Over at the Money View at the INET website, Daniel Neilson recently wrote a critique of one my all-time favorite papers, “Commercial Banks as Creators of Money,” a paper that I have previously praised and written about (here and here). The paper is not universally popular; old-style Monetarists, like Leland Yeager and Karl Brunner, seem especially critical of it. But as I pointed out here, Milton Friedman and Anna Schwartz wrote about it very favorably. So when I saw Neilson’s criticism of Tobin at the Money View, which features both Neilson and Perry Mehrling, I paid close attention. I don’t know Neilson, but I do know Perry Mehrling, and he is a very interesting and knowledgeable economist, whose book on Fischer Black is just outstanding. Since it seems to me that Black’s view of money is very much in the spirit of, if not directly influenced by, Tobin’s paper, I was a bit surprised to find Mehrling’s co-blogger writing critically about Tobin’s paper, though obviously Neilson isn’t obligated to agree with Fischer Black, much less James Tobin, just because Perry Mehrling wrote a biography of Black.
At any rate, Neilson makes some good points, so it is worth following his argument to see if he really does prove Tobin wrong.
Neilson starts by acknowledging an important point made by Tobin, while registering a strong reservation:
I agree wholeheartedly with Tobin’s dismissal of the
mystique of “money”—the tradition of distinguishing sharply between those assets which are and those which are not “money,” and accordingly between those institutions which emit “money” and those whose liabilities are not “money,”
but rather than enclosing the difficult word in quotes, I prefer to try to understand it. By all means let us not draw an arbitrary line between money and non-money. But Tobin is wrong to conclude that there is nothing special about money at all.
Moneyness should, moreover, be viewed as a property which can be possessed in degrees. No arbitrary line should be drawn, but some things are more like money than others: federal funds are very money-like, T-bills less so, equity shares not so much at all. The degree depends on how deeply the liquidity of each type of claim is supported by the banking system.
Asking whether the fact that their liabilities are monetary means that banks have privileged access to funds, Tobin finds that
[t]his advantage of checking accounts does not give banks absolute immunity from the competition of savings banks; it is a limited advantage that can be, at least in some part for many depositors, overcome by differences in yield.
Tobin imagines banks raising funds by issuing various kinds of securities—checking deposits, savings deposits, bonds, shares—and competing on yield with other issuers to raise funds. But the differences among those liabilities are not to be found only in yields. They possess moneyness to varying degrees, and when the need is for liquidity, no yield is high enough to entice lenders. Yield and liquidity are not commensurate, especially in a crisis.
A fair point, but in some circumstances, the liquidity offered by some assets may be enough to satisfy those seeking liquidity and in other situations even the liquidity offered by a commercial bank may not suffice, as is obviously the case during a bank run. Few people before September 2008 had any doubts about the moneyness of money market mutual fund shares which were guaranteed to be redeemable at par. But having invested in commercial paper issued by firms that had invested heavily in mortgage backed securities, the very money market securities that seemed completely liquid were no longer considered to be absolutely liquid. It is not necessarily the precise definition of the institution issuing a liability that determines its liquidity in a particular set of circumstances.
But here is where Neilson comes to the key point of Tobin’s argument.
Asking whether, in aggregate, an expansion of bank lending necessarily entails an expansion of deposits, he says that
[i]t depends on whether somewhere in the chain of transactions initiated by the borrower’s outlays are found depositors who wish to hold new deposits equal in amount to the new loan.
That is, Tobin says, the deposit that a bank creates for its borrower is soon spent, and so this deposit cannot be said to fund the loan for that bank. Moreover, it can neither be said to fund the loan for the banking system as a whole, because deposits will be held only if someone wishes to hold them.
In other words, what Tobin is saying is that banks can’t just arbitrarily issue money that must inevitably be held by the public forever and ever, independent of economic conditions. There is a certain ambiguity here about what it means to say that banks have the power to force the public to hold money. Could banks physically maintain in circulation a stock of money greater than the pubic wished to hold. Perhaps they could. But that doesn’t seem to me to be the relevant question. The relevant question is whether banks would have an economic incentive to maintain a greater quantity of money in circulation than the amount that the public wanted to hold. And that is what Tobin meant when he said that there must be depositors willing to hold the new deposits created by the banking system.
But Neilson doesn’t see it that way.
On this point Tobin is simply wrong. He neglects to consider who has the initiative in deposit creation and destruction. A bank’s role in the payment system, and the very reason that its deposit liabilities serve as money, is that they guarantee conversion of bank deposits at par, conversion into cash or conversion into deposits elsewhere in the system, at the initiative of the depositor.
A borrower can exit a position in bank deposits in two ways—by selling them to a non-bank, for example by buying real goods, or by selling them to a bank, for example by buying bank bonds. The former does not destroy aggregate bank deposits, it just moves them from one bank’s balance sheet to another’s. The latter does destroy aggregate bank deposits, but only if some bank is willing to sell bonds. Thus deposit destruction can happen only at a bank’s initiative.
The distinction about who has the initiative in deposit creation and destruction doesn’t seem to me to be the relevant one for this analysis. Sure banks commit to convert their liabilities at par — a dollar of currency in exchange for a dollar of deposits, and vice versa. What Neilson loses sight of is that, while banks are making new loans, the public is also repaying old loans, and whether the total quantity of deposits is increasing or decreasing depends on whether banks create new deposits as they make new loans faster than the public is paying back its loans to the banks. And how fast the banks are creating new deposits depends on the economic incentives for creating deposits reflected in the structure of yields on alternative assets and liabilities, and on the costs banks expect to incur in financing their creation of deposits. If banks expect that the public will hold additional deposits, it will be more profitable to create additional deposits than if the banks have to borrow reserves in order to meet an increased deficit in interbank clearings. The quantity of loans being made and the quantity of deposits being created are the result of the interaction of economic decisions being made by banks and the public reflected in the entire spectrum of yields on the full range of assets and liabilities purchased and sold by banks.
Money (bank deposits) may have special features, but the decision-making process that determines the amount of money in existence at any moment of time is not essentially different from the process by which the amount of other financial instruments created by other financial other intermediaries is determined.