Beyond Diamond and Dybvig: the banking system as a mutual society

In almost all models with monetary frictions, such as the search model of money, the first best outcome can be reached by what is sometimes called a gift-giving equilibrium: if we can convince everybody to participate in trust-based gifting (for example, until there is a deviation), the first best outcome can be achieved. In my view, banking should be understood as the means by which society creates the enforcement mechanisms that make something close to a gift-giving equilibrium possible.

Thus, in my view at the heart of the banking system lies the ability of (almost) everyone to borrow — or receive gifts — by “issuing” money. The real-world mechanism by which this money is created may, for example, be by drawing on an overdraft or credit line offered by a bank. (Historically this took other forms, such as the bill of exchange.) Because in a first-best equilibrium everybody needs to be able to borrow, the first-best form of money requires underwriting. That is, in order to sustain the system we need banks to eliminate from the system those individuals who will choose to cheat rather than to repay their debts — or give gifts.

One immediate implication of this view of money is that short-term bank credit cannot be distinguished from money, because the issuance of such credit is fundamental to how the money supply is created. This view underlies my skepticism of narrow banking proposals that purport to back all bank deposits by government debt or central bank reserves. Economic efficiency — or a first-best outcome — depends fundamentally on the ability of (almost) every individual in the economy to issue money by drawing on a bank credit line. A central bank — which is not equipped to underwrite such credit lines — by issuing reserves, but not making loans, cannot substitute for the role played by the banking system in the money supply.

Thus, the Diamond and Dybvig model, where bank deposits are literally objects deposited at the bank, leaves out an essential aspect of banking and how it can help make an efficient economic equilibrium possible. This is due to the fact that Diamond and Dybvig has no monetary frictions. In a model with monetary frictions, it becomes immediately obvious that in order for a first-best equilibrium to be reached transactional credit — or money that takes the form of debt — is necessary.

Banking is thus a mutual system in this sense: even though the deposits held in the banking system are assets that have been earned (in the accounting sense of the word) by their owners who have given value in exchange for money, the system of deposits should be viewed as completely integrated with the system of bank lending. And thus, the whole depository system should be understood as a mutual society through which some members of the economy lend to others in a way that makes the economy work better. In short, there is a sense in which bank deposits are fictional — because their value can only be realized if the debts that back them are actually paid. But this tension between assets earned and assets realized is always present in a mutual society.

To the degree that this view of banking is correct, the movement we have experienced over the past few years towards a system of bank money backed by central bank reserves may be problematic. After all, in the extreme case, where banks are wholly dependent on the central bank and therefore do not lend, we would expect this change to reduce the capacity of the economy to support economic activity.

In my view failure to understand the nature of banking — which can probably be attributed in large measure to the influence of Milton Friedman and James Tobin  on the economics profession — has had very adverse effects on the evolution of the banking system. And has led to “competitive” reforms that are destabilizing to the efficient equilibrium that can be obtained through banking.

What Gorton and Holmstrom get right and get wrong

Mark Thoma directs us to David Warsh on Gorton and Holmstrom’s view of the role of banking. I’ve written about this view in several places. My own view of banking is very different and here is a quick summary of my key points.

The source of Gorton and Holmstrom’s errors: Taking U.S. banking history as a model

In my view Gorton and Holmstrom err by basing their view of what banking is on the pre-Fed U.S banking system. Nobody argues that the U.S. represented a “state-of-the-art” banking system in the late 19th century. In fact, in the late 19th century the U.S. banking system was still recovering from the reputational consequences of the combination of state and bank defaults in the 1840s that had led many Europeans to conclude that American institutions facilitated fraud. By the end of the 19th century, however, the U.S. did have access to European markets and there is evidence that the U.S. banking system relied heavily on the much more advanced European banking system for liquidity (e.g. the flow of European capital during seasonal fluctuations). Indeed, the crisis of 1907, during which the none-too-respected U.S. banking system was at least partially cut off from the London money market, was so severe, it led to the decision to emulate European banking by establishing the Federal Reserve.

What Gorton and Holmstrom get right: the fundamental difference between money market and capital market liabilities, or as Warsh puts it: “Two fundamentally different financial systems [are] at work in the world”

In particular, it is essential for the debt that circulates on the money market to be price stable or “safe.” This distinguishes money markets are from capital markets, where price discovery is essential. Holmstrom writes:

Among economists, the mistake is to apply to money markets the lessons and logic of stock markets. … Stock markets are … aimed at sharing and allocating aggregate risk … [and this] requires a market that is good at price discovery. … [By contrast,] The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by … obviat[ing] the need for price discovery.

What Gorton and Holmstrom get wrong:

1.  The historical mechanisms by which the banking system created “safe” money market assets.

Holmstrom writes: “Opacity is a natural feature of money markets and can in some instances enhance liquidity.” This is the basic thesis of Gorton and Holmstrom’s work.

