Nick Rowe has answered the question in the affirmative. Nick mistakenly believes that I have argued that there cannot be an excess supply of commercial bank money. In fact, I agree with him that there can be an excess supply of commercial bank money, and, for that matter, that there can be an excess demand for commercial bank money. Our disagreement concerns a slightly different, but nonetheless important, question: is there a market mechanism whereby an excess supply of commercial bank money can be withdrawn from circulation, or is the money destined to remain forever in circulation, because, commercial bank money, once created, must ultimately be held, however unwillingly, by someone? That’s the issue. I claim that there is a market mechanism that tends to equilibrate the quantity of bank money created with the amount demanded, so that if too much bank money is created, the excess will tend to be withdrawn from circulation without generating an increase in total expenditure. Nick denies that there is any such mechanism.
Nick and I have been discussing this point for about two and a half years, and every time I think we inch a bit closer to agreement, it seems that the divide separating us seems unbridgeable. But I’m not ready to give up yet. On the other hand, James Tobin explained it all over 50 years ago (when the idea seemed so radical it was called the New View) in his wonderful, classic (I don’t have enough adjectives superlatives to do it justice) paper “Commercial Banks and Creators of Money.” And how can I hope to improve on Tobin’s performance? (Actually there was a flaw in Tobin’s argument, which was not to recognize a key distinction between the inside (beta) money created by banks and the outside (alpha) money created by the monetary authority, but that has nothing to do with the logic of Tobin’s argument about commercial banks.)
Message to Nick: You need to write an article (a simple blog post won’t do, but it would be a start) explaining what you think is wrong with Tobin’s argument. I think that’s a hopeless task, but I’m sorry that’s the challenge you’ve chosen for yourself. Good luck, you’ll need it.
With that introduction out of the way, let me comment directly on Nick’s post. Nick has a subsequent post defending both the Keynesian multiplier and the money multiplier. I reserve the right (but don’t promise) to respond to that post at a later date; I have my hands full with this post. Here’s Nick:
Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It’s asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money. (Nor can there be an excess demand for alpha money in terms of beta money.) Because people would convert their beta money into alpha money if there were. But there can be an excess supply of beta money in terms of goods, just as there can be an excess supply of alpha money in terms of goods. If beta money is in excess supply in terms of goods, so is alpha money, and vice versa. If commercial and central bank monies are perfect or imperfect substitutes, an increased supply of commercial bank money will create an excess supply of both monies against goods. The Law of Reflux will not prevent this.
The primary duty of a central bank is not to make a profit. It is possible to analyze and understand its motivations and its actions in terms of policy objectives that do not reflect the economic interests of its immediate owners. On the other hand, commercial banks are primarily in business to make a profit, and it should be possible to explain their actions in terms of their profit-enhancing effects. As I follow Nick’s argument, I will try to point where I think Nick fails to keep this distinction in mind. Back to Nick:
Money, the medium of exchange, is not like other goods, because if there are n goods plus one money, there are n markets in which money is traded, and n different excess supplies of money. Money might be in excess supply in the apple market, and in excess demand in the banana market.
If there are two monies, and n other goods, there are n markets in which money is traded against goods, plus one market in which the two monies are traded for each other. If beta money is convertible into alpha money, there can never be an excess supply of beta money in the one market where beta money is traded for alpha money. But there can be an excess supply of both beta and alpha money in each or all of the other n markets.
Sorry, I don’t understand this at all. First of all, to be sure, there can be n different excess demands for money; some will be positive, some negative. But it is entirely possible that the sum of those n different excess demands is zero. Second, even if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services. The process is equilibrated by adjustments in the spreads between interests on loans and deposits governing the profitability of the banks loans and deposits. This is what I meant in the first paragraph when I said that I agree that it is possible for there to an excess demand for or supply of beta money. But the existence of that excess demand or excess supply can be equilibrated via the equilibration of market for beta money and the market for assets (IOUs) providing money-backing services. If there is a market process equilibrating the quantity of beta money, the adjustment can take place independently of the n markets for real goods and services that Nick is concerned with. On the other hand, if there is an excess demand for or supply of alpha money, it is not so clear that there are any market forces that cause that excess demand or supply to be equilibrated without impinging on the n real markets for goods and services.
