What do banks do? A response to Krugman and Rowe

Paul Krugman’s critique of Steve Keen’s work has set off a debate in the econoblogosphere over the degree to which bank creation of money is constrained by central bank policy.  The clearest explanation of what, I think, is also Krugman’s view is presented by Nick Rowe:

An individual commercial bank can create money out of thin air simply by buying something. But the money it creates may not be its own. Its money may subsequently be redeemed for the money of another bank, or the central bank. The individual commercial bank that wants apermanent increase in its stock of money may need to persuade people not to redeem its money. Whether or not it needs to do anything to persuade them all depends on how the other banks, especially the central bank, react.

I can imagine a world in which an individual commercial bank can permanently create money. All it needs is that the central bank, which is free to do what it wants, allows the supply of its own money to increase in proportion to the supply of commercial bank money. This is what would happen if the central bank targeted a rate of interest, for example. One commercial bank creates money, and all the other commercial banks, and the central bank, respond to the hot potato process by increasing their own money supplies in response to the rising demand for loans and deposits and currency.

I read these two paragraphs as a statement that the velocity of money (with respected to the monetary base or currency) tends to be constant.  It’s far from clear to me why this would be the case — probably because the basic model of a credit-based monetary economy that I work with has infinite velocity; that is, the model demonstrates that the optimal solution to a monetary problem is an institutional structure with a monetary base of zero.  (See here for a formal model and here for a heuristic discussion of the model.)  The basic idea of this framework is that if a monetary problem exists, “good” credit will always be a better solution to the problem than money.  The question then becomes how do you establish a “good,” i.e. very low default, credit system.

My model of banks has them financing working capital (which they have been doing for centuries).  If one thinks of bank lending as the means by which the value of inalienable assets — the entrepreneur’s personal knowledge — are realized, then when banks are lending wisely and true value is being realized via bank lending while at the same time the monetary base is being held constant, the velocity of that base should increase since true new value is being created.  The problem arises when banks miscalibrate and lend unwisely, then there can be a temporary increase in velocity before the mistake is recognized as such, followed by a decline back to the “true” velocity given the “true” value of output.

I think the difference between my model and the one that Krugman and Rowe are working with is that they assume that economic output is not a function of bank finance, that is, output simply comes into being frictionlessly* and banks are then tacked onto this economy.  (In their posts Krugman‘s banks “offer a better tradeoff between liquidity and returns” and Rowe‘s banks “buy something”.)

By contrast, I assume that any output that exists, exists because it is financed by the banks — thus, an increase in “good” bank activity necessarily increases real GDP.  If the monetary base is held constant, the velocity of money will increase.  If this model is correct, then there is no need to “persuade” anyone to hold additional bank money, because the economy demands that money in order to pay for the real goods that were produced using bank financing.

*  Update 4-3-12:  Since a “friction” has many definitions in the economic literature, I should be specific that I am talking about monetary frictions here that create a role for a means of exchange.  In my lexicon that’s the missing friction that makes general equilibrium models very hard to relate to the real world — and by assumption eliminates the obvious role of banks.

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