“Real bills” banking prevented Minsky moments

The “real bills” approach to banking is profoundly misunderstood, as I explain in this paper. What I’ve just recently realized is that Minsky’s financial instability hypothesis is probably derived from real bills. In particular, Minsky cites Schumpeter, who was I believe familiar with contemporary banking theory.

A real bill is a short-term loan that arises out of a commercial transaction. These bills circulated as money in the commercial cities of Europe in the 17th and 18th centuries because banks stood ready to buy the bills. In accounting terms a real bill monetizes an asset that is earned, but not yet realized. What very few modern writers understand is that if a bank, instead of demanding payment on a real bill, rolls it over, the resulting line of credit is not a real bill. There are many names for this kind of loan including fictitious bill, accommodation bill, and finance bill. Finance bill is the term that stuck and lasted into the 20th century.

Limiting credit to real bills is very constricting, so in Britain finance bills were made negotiable (so they too could circulate easily as money) in the 1830s. Through a series of subsequent crises Britain learned about the dangers of zombie banks and loose credit more generally. By the third quarter of the 19th century, however, the Bank of England had learned how to manage the brave new world of finance bills, and Britain experienced a century of banking stability.

What was the key to banking stability in Britain? The principle that money market instruments should not be used to (i) finance the purchase and carry of capital market assets (or land) or (ii) be rolled over to such a degree that they were effectively playing the same role as an equity stake in a firm. This is the real “real bills” approach to banking.

What I’ve just realized is that the same principle underlies Minsky’s financial instability hypothesis (probably through Schumpeter). In fact, when the early Fed was worried about credit markets, it discusses the problem of an excessive growth of speculative bills. (See the Fed’s 10th annual report.) And the Fed uses the term “speculative” in exactly the same sense that Minsky does.

Recall that Minsky defines three types of finance:

Hedge finance takes place when the borrower is able to pay both interest and principal out of cash flows. This is not destabilizing.

Speculative finance takes place when the borrower only has expectations of paying interest on the loan and thus the loan has to be rolled over repeatedly. Just like the Fed in 1923, Minsky argued that the growth of speculative finance was a sign of destabilization building up in the economy.

Ponzi finance takes place when the borrower’s cash flow leaves the borrower unable even to pay interest, so the borrower must either sell assets or rely on increases in asset value together with new loans to stay current on the debt. Minsky argued that this is what is going on right before a crash.

Overall, the real bills approach to managing the banking system should be understood as a policy of controlling the growth of speculative and Ponzi finance in the economy. The evidence indicates that the Bank of England was actually very good at doing this for many, many years.

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.