Nick goes on to pose the following question:
Start in equilibrium, where the existing stocks of both alpha and beta money are willingly held. Hold constant the stock of alpha money. Now suppose the issuers of beta money create more beta money. Could this cause an excess supply of money and an increase in the price level?
That’s a great question. Just the question that I would ask. Here’s how Nick looks at it:
If alpha and beta money were perfect substitutes for each other, people would be indifferent about the proportions of alpha to beta monies they held. The desired share or ratio of alpha/beta money would be indeterminate, but the desired total of alpha+beta money would still be well-defined. If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods. But no individual would choose to go to the beta bank to convert his beta money into alpha money, because, by assumption, he doesn’t care about the share of alpha/beta money he holds. The Law of Reflux will not work to eliminate the excess supply of alpha+beta money against all other goods.
The assumption of perfect substitutability doesn’t seem right, as Nick himself indicates, inasmuch as people don’t seem to be indifferent between holding currency (alpha money) and holding deposits (beta money). And Nick focuses mainly on the imperfect-substitutes case. But, aside from that point, I have another problem with Nick’s discussion of perfect substitutes, which is that he seems to be conflate the assumption that alpha and beta moneys are perfect substitutes with the assumption that they are indistinguishable. I may be indifferent between holding currency and deposits, but if I have more deposits than I would like to hold, and I can tell the difference between a unit of currency and a deposit and there is a direct mechanism whereby I can reduce my holdings of deposits – by exchanging the deposit at the bank for another asset – it would seem that there is a mechanism whereby the excess supply of deposits can be eliminated without any change in overall spending. Now let’s look at Nick’s discussion of the more relevant case in which currency and deposits are imperfect substitutes.
Now suppose that alpha and beta money are close but imperfect substitutes. If beta banks want to prevent the Law of Reflux from reducing the stock of beta money, they would need to make beta money slightly more attractive to hold relative to alpha money. Suppose they do that, by paying slightly higher interest on beta money. This ensures that the desired share of alpha/beta money equals the actual share. No individual wants to reduce his share of beta/alpha money. But there will be an excess supply of both alpha and beta monies against all other goods. If apples and pears are substitutes, an increased supply of pears reduces the demand for apples.
What does it mean for “beta banks to want to prevent the Law of Reflux from reducing the stock of beta money?” Why would beta banks want to do such a foolish thing? Banks want to make profits for their owners. Does Nick think that by “prevent[ing] the Law of Reflux from reducing the stock of beta money” beta banks are increasing their profitability? The method by which he suggests that they could do this is to increase the interest they pay on deposits? That does not seem to me an obvious way of increasing the profits of beta banks. So starting from what he called an equilibrium, which sounds like a position in which beta banks were maximizing their profits, Nick is apparently positing that they increased the amount of deposits beyond the profit-maximizing level and, then, to keep that amount of deposits outstanding, he assumes that the banks increase the interest that they are paying on deposits.
What does this mean? Is Nick saying something other than that if banks collectively decide on a course of action that is not profit-maximizing either individually or collectively that the outcome will be different from the outcome that would have resulted had they acted with a view to maximize profits? Why should anyone be interested in that observation? At any rate, Nick concludes that because the public would switch from holding currency to deposits, the result would be an increase in total spending, as people tried to reduce their holdings of currency. It is not clear to me that people would be trying to increase their spending by reducing their holdings of deposits, but I can see that there is a certain ambiguity in trying to determine whether there is an excess supply of deposits or not in this case. But the case seems very contrived to say the least.
