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.