A study of the early 20th century London money market indicates, however that the best way to create safe money market assets is to (i) offset the implications of “opacity” by aligning incentives: any bank originating or selling a money market asset is liable for its full value, and (ii) establish a central bank that (a) has the capacity to expand liquidity and thereby prevent a crisis of confidence from causing a shift to a “bad” equilibrium, and (b) controls the assets that are traded on the money market by (1) establishing a policy of providing central bank liquidity only against assets guaranteed by at least two banks, and (2) withdrawing support from assets guaranteed by low-quality originators. (ii)(b) plays a crucial role in making the money market safe: no bank can discount its own paper at the central bank, so it has to hold the paper of other banks; at the same time, no bank wants to hold paper that the central bank will reject. Thus, the London money market was designed to ensure that the banks police each other — and there is no American-style problem of competition causing the origination practices of banks to deteriorate.

The Gorton-Holmstrom approach is based on the historical U.S. banking system and sometimes assumes that deterioration of origination quality is inevitable — it is this deterioration that is “fixed” by financial crises, which have the effect of publicizing information and thereby resetting the financial system. In short, by showing us how a banking system can function in the presence of both opacity and misaligned incentives, Gorton and Holmstrom show us how a low-quality banking system, like that in the late 19th century U.S. which could only create opaque (not safe) assets, can be better than no banking system.

Surely, however, what we want to understand is how to have a high-quality banking system. The kind of system represented by the London market is ruled out by assumption in the Gorton-Holmstrom framework which focuses on collateralized rather than unsecured debt. An alternative model for high-quality banking may be given by the 1930s reforms in the U.S. which improved the origination practices of U.S. banks and — temporarily at least — stopped the continuous lurching of the U.S. banking system from one crisis to another that is implied by opaque (rather than safe) money market assets.

2. Gorton and Holmstrom err by focusing on collateral rather than on overlapping guarantees.

Holmstrom writes: “Trading in debt that is sufficiently over-collateralised is a cheap way to avoid
adverse selection.” His error, however is to use both language and a model that emphasize collateral in the literal sense. The best form of “over-collateralization” for a $10,000 privately-issued bill is to add to the borrower’s liability the personal guarantee of Jamie Dimon — or even better both Jamie Dimon and Warren Buffett. This is the principle on which the London money market was built (and because both extended liability for bank shares and management ownership of shares was the norm until the 1950s in Britain, personal liability played a non-negligible role in the way the banking system worked). This is rather obviously an excellent mechanism for ensuring that money market debt is “safe.”

The fact that it may seem outlandish in 21st century America to require that a bank manager have some of his/her personal wealth at stake whenever a money market asset is originated, is really just evidence of the degree to which origination practices have deteriorated in the U.S.

Note also that there is no reason to believe that the high-quality money market I am describing will result in restricted credit. Nothing prevents banks from making the same loans they do now; the only issue is whether the loans are suitable for trade on the money market. Given that our current money market is very heavily reliant on government (including agency) assets and that these would continue to be suitable money market assets, there is little reason to believe that the high-quality money market I am describing will offer less liquidity that our current money market. On the other hand, it will offer less liquidity than, say, the 2006 money market — but I would argue that this characteristic is a plus, not a minus.

3. Holmstrom errs by focusing on debt vs. equity, rather than money markets vs. capital markets

Holmstrom claims that: “Equity is information-sensitive while debt is not.” He clearly was not holding GM bonds in the first decade of the current century. A more sensible statement (which is also consistent with the general theme of his essay) is that capital market assets including both equity and long-term debt are information sensitive, whereas it is desirable for money market assets not to be informationally sensitive.


In short, I argue that in a well-structured banking system money market assets are informationally insensitive because they are safe. For institutionally-challenged countries, a second-best banking system may well be that presented by Gorton and Holmstrom, where money markets assets are “safe” — at least temporarily — because they are informationally insensitive.

In my view, however, we should establish that a first-best banking system is unattainable, before settling on the second-best solution proposed by Gorton and Holmstrom.

Reasons to reform macro by rejecting “M” #2: To End the Mission-Creep of Central Banks

New monetarist theory tells us that monetary frictions can only be fully addressed by unsecured private sector debt — and thus can only be solved by designing incentive structures that make unsecured private sector debt enforceable, or in other words by a carefully designed banking system.

Prior to the 1930s, the central bank played two main roles: it supported the private sector money supply through panics and monitored the growth of credit, taking action to prevent credit-boom-driven inflation. (The latter was the real bills approach to bank regulation, which the Fed unfortunately was not well-equipped to address — explained here.)

Monetarism introduced a new era in which it was believed that government “control” of the money supply played an important role in economic activity. The financial system has evolved to match the theory. There has been a steady increase in the role of the central bank over the past few decades, and this evolution culminated in the vast expanse of the central bank role subsequent to the crisis of 2007-08.