A more plausible way to look at the case Nick has in mind might be the following. Suppose banks perceive that their (marginal) costs of intermediation have fallen. Intermediation costs are very hard to measure, and banks aren’t necessarily very good at estimating those costs either. That may be one reason for the inherent instability of credit, but that’s a whole other discussion. At any rate, under the assumption that marginal intermediation costs have fallen, one could posit that the profit-maximizing response of beta banks would be to increase their interest payments on deposits to support an increase in their, suddenly more profitable than heretofore, lending. With bank deposits now yielding higher interest than before, the public would switch some of their holdings of currency to deposits. The shift form holding currency to holding deposits would initially involve an excess demand for deposits and an excess supply of currency. If the alpha bank was determined not to allow the quantity of currency to fall, then the excess supply of currency could be eliminated only through an increase in spending that would raise prices sufficiently to increase the demand to hold currency. But Nick would apparently want to say that even in this case there was also an excess supply of deposits, even though we saw that initially there was an excess demand for deposits when banks increased the interest paid on deposits, and it was only because the alpha bank insisted on not allowing the quantity of currency to fall that there was any increase in total spending.
So, my conclusion remains what it was before. The Law of Reflux works to eliminate excess supplies of bank money, without impinging on spending for real goods and services. To prove otherwise, you have to find a flaw in the logic of Tobin’s 1963 paper. I think that that is very unlikely. On the other hand, if you do find such a flaw, you just might win the Nobel Prize.
Uneasy Money 
Btw, Nobel prize winners are worst when it comes to monetary economics. Tobin is an exception but let’s not even go and talk about the prize.
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“To prove otherwise, you have to find a flaw in the logic of Tobin’s 1963 paper. I think that that is very unlikely. On the other hand, if you do find such a flaw, you just might win the Nobel Prize.”
OK, here’s the flaw. (Don’t worry, I’ve already notified Stockholm.)
“Unlike governments, bankers cannot create means of payment to finance their own purchases of goods or services. Bank created “money” is a liability, which must be matched on the other side of the balance sheet. And banks, as businesses, must earn money from their middleman’s role. Once created, printing press money cannot be extinguished, except by reversal of the budget policies which led to its birth. The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies. For bank-created money, however, there is an economic mechanism of extinction as well as creation, contraction as well as expansion.”
He’s right that fountain pen money is the issuer’s liability. He’s wrong that printing press money is not the central bank’s liability. No mechanism of extinction? Has he never heard of open-market sales, loan repayments, tax payments, or the winding up of a central bank’s affairs?
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I think Nick’s point is that there can be an excess supply of money (including commercial bank money) from the point of view of the central bank, even though there is no excess from the point of view of commercial banks.
But a shift from currency into deposits can’t cause inflation. It can cause a decrease in the quantity of base money.
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David: thanks for this very thorough examination of my post!
“So starting from what he called an equilibrium, which sounds like a position in which beta banks were maximizing their profits, Nick is apparently positing that they increased the amount of deposits beyond the profit-maximizing level and, then, to keep that amount of deposits outstanding, he assumes that the banks increase the interest that they are paying on deposits.”
My fault there. I wasn’t clear. What I had in mind was something changing so that individual banks found the old equilibrium no longer profit-maximising, so they found it profitable to expand loans and deposits even if they needed to increase interest rates on deposits to dissuade people from swapping those deposits for central bank money and prevent the Law of Reflux kicking in.
“Suppose banks perceive that their (marginal) costs of intermediation have fallen.”
Yep. That would be an example of something changing, so that individual banks found the old equilibrium no longer profit-maximising.
“But Nick would apparently want to say that even in this case there was also an excess supply of deposits, even though we saw that initially there was an excess demand for deposits when banks increased the interest paid on deposits, and it was only because the alpha bank insisted on not allowing the quantity of currency to fall that there was any increase in total spending.”
This is what I would want to say: holding the stock of base money constant, assume the beta banks increase the stock of deposits and the interest rate paid on deposits at the same time, so we never observe either an excess supply or an excess demand for deposits **in the market where deposits are traded for alpha money at a fixed exchange rate**. But that is only one of the many markets in which (chequable demand) deposits are traded. There is now an excess supply of deposits (and alpha currency too) in the other markets where those deposits (and alpha currency) are traded against all other goods.
