Every good model is designed to emphasize certain empirical regularities that characterize the real world and by doing so to explain certain aspects of how the real world functions. Thus, the first question when discussing how to model money and banking is: What are the empirical regularities that a model of money and banking should capture?
Drawing on my knowledge not only of the history of money and banking, but also of the structure of modern money markets, I have strong views on the empirical regularities that a model of money and banking should capture. Depending on the purpose of the model, there can be good reasons for focusing on getting either the asset or the liability side of banking right, so I will set forth the relevant empirical regularities separately for the two sides of the bank balance sheet. (Obviously there are also benefits to putting both into the same model, but frequently with formal modelling it is useful to start with something simple.) In both cases, first I state the key features that model should have and then I follow up with a brief discussion of some of the objections that I expect to hear to the approach I am describing.
Banks as issuers of money
When modelling the liability side of banking, there are two key features:
(1) Bank liabilities circulate as money. This means that bank liabilities are generally accepted, or, in other words, that the bank is trusted by everybody in normal times; and
(2) Any constraints on bank borrowing should be clearly explained, and should not imply that the individual members of the public are imposing borrowing constraints on banks. Thus, Diamond and Dybvig appropriately explains a run as a coordination problem, which is not at heart an individual action. And there can clearly be a constraint imposed by an outside authority like a regulator or central bank. But the idea that the individual members of the public refuse to lend to the bank past a certain amount should be viewed as contradicting the basic fact that bank liabilities circulate as money because banks are trusted by the public.
Sometimes the claim is made that non-bank liabilities can also circulate as money. While it is true that there are historical examples of private non-bank liabilities circulating as money, these are almost always very localized affairs and thus don’t actually represent examples of generally acceptable means of exchange. These examples are not only lacking in geographic breadth, they are also typically short-lived, of very limited scope, and rare. In short, historical examples of circulating private non-bank liabilities are essentially measure zero events in the history of money. While certain historical events may be worth modeling in order to understand the event in question, these episodes are of far too little importance to be incorporated into a model that is trying to understand the general principles of money and banking.
The basic implication of the approach that I am advocating is that banks are not just a little more trustworthy than other economic entities. When modelling banks (in normal times), banks sit at the extreme of a spectrum of trustworthiness. Thus, models that purport to treat the trustworthiness of banks as only incrementally distinguished from other agents should not be considered as logically consistent with the statement that banks are issuers of money.
Banks as lenders
When modelling the asset side of banking — and especially when modelling how bank lending compares to market-based lending — the essential empirical regularities are:
(1) Banks, with their easy access to liquidity via the issue of monetary liabilities, are the economy’s short-term lenders.
(2) If there is going to be market-based short-term lending that competes directly with banks, then the banks’ role in “wrapping” (or guaranteeing) the short-term debt to make it saleable should be modeled. The reason for this is that in practice bank lending is frequently indirect and takes the form of a backup promise to pay in case the original borrower defaults; the use of these bank guarantees is so common that money market assets are in practice not marketable without bank support. (For a lengthier discussion of this issue, see here.) Note that for simplicity, both market-based short term lending and the bank guarantees that support it can be omitted from most models. It is, however, a clear error to include market-based short term lending without modelling the bank guarantees that support it.
(3) The market-based lending that takes place without bank support is long-term lending, such as 5-30 year bonds. Banks don’t have a comparative advantage here, because their ability to issue monetary liabilities is as likely to get them into trouble as to help them when the loan is long term. (They can easily like the S&Ls or Diamond-Dybvig run into financing problems.)
Thus, a key issue that a model seeking to address both bank lending and market-based lending is: What is the term of the lending in the model? Many models have both bank lending and market-based lending for the same term of the loan. I would argue that all models with this characteristic are effectively assuming long-term lending. Thus, when they find that markets can in many circumstances lend just as well as banks, they reach this conclusion by looking at the type of lending in which banks do not have a comparative advantage. A better way to model bank lending together with market-based lending is to model banks as lending short-term, e.g. working capital, while market-based lending is long-term (with or without banks competing in long-term lending).
Many economic theory papers that purport to study money and banking effectively assume that markets in debt can exist in the absence of banks. One might almost say that these papers take markets as the fundamental economic unit and are trying to place banks within that context.
At least from my perspective, this presumption is precisely what heterodox theory seeks to challenge. My read of the history is that, while markets certainly existed before banks became important, neoclassical markets where there is something akin to a single price for a good could only be imagined in a world where banks were providing liquidity so that the typical trader was not liquidity constrained.
That is, “markets” in the sense of common usage have of course always been around, but this is a completely different concept from what an economist means when speaking of markets where every homogeneous good has a single price. Historically it is true that every community has, for example, weekly markets where people get together to trade. Prices in those markets are, however, typically based on individual bargaining and are very variable depending on who you are. People who have traveled broadly may have visited this kind of market, where a local friend is likely to tell you “Just let me know what you want to buy and then go away. I’ll handle the negotiations.” The neoclassical economic model is not designed to capture this kind of market.
The kind of markets that are made possible by banks are neoclassical-like markets. Based on sources like Adam Smith it appears that this type of market only started to grow up in Britain in the late 18th century. Suddenly people had access to enough liquidity that differential liquidity constraints stopped being the determining factor in prices, as is the case in traditional markets. And as Larry Neal explains in The Rise of Financial Capitalism (1990: 35) it was around the same time that published price lists expanded dramatically and began to take on “an increasingly official character.”
Thus, I would argue that markets as they are typically modeled in economic theory papers exist only because banks provide the liquidity that makes the efficient prices they produce feasible. For this reason, a realistic model of banks and markets will reflect the role played by bank-based liquidity in the formation of market prices. This view, as was discussed in this post, is consistent with the realities of markets today, where short-term lending is heavily dependent on banks – and of course it’s hard to imagine how capital markets could function, in the absence of these bank-dependent money markets.
To summarize, in order to capture both bank lending and market-based lending an economic model needs to have at least a three period horizon with banks offering one period debt and markets offering two period debt. Ideally the model would be able to illustrate why markets are better for long term debt and banks are better for short-term debt.
Many thanks to David Andolfatto as this blog post was generated by email correspondence with him.