Paul Krugman writes: “while banks are indeed more complicated creatures than the mechanical lenders of deposits we like to portray in Econ 101, this doesn’t mean either that they have unlimited ability to create money or that they are somehow outside the usual rules of economics”
I want to propose a very different view of banking than the one Krugman embraces. Banking is what makes the “usual rules of economics” conceivable. Remember that Adam Smith wrote the Wealth of Nations in 1770’s Scotland, which was one of the birthplaces of modern banking — and banking was having an extraordinary effect on the economy that Smith acknowledged. (Book II, Chapter 2, paras. 40-41 )
If one discards the neo-classical framework and conceives as the economy as an environment where the average person’s life is defined by liquidity constraints that preclude profitable investment, then one can understand banking as the crucial innovation that allows the average person to overcome liquidity constraints and, thus, that makes the neo-classical framework a meaningful model of economic behavior.
Of course, banks have never had “unlimited ability to create money” — even though the statement that banks “create money at the stroke of a pen” is a shorthand description that can be misread if taken out of context. Banking functions to alleviate liquidity constraints because of the institutional constraints on banks’ ability to create money — just as debt can alleviate liquidity constraints only if institutional constraints make it enforceable.
It is true that banks “create money at the stroke of a pen,” but it is also true that they are liable for the deposits that they create when doing so — just as they are liable for liquidity puts that make the issue of asset-backed commercial paper possible. It is the institutional structure in which banks operate which controls the money supply.
In my view, when there is an institutional infrastructure that makes it possible for banks to issue safe private sector assets abundantly, the economy performs well — because the new-classical framework becomes a not-unreasonable approximation of the economy. By contrast, when this institutional infrastructure starts to break down as it has in recent years, we begin to inhabit an economy where liquidity constraints are one of the most important forces in the average individual’s life and vast amounts of profitable investment never see the light of day.
A paper that expresses my view and its implications for shadow banking in detail is here. Some related posts are here, here, here and here.
Other blogposts and articles related to this topic are:
Atif Mian & Amir Sufi, 100% Reserve Banking — The History
Paul Krugman, Is a Banking Ban the Answer
Martin Wolf, Strip Private Banks of Their Power to Create Money
John Cochrane, Toward a Run-Free Financial System
Isabella Kaminsky, Martin Wolf on Funny Money Creation, On the Elimination of Privately Issued Money
Stephen Cecchetti & Kim Schoenholtz, Narrow Banks Won’t Stop Bank Runs
Synthetic Assets 