With the collapse of interbank lending markets, the growth of central bank reserves, and the shift to secured lending backed by government debt, the role of unsecured private sector debt in the money supply has declined dramatically. In short, the better part of a century after it was first set forth the monetarist agenda of putting in place government control over the money supply and of minimizing the role of the private sector in the money supply is finally being achieved.

And just as new monetarist theory would predict, the decline in the use of unsecured, private sector instruments as money is associated with sluggish economic activity — because “M” is a poor substitute for the money that a well-structured banking system can provide.


Reasons to Reform Macro by Rejecting “M” #1: Banking is no longer a mystery

In my previous post, I explained that when one actually models monetary frictions (as new monetarist models do), it becomes immediately clear that the only full solution to these frictions is a debt-based form of money. The intuition behind this fact is simple: some people need to buy before they receive payment for what they have sold. For example, consider the case of the employee who won’t be paid until two weeks after he starts work, but who needs to eat in the meanwhile. Or alternatively, consider the case of his employer who needs to pay her employee but won’t actually receive payment for the good the employee produced until two weeks after the paycheck is due. The earliest banking systems existed to turn these claims to future payment (i.e. those which are already “earned” or receivable in accounting terms) into immediate cash at a slight discount.

In many of these cases there is virtually no uncertainty that payment will be forthcoming, so it is inefficient for employee or his employer to be unable to draw on his or her expected earnings. Observe in these examples how important debt is not just to the flow of money through the economy, but also to the flow of economic activity through the economy. Thus, banking institutionalizes and stabilizes the system of monetary debt which makes possible the flow of economic activity to which we are accustomed. The stabilization that is provided by banking includes both monitoring to minimize the degree to which cheaters are able to take advantage of the system of debt, and controls on the growth of monetary debt to make sure that it is commensurate with economic activity — and to limit the likelihood of inflation. (This stabilizing anti-inflation policy was known by the term “real bills,” but is a matter of profound confusion for modern scholars particularly in the U.S. as is explained here.)

Given the conclusions that can be drawn from the formal models that make up the new monetarist literature, from a logical point of view it is remarkable that most of modern macroeconomics studies “M” or a form of money that is not based on private sector debt. (As noted in my previous post, this phenomenon can, however, be explained by taking a sociological view of the economics profession.) It is important to be clear that it is not just monetarists, and their intellectual heirs, who make this error. James Tobin was equally confused about this issue, writing that “the linking of deposit money and commercial banking is an accident of history.” (h/t Matthew Klein).

These entirely misguided beliefs about the nature of money and the nature of banking can almost certainly be attributed to the fact that the models that were being used in the mid-20th century when the field of macroeconomics was being developed did not include monetary frictions. Thus, Friedman and Tobin and the vast majority of their colleagues failed to comprehend the simple truth that in the absence of loans to the individuals who seek to trade in an economy, there is no reason to believe that the monetary friction will be solved at all.

In short, theory tells us that that the linking of what circulates as money and commercial loans is necessary in order for an efficient economic outcome to be attainable. Under these circumstances, it seems extremely unlikely that the well-established link between the two in modern economies is an “accident of history.” It is much more plausible that, because in the presence of monetary frictions an efficient outcome is only possible when money is based on the debt of the traders in the economy, banks developed to institutionalize this efficiency-enhancing phenomenon.

Rebutting the “It Takes a Model …” Defense of Modern Macroeconomics

Steve Williamson writes “It takes a model to beat a model. You can say that you don’t like [modern macroeconomics], but what’s your model? Show me how it works.” Well, I’m going to take up that challenge, because I wrote that model.

In my view, the challenge is not to write a model that works, but to write a model that the macroeconomic establishment will find “convincing.” And that generally requires writing a model that comes to conclusions that are closely related to the existing literature and therefore “make sense” to the establishment. The problem, however, is that many of the implications of the existing literature are batshit insane. (My personal pet peeve is explained in detail below, but there are others … ) The choice faced by a young economist is often to join the insanity or leave the profession. (This is actually a conversation that a lot of graduate students have with each other. Many compromise “temporarily” — with the goal of doing real research when they are established.)

Williamson’s own area of macro, new monetarism, which is the area that I was working in a decade ago too, illustrates the gravitational pull of conformity that characterizes the macroeconomics profession, and that interferes with the development of a genuine understanding by economists of the models they work with.

Williamson acknowledges, as every theorist does, that the models are wrong. The problem with macro (and micro and finance) is that even as economists acknowledge that formally there is a lot to criticize in the market clearing assumptions that underlie far too much of economic theory, they often dismiss the practical importance of these critiques — and this dismissal is not based on anything akin to science, but instead brings to mind a certain Upton Sinclair quote. (Note that there are sub-fields of economics devoted to these critiques — but the whole point is that these researchers are separated into sub-fields — in order to allow a “mainstream” segment of the profession to collectively agree to ignore the true implications of their models.)