If we were talking about (say) term deposits, which are not used as a medium of exchange, then there would be only one market in which those term deposits are traded, so we could talk about an excess demand or supply of term deposits without ambiguity. If central bank currency were the only medium of exchange, and if all deposits were term deposits or non-chequable savings accounts, then we could ignore the other markets in which deposits are traded.
I think there are some things wrong with Tobin’s article, great economist though he was. I may do a blog post on it.
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David: “If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services.”
That sentence would work equally well if we were talking about central bank money. All it means is that the market in which those IOUs are traded will always clear. If the price of peanuts were perfectly flexible, or if banks and central banks bought and sold money for peanuts at some announced price of peanuts, there could never be an excess demand or supply of money in terms of peanuts.
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Part of the problem here is that the way the question is framed means that the excess supply cannot be separated from the change that caused it. Maybe a better question is as follows:
Start from a position of equilibrium, where everyone holds the balances they want. Then assume that, for some reason, households decide they want to hold lower deposit balances. So the immediate impact is an excess supply of commercial bank money. Can this lead to an increase in expenditure?
The answer depends, I think, on what else you assume about the change in household preference, i.e. does the desire for a reduced deposit balance imply a desire for a higher balance of some other financial asset, or does it reflect a lower overall demand for financial assets?
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I was thinking about Nick’s point in the context of how fractional reserve banking may have evolved.
Start with a world where gold is the alpha currency. Someone creates a beta currency that trades 1/1 with alpha currency. They discover they can (via FRB and the money multiplier) create lots more beta money than alpha money and still maintain the 1/1 exchange rate.
As beta money (and FRB) expands then the price levels will also rise and the value of gold will fall. The only way to avoid this would be to restrict the supply of gold. If nothing else changes then an equilibrium will be reached where the relationship between alpha and beta money, and the price level , will be stable.
However if something changes (the demand for loans increases and drives an increase in the equilibrium rate of interest, or banks find a way to be more efficient as in David’s example) then more gold will drawn into the banking system and the qty of beta currency will expand (even while maintaining the 1/1 exchange rate – and (if production doesn’t also expand proportionately ) there will be a further increase in the price level. I take this last bit to be Nick’s point.
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Nick, you write:
“If the price of peanuts were perfectly flexible, or if banks and central banks bought and sold money for peanuts at some announced price of peanuts, there could never be an excess demand or supply of money in terms of peanuts.”
But that’s what I think I was getting at here (your response in to me in David’s last article):
“Tom Brown: “But “other goods” does NOT include bank assets, for which there can be neither an excess supply nor demand, true?”
False. Sometimes beta banks’ assets include fixed term loans, which you cannot pay off any time you want, unless beta banks agree. And sometimes beta banks may ration loans.”
So we could apply the same argument here when the banks’ assets are peanuts, right? Sometimes banks’ peanuts were purchased for contractually fixed periods of time, and they cannot be sold back during those times unless the beta banks agree. And sometimes beta banks may ration the number of peanuts they buy.
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… well I guess you cover that with you conditions on the peanut markets… I more just wanted to verify that we essentially are both talking about bank assets (and the market for them), and that given the right conditions, it could apply to loans as well, true?
If banks didn’t have the conditions you mentioned on loans: no rations and no term limits, then they would be agreeing to sell dollars-worth of loan principal back to each borrower at a fixed 1:1 (one dollar of borrower deposit or cash for one dollar of loan-principal held as a bank asset).
However, they can limit their sales back to the original borrower though right? Essentially only letting borrowers pay down each loan. Whereas your peanut market sounds different in that regard: anybody can buy back the peanuts?
How similar are dollars of loan-principal purchased from borrowers in the loan market and dollar bags of peanuts in this analogy?
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David you write:
“if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services.”
What are some examples of “assets providing money-backing services?”
loans? Something else? The bank can also offer time-deposits for sale. Are those included?
Is it possible that your use of an aggregated “public” is too big? Perhaps the subset of the public willing to participate in the market for “assets providing money-backing services” is such that they can experience neither an excess supply nor demand for their deposits, but everybody else in the public might? Is that possible?
