking just a single commercial bank, otherwise replace “bank” with “banks in aggregate.”
So what do the banks in aggregate do to accept your payment for both the principal and interest? They debit your bank deposit in both cases. Or they accept cash. In the former case (debit) inside money (bank liabilities) are destroyed. In the case of you paying $800 principal the OTHER IOU is also adjusted (your IOU to the bank: your mortgage). That’s the only difference. For the $800 principal payment TWO IOUs are marked down by $800, and for the $1200 interest payment just one IOU is marked down (your deposit).
The bank will have added $1200 to its equity position (which is just an abstract dollar amount representing the value of assets in excess of the value of liabilities). What they “do with it” is a totally separate issue… maybe they pay their taxes, who knows… maybe they leave it sit there as a buffer. They don’t HAVE to turn around and create more money with this difference (the equity) by crediting anybody’s bank deposit. They can, but they don’t have to. There’s no “law of the preservation of bank deposits” in play. Those are free to grow or shrink depending on what the bank decides to do.
Nick, my response to Odie is in your spam.
Odie, my longer response is in spam, but the short answer is there’s no law of the preservation of bank deposits… I agree with everything your write up until “Instead it will…” to the end of your comment: you’ve only described a possible outcome there. There’s nothing compelling the bank to turn around and credit any entity with $1200. The fact is $2000 of net inside money was destroyed. $1200 of it representing an increase in bank equity. At that point more inside money may or may not be created in the future. Nothing compels the banks in aggregate to immediately create another $2000 or $1200 or any other amount.
In the real world, banks both borrow and lend. They sell their own IOUs (borrow) and buy other people’s IOUs (lend). But what would change if banks only borrowed, and did not lend?
They wold not generate an income stream out of the houses unless they sold them regularly at a profit. What you’re describing is proprietary trading. And where and how would people deposit their income? Under their mattresses? How would they exchange their bank IOUs for base money? And would happen to bank balance sheets in the process?
The money that banks create is a loan. It is an IOU, signed by the bank. It is a loan to the bank by whoever owns that IOU. Banks borrow when they create money.
Banks borrow from the central bank when they make a loan. And it’s the credibility of the central bank to keep the promise that makes bank IOUs near money substitutes. An IOU from a bank is a promise to pay out central bank money, not to trade it for someone else’s bank IOU.