Let’s, however, get to the meat of this post: Williamson wants a model to beat a model. I have one right here. For non-economists let me, however, give the blog version of the model and its implications.

(i) The model fixes the basic error of the neo-classical framework that prevents it from having a meaningful role for money. I divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability.

Note that because the model is designed to fix a well-recognized flaw in the neo-classical framework, it’s just silly to ask me to provide micro-foundations for my fix. The whole point is that the existing “market clearing” assumptions are not just microunfounded, but they interfere with the neo-classical model having any relationship whatsoever to the reality of the world we live in. Thus, when I adjust the market clearing process by inserting into it my intra-period friction, I am improving the market-clearing mechanism by making it more micro-founded than it was before.

Unsurprisingly, I wasn’t comfortable voicing this view to my referees, and so you will see in the paper that I was required to provide micro-foundations to my micro-foundations. The resulting structural assumptions on endowments and preferences make the model appear much less relevant as a critique of the neo-classical model, since suddenly it “only applies” to environment with odd assumptions on endowments and preferences. Thus, does the macroeconomics profession trivialize efforts to improve it.

(ii) An implication of this model in an environment with heterogeneous agents is that (a) money in the form of Milton Friedman’s “M” cannot solve the monetary problem, but that instead (b) a monetary form of short-term credit is needed to solve the monetary friction. To be more precise, in order to support a good outcome using “M” in an environment with heterogeneous agents the monetary authority needs to impose different lump-sum taxes for every type of agent (otherwise either some agents face a binding cash-constraint or the transversality condition that keeps agents from forever holding and never spending increasing amounts of money is violated). Thus, technically “M” can solve the monetary problem but only if an all-knowing monetary authority is constantly tweaking the amount of money that each member of the economy holds — that is, only if “M” does not have the anonymous properties that we associate with money.

In short, when the neo-classical model is corrected for its obvious flaws, we learn that the basic premise of monetarism, that there is some “M” which is clearly distinguishable from credit and which can solve the monetary problem, has no logical foundations. This whole approach to money is a pure artifact of the neo-classical model’s fatally flawed market-clearing assumptions.

These issues with “M” are actually well-established in the new monetarist literature. (See, e.g. here or here.) The problem is that this motivated changes in the literature, discussed below, that protect the concept of “M.” (Moral: if you want to get published be careful to rock the boat with a gentle lulling motion that preserves the comfort of senior members of the profession — they don’t like swimming in unfamiliar waters.)

(iii) I interpret (ii)(b) as a wholesale rejection of the concept of “M.” The fact that the fundamental monetary problem can only be fully addressed by credit points directly to the importance of the banking system. We need the transactional credit that banking systems have long provided — not incidentally starting at the dawn of modern growth trends — in order to solve the monetary problem.

This is where, in terms of modern macroeconomics, I go completely off the rails. Correctly viewed, however, this is where modern macroeconomics goes completely off the rails. Every modern macroeconomist, whether of the salt- or of the fresh-water school was trained to ignore the banking system. They are persuaded that it doesn’t matter, because if banking is a fundamental determinant of economic performance, then the whole of their understanding of how the economy works is fundamentally flawed. (See Upton Sinclair above.)

So we have the development of a sub-field of macroeconomics, new monetarism, and the implications of this literature should be understood as a direct challenge to the concept of “M.” What, in fact, happened to this literature? The basic model was tweaked, so the workhorse model in this area is now the Lagos-Wright model. What does this model do? After every trading period with frictions it introduces a frictionless stage in which money balances, “M,” can be reallocated using standard neo-classical market clearing assumptions. (To make this work the axioms of preference are also relaxed with respect to one good, but that’s another issue.) That is, it guts the basic intuition that economists should derive from the older new monetarist literature. Why does it do this? Because it turns the model into something that simply tweaks the traditional understanding of “M” and makes it easier for economists to continue to ignore the fundamental monetary role of the banking system — carefully lulling the macroeconomic boat.

To conclude, the models Williamson has been working with for years should tell him to reject the monetarist view of money. While he and other researchers in this area have explored bank money and its benefits, they do so in a tentative manner without in fact directly challenging the conceptual foundations of “M.” In short, the problem with macroeconomics today is not the models we have, but the illogical, emotionally-tied manner in which economists choose to interpret them.