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David, one way to summarize the above is that perhaps Nick is thinking in terms not of a homogeneous “public” but instead of two distinct, but intersecting sets:
1. Depositors (A majority of the public (I would think!))
2. Borrowers (mostly a subset of depositors (I would think!))
And it’s the borrowers and banks interacting that can determine the stock of deposits for everyone.
But then if depositors are buying time-deposits (or bank equity) from banks, that kind of blows the distinction a bit I guess… but still, perhaps there’s one to be made? I don’t know: this is very interesting to me though.
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Tom,
I can’t speak for what Nick is thinking, but in my view recognising the fact that depositors and borrowers are on the whole not the same people is pretty important in understanding this sort of issue.
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Ramanan, I agree that the Prize Committee has made its share of type-1 and type-2 errors (none worse as I have observed before than failing to award the prize to Armen Alchian).
Mike, Mike, Ramanan’s comment notwithstanding, I’ll be rooting for you.
Max, It can’t cause inflation if the CB allows the quantity of deposits to fall. If it keeps the quantity of deposits constant, there will be inflation.
Nick, You’re welcome. These are hard issues and it helps to think them through and discuss them with people who look at the issues differently from how we do.
I think at the moment at which beta banks increase the interest rate they offer on deposits, the quantity of deposits demanded will rise, but I don’t think that the quantity of deposits will adjust instantaneously, so I think there will be some finite time in which there is an excess demand for deposits, while there is also an excess supply of currency. The excess supply of currency could be eliminated if the central bank allowed the quantity of currency to fall as people shifted from currency to deposits. It is only because the central bank is keeping the quantity of currency constant that an excess supply of currency comes into existence. If you choose to maintain that there is necessarily an excess supply of deposits whenever there is an excess supply of currency, I guess that you are free to do so, but I don’t think you can derive that result as a theorem from some the assumptions and definitions that we have agreed on.
You are right that, the central bank could allow reflux to operate, as Mike Sproul argues. The difference is that the central bank is not operating under the same constraints and with same incentives as the beta banks.
Nick Edmonds, Actually, I think the excess supply can be separated from the change that caused it, but perhaps I am mistaken.
About the immediate effect of an excess supply of commercial bank money, I don’t exclude the possibility that some people might increase their spending to reduce their bank balance, the point is that there will be an incentive for banks to allow their deposit liabilities to go down rather than continue to lend as much as they were lending before the demand for deposits fell. There is an economic process whereby the quantity of deposits adjusts to the amount that people want to hold. A deposit once created does not have to endure forever.
Rob, The stock of gold, unlike the stock of deposits, exists in perpetuity. The laws of physics imply that gold lasts forever. If, as a result of progress in banking, people shift from holding gold to holding banknotes or bank deposits, the demand for gold will fall, the value of gold will fall as more gold is diverted to the few real uses it can be put to, implying that prices in terms of gold will rise. The same analysis holds for a fiat currency, except that the central bank can allow the quantity of currency to fall as people shift out of currency into beta money so that the value of the currency can be kept stable.
Tom, Look at the assets banks acquire when they create deposits. Those assets are providing money-backing services to the banks. For the most part they are IOUs, but banks can also buy stuff and pay for that stuff with deposits.
I don’t think that depositors and borrowers are non-overlapping sets. Do you have a credit card or installment credit? Have you ever paid down your credit card or installment debt using your bank balance?
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Rob, that makes sense. A central bank that wanted to maintain price stability could respond by imposing a reserve requirement (or if it doesn’t mind losing money, by buying gold and paying interest on excess reserves).
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David, not “non-overlapping”… almost entirely overlapping, but with the set of borrowers probably mostly a subset of depositors.
But then again, maybe groups of people is not important: perhaps it’s all about the separate markets, like Nick R. says. The people could very well be a homogeneous lot.
I don’t know!
