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.