A broken banking system can explain stagnation

The economy may not be in a recession, but it still isn’t performing very well. A variety of explanations have been floated for this poor performance:

  • Larry Summers argues that “secular stagnation” takes place because interest rates are bounded below and cannot fall to the market clearing level, so we will suffer from insufficient investment until the zero lower bound problem is solved (which may require changing expectations of inflation). He also argues that growth since the late 1990s has been powered by unsustainable increases in the household debt burden, so the underlying economic malady may be of long-standing.
  • Ben Bernanke argues that the global savings glut can explain low interest rates and that to the degree that the U.S. is in an economic slump, this can be addressed by removing barriers to the flow of U.S. funds into foreign investments and reducing intervention in foreign exchange markets.
  • Steve Williamson (h/t Nick Rowe) makes the point that low interest rates can be explained by a financial problem — a safe assets shortage where there is too little government debt outstanding relative to the demand for its use as collateral — and he argues that it may be this safe asset shortage that causes poor economic performance.

I want to take Williamson’s view one step further and argue that we have a safe asset shortage, and therefore low interest rates and lethargic growth, because we broke the banking system. This argument is premised on the view that the most important economic function of the banking system is the creation of safe privately issued assets that are not secured by collateral. (The long form version of this argument is available here, and I outline below how a banking system can be structured to create safe privately issued unsecured assets.)

When the banking system creates an environment where participants in the economy are able to borrow on a short-term, but unsecured, basis and are incentivized by long-term relationships with their banker to borrow wisely, banking promotes economic activity and fosters entrepreneurship by making it possible for the average person to slowly grow a business alongside a credit history. In short, by providing a stable source of short-term credit for almost everybody banking can mitigate the problem that only a select sub-group of the population is ever likely to have access to substantial sums of long-term business credit.

Thus, the principal economic function of the banking system is to make short-term unsecured debt available in ample quantities and thereby ensure that liquidity constraints are not too binding on most economic agents. This system of unsecured debt works because it is a mutual system: the same people who borrow from the banks on an unsecured basis also use bank deposits as money and vice versa. Short-term credit can be provided abundantly because the funds that are lent don’t leave the banking system as a whole, but are simply recirculated from one account to another.

The modern banking system, by contrast, has been evolving in ways that undermine its mutual nature. Since the early years of the current millennium, the cash assets of institutions, including asset managers and corporate treasuries, have been moved away from unsecured bank and money market liabilities and into collateralized short term liabilities, such as repurchase agreements. (Pozsar 2011). In addition, since the crisis unsecured interbank lending markets, such as the Federal Funds and London markets, have collapsed and been replaced with collateralized debt. In other words, both institutional cash pools and the banks themselves have started to opt out of the mutual uncollateralized system that has supported economic activity for more than a century.

Low interest rates and the savings glut may therefore just be the most obvious symptoms of an increasingly dysfunctional financial system where the largest participants have difficulty borrowing unsecured — except from the central bank. An even greater problem is that a banking system built on unsecured debt works because the incentive structure that supports the debt is calibrated and adjusted as the banking system evolves. Thus, when interbank markets break down and remain inoperational for years, the capacity of the system to create unsecured debt may end up being irreparably broken. If my thesis that unsecured debt is an engine of economic performance is correct, then the broken banking system is a very serious problem.

How can a financial system create safe privately issued assets?

The London money market at the turn of the 20th century provides a model of how safe assets are created by a banking system. The elements of the model are this:

  1. In order for a trade debt (owed by one non-bank to another) to become a tradable asset on the money market, the payor’s bank had to accept (or guarantee payment on) the debt. Accepted bills traded freely on the money market, because …
  2. The central bank provided liquidity to the money market by standing ready to discount accepted bills a long as the discounting bank was different from the accepting bank.
  3. To emphasize, what made a bill eligible at the central bank’s discount window, and therefore liquid, were the overlapping guarantees of payment. Many bills were not collateralized.

In short, one way to ensure that the banking system creates safe assets is for the central bank to provide liquidity against paper that has two bank guarantees and one commercial promise of payment. Because a bank accesses central bank liquidity by discounting bills originated by a different bank, this structure ensures that the banks monitor each other and it helps prevent the type of interbank competition that can undermine credit standards.

Thus, it’s possible to have safe privately issued assets — if the incentive structure of the banking system is correctly calibrated.

The mid-20th century U.S. banking system (which I need to study in much more detail than I have to date) took a different form than the model described above, but it was not prone to excessive risk-taking. Instead, competition was repressed, and bankers had the luxury of living by the 3-6-3 rule.

New Monetarism and Narrow Banking: Take Two

The new monetarist framework makes it possible to draw a distinction between two types of liquidity: monetary liquidity and market liquidity. First, observe that market liquidity is the type of liquidity that is modeled in a competitive equilibrium framework. Or to be more precise, because models of competitive equilibrium are driven by market clearing which by assumption converts individual demand and supply into a price-based allocation, they give us information about the kind of liquidity that derives from the meeting of demand and supply. Not only do prices change in such market models, but it is an essential aspect of market liquidity that prices must change in response to fundamental changes in supply and demand.