To use one of Nick R’s examples, imagine an all hair cut based economy. hair-cutters are all the same and they simultaneously decide on more frequent hair cuts for themselves. Perhaps interest rates are lowered to look favorable, so they all go out and borrow more hoping to increase the frequency of their own haircuts, but since everybody did that the price of haircuts eventually gets pushed up (w/o anybody every getting more frequent haircuts!). So perhaps they were all happy with their loans, but still an excess supply of money was created which pushed hair cut prices up. I’m not even thinking about maximizing bank profits there…
Is it possible for there to be neither an excess supply nor demand for loans (in this simplified world) and thus neither an excess supply nor demand for money in the loan/money market, but still an excess supply of money in the haircut market?
Anybody: feel free to straighten me out here…
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I think the point is not that there aren’t people with both debts and financial assets, but rather that there are people with large debts and few financial assets and people with large financial assets and few debts. There are also a few with large debts and large financial assets (and some with little of both), but the general pattern is that a lot of the debt is with people with relatively few financial assets and a lot of the financial assets are owned by people with relatively little debt.
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Nick E., thanks for the feedback there: interesting. But what if they truly are a homogeneous set of people with very few differences… do you think they could be happy w/ their loan status’ given the current terms offered by the banks, but still feel frustrated by their money situation in other markets (i.e. either too little or not enough: but with a definite bias in one direction or the other)? And I guess the banks themselves might be happy with the loan market as it stands too. Can all those things happen at once?
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Tom,
I have to try and work out what such a world would look like. I can’t understand why people would want to have term loans and term deposits, given that the deposits are going to pay less.
I can imagine a position with homogenous households where banks’ only liabilities were transaction accounts – money. Banks then provided everyone with a term loan which funded their holding of money. On average over the payment cycle, everyone holds money equal to their loan, but they need the loan because their money balance will vary from day to day. In this world, people are borrowing just to generate liquidity, and it is equivalent to banks provided committed overdraft rather than term loans.
I’m not sure I give my answer to your question, as I don’t tend to approach this the same way as Nick. When he thinks of there being n-1 markets, I think of there being n markets and a budget constraint. So people either want more money balances or less; they can’t want one thing in one market and something else in another. But if their desired money balance is different from their actual money balance, there must be at least one other market where they also want something different to what they have. For example, if they have more money than they want, they must have something they want to use that excess money for.
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David: Two places where I still disagree:
1. You say “I think at the moment at which beta banks increase the interest rate they offer on deposits, the quantity of deposits demanded will rise, but I don’t think that the quantity of deposits will adjust instantaneously, so I think there will be some finite time in which there is an excess demand for deposits, while there is also an excess supply of currency.”
I see the temporal sequence the other way around. Money is not like refrigerators. A producer of refrigerators must persuade people to want to hold more refrigerators *before* he can increase the stock of refrigerators in public hands. A commercial bank can persuade someone to take a loan in the form of a deposit without needing to persuade anyone to want to *hold* more deposits. The borrower does not plan to hold any more demand deposits than he did before, except very temporarily; he plans to spend the loan, almost immediately. This is where the Tobin in this paper forgets the Tobin of the Baumol-Tobin inventory-theoretic approach. The whole point of holding an inventory is so you can have temporary fluctuations in the level of that inventory above and below the average desired level. The extra deposit is created, and only later, after that deposit is spent, do we ask whether anyone would want to hold extra deposits or would prefer to hold extra currency instead. And remember too: if the new loan has been spent, the hot potato effect has already started working, because someone who sold whatever the loan was spent on has observed an increase in his sales of goods.
2. You say; “If you choose to maintain that there is necessarily an excess supply of deposits whenever there is an excess supply of currency, I guess that you are free to do so, but I don’t think you can derive that result as a theorem from some the assumptions and definitions that we have agreed on.”
We have no choice in the matter. The “theorem” is straightforward. If people are indifferent on the margin between holding currency and deposits, and they must be given that deposits can be redeemed for currency, then if they prefer some other goods to currency they must prefer those other goods to deposits too.
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Take a crazy extreme example:
Suppose the desired stock of refrigerators was perfectly inelastic with respect to everything. Each household wants exactly one fridge, regardless of the price of fridges or anything. Start in an initial equilibrium where everyone holds exactly one fridge. If the producer of fridges does a helicopter operation, people would simply leave the new fridges lying on the ground. Nobody would pick them up.
