My recent work has led me to study classical banking theory, which informed both Wicksell’s and Schumpeter’s understanding of the economy. Classical banking theory views bank liabilities as the primary form of money and argues that, given a well-structured financial system, the quantity of money is endogenously determined by the demands of the business community for the finance of accounts receivable and similar short-term loans.
This theory of money views the role of banks and supply of money as passively responding the needs of the real economy. And this view was, probably correctly, targeted as one of the reasons U.S. officials failed to act aggressively during the Great Depression in he 1930s. Certainly both the Monetarists and the Keynesians who would develop what is now known as macroeconomics saw classical banking theory as a school of thought that was best exterminated. And these days extraordinarily sophisticated works that took a banking theory approach in the mid-20th century are now relegated to the moth-balled “depository” shelves of university book stacks (e.g. the work of R.S. Sayers).
In short, in the 1930s there was a predominant model of the money and banking system. This model when it was applied to circumstances far beyond the realm of its usual operation failed. When it failed, proponents could not recognize that failure and instead used the model to justify the view that real economic performance was a “natural” phenomenon about which there was nothing they could do. They were firmly convinced there was no need to act.
Reading David Beckwith and Paul Krugman today, I couldn’t help wondering whether history is beginning to rhyme. After describing the views of those who doubt the continued efficacy of policy rates that are held at zero, Beckwith writes:
What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed caused interest rates to be depressed and the Fed did its best to keep short-term interest rates near this low market-clearing level.
Krugman, discussing Beckwith’s post, gives a very clear description of how this view is the output of the current predominant model of the macroeconomy:
He’s completely right about the economics. . . . we have a very clear model that tells us what interest rates would be in the absence of distortions and rigidities, the Wicksellian natural rate — the rate of interest consistent with an economy subject neither to inflationary overheating nor deflationary excess supply. And with inflation consistently below the generally accepted 2 percent target, this model says that the actual interest rate, at zero, is above the natural rate, not below.
And all I can hear reading this is the rhyme of history. We have a model and we rely on it to be right. That model tells us that low rates are “natural.” There is nothing more to be done. We must keep rates at zero until the economy improves. But just as in the 1930s the model is being applied far beyond the region of the data in which we have knowledge that it works.
And my guess is that just as in the 1930s we will find that we need to develop a completely different model, built on completely different premises in order to develop policy recommendations for our current problems. My own view is that this a good time to revive classical banking theory and relearn what it has to say about central bank policy and what makes the economy tick.
David Andalfatto has given a very simple explanation of why such new models are needed: the data can be explained by debt-constraints just as well as it can be explained by a negative real interest rate. This accords very closely with Schumpeter’s view that every economic “catastrophe” can be attributed to dysfunction in the banking sector. Perhaps it will be only after we have relearned how to model the monetary role of the banking system that we will be able to escape the tragedy of ZIRP.
Synthetic Assets 