Of course, money is not essential in competitive equilibrium models and the new monetarist framework grew out of the project of figuring out how to make money essential. The short version of the outcome of this project (discussed at somewhat greater length in my first post on New Monetarism and Narrow Banking) is that money is essential in models where agents buy and sell at different points in time.

As I have argued elsewhere, an implication of new monetarism is that the competitive equilibrium framework can be easily augmented to make money essential. All that is necessary is to divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability. (Note that the demand for micro-foundations meant that I was required to introduce the monetary friction in the form of assumptions regarding endowments and preferences — that as far I as am concerned simply muddy the model.)

An important advantage of introducing this simplest of monetary frictions into competitive equilibrium models is that all the implications that have ever been drawn from such models are still valid given one proviso: they must explicitly assume that the process of providing within period (or short-term) credit is perfect. In short, careful use of new monetarist methods can be used to illuminate the assumptions underlying the concepts of competitive equilibrium and market liquidity.

Monetary liquidity is then the process of addressing the within period frictions. It becomes immediately obvious in this framework that cash is an inadequate means of addressing the monetary friction, because an endogenous cash-in-advance constraint is generated. Any agent who is assigned to buy first and doesn’t hold enough cash will be liquidity constrained. In this framework, it is essential to have enforceable short-term debt contracts in order to eliminate the monetary friction and have perfect provision of monetary liquidity.

This last point is why narrow banking proposals are misguided. They misconceive of what is necessary to have perfect provision of monetary liquidity. Cash or sovereign/central bank solutions to the monetary problem generate a cash-in-advance constraint. Only a form of money that includes short-term debt can fully address the monetary friction.

New Monetarism and Narrow Banking

As any reader of this blog knows, in my view proposals to eliminate financial instability by adopting 100% reserve banking are a mistake because lending is integral to banking and to money itself. In commenting on John Cochrane’s blog, I think I found a good way to explain the intuition behind this view of banking, so I’m expanding on it here.

First, let me point out that my basic intuition for banking comes from new monetarism, and in particular from the search model of money. As Williamson and Wright point out in their addendum to their Handbook article:

Suppose the government were to, misguidedly as it turns out, impose 100 percent reserve requirements. At best, this would be a requirement that outside money be held one-for-one against bank deposits. We are now effectively back to the world of the model without banks in the previous section, as holding bank deposits becomes equivalent to holding currency. Agents receive no liquidity insurance, and are worse off than with unfettered banking, since the efficiency gains from the reallocation of liquidity are lost. . . . This obviously reduces welfare. A flaw in Old Monetarism was that it neglected the role of intermediation in allocating resources efficiently.

Here I want to, first, give a simple verbal explanation of what underlies this conclusion. (I will be using a search type framework rather than the Lagos-Wright type framework that Williamson and Wright use.) Second, explain my own view of banking. Third, give an illustrative real-world example of why this matters. And, finally, to tie this back into proposals for narrow banking.

The Intuition Behind New Monetarist Models

Monetary frictions are created when buying and selling take place at different points in time, so it is valuable for an economic actor to be able to carry purchasing power over from one time period to the next. If some kind of a chit is introduced into a model with monetary frictions, efficiency increases: people who start with a chit can buy at their first opportunity, and people who have an opportunity to sell in exchange for a chit can then use the chit to buy when they get an opportunity to do so. Note that even though the introduction of chits is welfare improving, chits impose a “cash-in-advance” constraint and the first best can’t be achieved: as long as the monetary friction allows for situations where people would like to buy and are willing to sell in the future to pay their debt, but these people are constrained by the fact that they don’t have a chit, valuable opportunities to trade are being wasted.

Thus, the basic intuition of monetary friction models can be expressed very simply:

  • Sometimes people want to sell before they buy.
    Cash — or chits or some other transferable asset — solves this problem.
  • Sometimes people want to buy before they sell.
    Debt is needed to solve this problem.

This is the basic intuition behind new monetarist models. And it is hard to argue that these models don’t capture something fundamentally important about monetary economics. After all, in fact for every economic actor buying and selling take place at different points in time. This matters. And leaving it out of the models which economists use to develop their intuition about the economy is a mistake.

Banking and New Monetarism

Where I diverge from the mainstream of the New Monetarist literature is that this literature has focused on how to make money in the form of cash or chits essential, whereas the banking historian in me can’t help but simply see short term debt as just another form of money (cf. bills of exchange).

What is money? Money is something (often a piece of paper) that allows people to either sell before they buy or buy before they sell.

In order to make the form of money that they are interested in essential, the New Monetarist literature assumes away the ability to commit to future payments and/or to keep records. While the banks in New Monetarist models almost always play a monetary role because they affect commitment and/or record-keeping, I have long argued that the whole point of banking is to solve the problem that people want to buy before they sell. In short, we should be using New Monetarist models to study how financial intermediation can be structured so that debt functions as money — and so that we maximize our ability to solve monetary frictions.