Suppose the desired average inventory stock of money was perfectly inelastic with respect to everything. Each household wants to hold exactly $100 on average, regardless of the price level or income or interest rates or anything. Start in an initial equilibrium where everyone holds exactly $100. If the producer of money does a helicopter operation, people would not leave the new money lying on the ground. Each individual would pick up the new money, and try to get rid of it by buying more goods. And each individual would accept that new money in exchange for goods, because he knows he can get rid of it too. Each individual can get rid of the extra money, but in aggregate they cannot. And the hot potato process would never end.
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Mike Sproul,
My interpretation of your point re Tobin:
Tobin implicitly consolidates the view of government – Treasury plus the Central Bank.
This assumes away (typical) central bank assets, which are eliminated on consolidation.
The central bank asset transactions you note then become a matter of shifting the mix of liabilities within the consolidated net liability profile. That mix (which includes currency) can change. Tobin’s descriptive language gets pretty loose though – because he seems to identify that entire consolidated liability profile as currency – when in fact it typically includes bank reserve balances and Treasury bonds. His view seems implicitly to assume away the easy inter-convertibility of these liability types – perhaps because he has a further point to make and emphasize. Which is that the overall size of the consolidated net liability profile can only be changed by government budget surpluses or deficits. And I think that’s his key message in distinguishing between currency and bank deposits – notwithstanding his rather loose blending in the use of the term “currency”. I think his main point then is about the nature of the budget as a constraint on the size of the net liability profile, which includes currency as one component.
He compares that to the banking system balance sheet. The banking system liability mix (which includes deposits) can change through a process analogous to the case of the consolidated government net liability mix – inter-convertibility of demand deposits and time deposits for example. But the banking system balance sheet has a further degree of freedom with respect to asset transactions – the size of the balance sheet can also change through asset transactions with the rest of the financial sector. So that is a further degree of freedom to allow adjustment in the deposit component of the banking liability mix – in a way that is not analogously present in the case of the consolidated net liability profile of the government (where only surpluses and deficits within the government sector do the trick in terms of overall size). This idea of extra freedom seems copacetic with an “exogenous/ endogenous” characterization of the distinction between the two cases.
I agree that this part of Tobin’s essay is a comparatively rough patch.
Anyway, that’s my take.
But it’s a great paper. He covers an extraordinary range of stuff in a very short space.
I tried my hand at it here:
http://monetaryrealism.com/economics-and-banking-james-tobin-1963-redux/
Look forward to Nick’s review of Tobin (hope he goes for it).
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“If people are indifferent on the margin between holding currency and deposits, and they must be given that deposits can be redeemed for currency, then if they prefer some other goods to currency they must prefer those other goods to deposits too.”
Nick, I’m not sure I get this. I thought you were assuming imperfect substitutability, in which case people would not necessarily be indifferent between currency and deposits.
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Nick E., thanks again for your response. You have some meat in there I need to chew on a bit more. You write:
“For example, if they have more money than they want, they must have something they want to use that excess money for.”
In my (really Nick R’s) world of hair-cutters example: they all want to use the money on additional haircuts for themselves, but because everyone wants the same thing they can’t get any extra haircuts scheduled.
Since each person is also turning away business (since they all cut hair), then they figure they can raise their prices, which they do until they are no longer turning away customers: that’s the point at which the additional borrowed money has forced the economy to a new equilibrium: prices are higher, wages are higher, peoples stock of money is higher, interest rates are perhaps lower (on new debt), but loan balances are higher too… so total interest payments are higher (assuming some old debt is still outstanding at least until they refinance the old debt… then it’s not clear)
A corny example maybe… and nobody actually gets what they originally wanted with the additional money borrowed, but perhaps they can reach a new equilibrium where they are getting what they’re willing to pay for, and they can pay the interest on their total loans.
