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.

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3 thoughts on “New Monetarism and Narrow Banking”

  1. I can see the importance of short-term credit, but how do the narrow banking proposals interfere with it? The advocates merely want it to be funded by equity. That requirement does raise costs, because equity is an expensive form of funding for banks. Is there more?

    1. Equity finance ends up working just like a cash/collateral in advance constraint. If the banks can only lend after they have been funded with equity then that limits their ability to lend.

      In my view, the purpose of banking is to use carefully structured incentives to make reputation-based short-term lending possible. When banks lend, they expand the money supply, but this doesn’t matter as long as the incentive structure that enforces payment on the loans is sound.

      What narrow banking proposes is to eliminate the ability of banks to engage in this form of lending. If I am right about what banks do, then narrow banking will result in an increase in binding liquidity constraints and thus adversely affect economic performance.

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