Overall, the whole point of banking is that increases efficiency by eliminating the cash-in-advance constraint for most economic actors and by making it possible for debt to function as money. In my view, it is a historical fact that fiat money (which I date to 1797 in Britain) grew out of banking — and in particular the system of inland bills that made up the British money supply in the late 18th century. Only after private economic actors in the form of banks had solved the incentive problem that prevented debt from serving as money, was it possible for a government/central bank to gain the credibility necessary to issue fiat money.

In short, the New Monetarist literature tells me that the study of banking should focus on the study of the institutional structures that make the repayment of short-term debt incentive compatible. My most recent efforts to advance this study can be found here and here.

What do banks do? Banks are the enforcement agents that make it possible for short-term debt to circulate as money. The precise role of banks will always depend on the institutional structure within which they function.

A simple modern example of why we want short-term debt to be liquid

The typical worker extends a short term loan of a week or two to his/her employer, since paychecks are periodic and work is a daily activity. Because of this structure employers get to buy before they sell. In a world that where liquidity constraints did not bind, the worker would be able to turn the employer’s debt into cash at very low cost – after all the worker is the creditor of a creditworthy entity.

In fact, workers with bank accounts were (up to 2014) offered “paycheck advance” services, but only at interest rates of 200% or more per annum. Such fees are not dissimilar to the payday advance services offered by non-banks. It seems to be an extraordinary market failure that banks that can borrow at 0% and are virtually guaranteed repayment by direct deposit do not offer these services at competitive rates to their own customers.

It is, of course, not just consumers who face such liquidity constraints. Businesses, small and large, also need to buy before they sell. Banks today as in the past provide a large number of services that make it possible for businesses to borrow on a short-term basis.

Why narrow banking proposals are wrong

The reader has probably gathered by now that the problem with narrow banking proposals is that they ignore how important it is for debt to function as money. In the real world the need for economic actors to buy before they sell is ubiquitous: employers owe their employees and many of them would face a serious cash-crunch if their wage bill had to be prepaid. Similarly it is much harder for businesses to operate on a COD basis, than on a 30 days payable basis.

The goal of a banking system should be to make sure that as much of this simple transactional credit is available as possible at very low cost — because that’s a baseline requirement for the economy to be functioning reasonably efficiently. By eliminating simple short-term bank loans — without providing for the government to provide the service instead — narrow banking proposals are likely to hobble the economy, turning it from one where debt-based money is available to one where such money has dried up entirely.

A Counterproposal to “Shifts and Shocks”

Martin Wolf in Shifts and Shocks does a remarkable job of taking a comprehensive view of all the moving parts that have played a role in creating our current financial malaise and ongoing risks to financial stability. He also does a wonderful job of laying them out clearly for readers. Furthermore, I am entirely convinced by his diagnosis and prognoses of the Eurozone’s problems. When it comes to the question of the financial system more generally, however, even though I’m convinced that Wolf understands the symptoms, I don’t think he’s on target with either his diagnosis or his solutions. In fact, I think he too shows signs of being hampered by the problem of intellectual orthodoxy.

This post is therefore going to combine commentary on Shifts and Shocks with an introduction to my own views of how to understand the boondoggle that is the modern financial system. (I have nothing to say about the Eurozone’s grief except that you should read what Martin Wolf has to say about it.) For the long form of my views on the structural reform of the financial system, see here.

First, let me lay out the many things that Wolf gets right about the financial system.

  • The intellectual failures are accurately described:
    • orthodox economics failed to take into account the banking system’s role in creating credit, and thus failed to understand the instability that was building up in the system.
    • this has led to a dysfunctional and destabilizing relationship between the state and the private sector as suppliers of money
  • His basic conclusion is correct:
    • the system is designed to fail because banks finance long-term, risky and often illiquid assets with short-term, safe and highly liquid liabilities.
  • The inadequacy of the solutions currently being pursued is also made clear. Combining macro-prudential policy and “unlimited crisis intervention” with resolution authorities
    • just worsens the dysfunctional relationship between the state and the private sector
    • forces rulemaking that is designed to preserve a system that the regulators don’t trust and that is so complex it is “virtually inconceivable that it will work” (234)
  • His focus on the need for more government expenditure to support demand instead of attempts to induce the private sector to lever up yet again is correct.
  • The key takeaways from his conclusion are also entirely correct (349)
    • The insouciant position – that we should let the pre-crisis way of running the world economy and the financial system continue – is grotesquely dangerous.”
    • “leveraging up existing assets is just not a particularly valuable thing to do; it creates fragility, but little, if any, real new wealth.”

I think Wolf makes a mistaking in diagnosing the problem, however. One can view our current financial system as simply exhibiting the instability inherent in all modern economies (a la Minsky), or as exhibiting an unprecedented measure of instability even taking Minsky into account, or something in between. Wolf takes the hybrid position that while the basic sources of instability have been present in financial systems since time immemorial, “given contemporary information and communication technologies, modern financial innovations and globalization, the capacity of the system to generate complexity and fragility, surpasses anything seen historically, in its scope, scale and speed.” (321) This, I believe, is where the argument goes wrong.

To those familiar with financial history the complete collapse of a banking system is not a particularly unusual phenomenon. The banking system collapsed in Antwerp in the mid-15th century, in Venice in the late 16th century, in France in the early 18th century, and in Holland in the late 18th century. What is remarkable about 19th and 20th century banking is not its instability, but its lack of total collapse.

Indeed, the remarkable stability of the British banking system was founded in part on the analysis of the reasons behind 18th century financial instability on the continent. (There is no important British banking theorist who does not mention John Law and his misadventures in France.)  In particular, a basic principle of banking used to be that money market assets — and bank liabilities — should not finance long-term assets; capital markets should have the limited liquidity that derives from buyers and sellers meeting in a market. Thus, when Wolf finds that our modern system is “designed to fail” because money market assets are financing risky long-term assets, and that market liquidity is a dangerous illusion that breeds overconfidence and is sure to disappear when it is most needed (344), he is simply rediscovering centuries-old principles of what banks should not do.

By arguing that the structural flaws of modern finance are as common to the past as to the present, Wolf embraces the modern intellectual orthodoxy and sets up his radical solution: that our only option for structural reform that stabilizes banking is to take away from banks the ability to lend to the private sector and require that all debt be equity-financed. Thus, Wolf obfuscates the fact that the 19th and 20th century solution to banking instability was to limit the types of lending to the private sector that banks were allowed to engage in. Britain had a long run of success with such policies, as did the U.S. from the mid-1930s to the 1980s. (Recall that the S&Ls were set up in no small part to insulate the commercial banks from the dangers of mortgage lending — as a result the S&L crisis was expensive, but did not destabilize the commercial banks, and was compared to 2007-08 a minor crisis.) Thus, there is another option for structural reform — to stop viewing debt as a single aggregate and start analyzing which types of bank lending are extremely destabilizing and which are not.

The real flaw, however, in Wolf’s analysis is that he doesn’t have a model for why banking lending is important to the economy. Thus, when he acknowledges that it is possible that the benefits of “economic dynamism” due to banking exceed the massive risks that it creates (212-13), he doesn’t have a good explanation for what those benefits are. As a result, Wolf too is intellectually constrained by the poverty of modern banking theory.

19th c. bankers were far less confused about the benefits of banking. When everybody is willing to hold bank liabilities, banks have the ability to eliminate the liquidity constraints that prevent economic activity from taking place. The merchant who doesn’t have enough capital to buy at point A everything he can sell at point B, just needs a line of credit from the bank to optimize his business activities. This problem is ubiquitous and short-term lending by banks can solve it. Furthermore, because they solve it by expanding the money supply, and not by sourcing funds from long-term lenders, the amount of money available to borrow can easily expand. Of course, there are problems with business cycles and the fact that the incentives faced by banks need to be constantly monitored and maintained, but these are minor issues compared with the asset price bubbles that are created when banks get into long-term lending and that destabilized the financial system in 2007-08.

Overall, banks can do a lot to improve economic efficiency without getting into the business of long-term lending. And a recipe for financial stability should focus on making sure that long-term lending, not all bank lending, is funded by equity.

Notes on the History of Monetary Thought

I’m working on a series of papers on traditional banking theory as an alternative framework for understanding the relationship between banking, finance and the macroeconomy, (part 1 is here) and in this post I’m just jotting down some thoughts on the history of economic thought.

As my papers argue by the early 20th century there was a fairly coherent theory of the relationship between banking, economic activity, the price level, and the guidance of these factors using the central bank policy rate — I call this “traditional banking theory.” With the growth of the “quantity (of money) theorists,” this school was sometimes described as “qualitative,” but it’s proponents pointed out (Beckhart, AER 1940) that the two schools didn’t differ in the importance they placed on the use of data, but rather in the value of using aggregate quantities to determine policy.

There are two points to make here:

After the Depression (and I believe massive policy influence in the 1930s), this traditional school of monetary thought was entirely displaced by two aggregate theory approaches: Monetarists and Keynesians. The histories I am familiar with focused on the debate between the two macro schools and the view that macro cannot be understood without a micro-understanding of debt disappeared from academic discourse. (I still don’t understand how this happened, but maybe the “invention” of macro played a role in it.)

Traditional banking theory didn’t really disappear. Instead it became part of the vast gulf that developed between market practitioners and academic theorists. For example, Marcia Stigum’s Money Market, a textbook written based on interviews with practitioners, reflects aspects of traditional banking theory.


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