And then the banks lower the interest rate again on new debt…
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Nick Rowe,
In your helicopter drop of money example, if some of those people who pick up the money have debts at banks, then they may use the money they’ve picked up (putting them in excess of their desired $100) to pay those down, thus destroying the money. Are you saying that will always constitute a minority of the choices of the way the helicopter money is used? So that if a total of $X is dropped from helicopters only some fraction of it will go to paying down outstanding debts? And essentially a new higher equilibrium will be reached in terms of the quantity of money people hold?
Or have I hijacked your example and taken it somewhere you didn’t intend?
If the law were changed to allow banks to take out a one-time loan for $X for all their customers on Jan 1, 2015, w/o their customer’s consent (they just get a credit to their bank deposits and simultaneously a loan they’re responsible for), how many of those customers would immediately repay the loan?
But perhaps that’s not a fair way to frame the question. Let me ask you what I asked Nick E. above. Is it possible for all of the following to be simultaneously true in a group of homogenous people (all in pretty much the same circumstances… like your world of haircutters example):
1. The public is comfortable with the amount of money they’ve borrowed and don’t have a desire to either pay down existing debt or take on new debt for the terms currently available from the banks. Say commercial banks only have loan assets and don’t offer anything other than checking accounts. They don’t sell stock in the banks either.
2. The public feels that they have either too little or too much money on hand for their spending needs in all other markets. Of course this can be a temporary situation until prices adjust.
3. Banks are maximizing profits and don’t need to make any changes: they are happy with the size of their balance sheets.
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Tom, I think Nick Edmonds (4/2/2014 at 12:42 am) gave you as good a response as I could have.
Nick Edmonds, OK. If the people with a lot of debt and few assets suddenly have more deposits than they want, why can’t they use the cash to retire some of their indebtedness to the banks? If people with a lot of assets suddenly have more deposits than they want to hold, what prevents them from using the deposits to acquire other financial assets or to pay off their indebtedness to the banks?
Nick Rowe,
1 I agree that money holdings are a buffer stock, which people, for short periods of time allow to fluctuate in both directions. The idea of a demand for money therefore makes sense only in terms of some average balance that they want to maintain on average over time. People may be willing to hold $50k in their bank account for a short time, but they will not generally do so (unless they are a lot richer than I am) for an extended period. So Tobin 1 and Tobin 2 are talking about different thought experiments. If banks increase the interest they pay on deposits, the idea is to increase the average desired level of deposits that their depositors want to hold. Unless they do so, the bank will not be able to increase the size of its asset holdings by making a loan. The hot potato effect that you are talking about may last for a short time, but it peters out quickly because the money must be held willingly. A deposit once created, unlike an ounce of gold, need not remain in existence until the world comes to an end.
2 Nick, as JP points out, you are assuming that currency and deposits are perfect substitutes. For this to be true, it must be the case that the nominal yield on currency equals the nominal yield on deposits. In general that isn’t true, though at the zero-lower bound it is close to being true. In the normal case, the nominal yield on currency is less than nominal yield on deposits, so, at the margin, currency provides a net flow of liquidity services greater than does an equal value of deposits. There are multiple margins here. There is current-consumption/future-consumption margin and there is the asset-portfolio margin. I don’t know which margin you are talking about when you say that people prefer other goods to currency. I think the relevant model has to be spelled out more carefully than you have done so far.
What does you helicopter example have to do with bank money, which, once created, need not exist, in contrast to gold or your refrigerators, in perpetuity?
JKH, Thanks for that very nice summary of Tobin’s paper and the link to your commentary.
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Tom,
Your haircut example. Within that limited world, I think I agree with you. Everyone has would rather have lower money balance and more haircuts. Excess supply of money balances, excess demand for haircuts. Likely to lead to a rise in the price of haircuts. Once the price of haircuts has changed though, everything else is potentially out of equilibrium. So what happens next depends on your other assumptions.
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David,
Very generally, those with debts are probably holding a bare minimum of deposits, so they are unlikely to be the ones to suddenly decide they want less. But if they did, I’d agree they would most likely repay some debt.
Likewise, those who are asset rich tend to only have convenience debts, so it’s quite possible it won’t make sense to pay those down. But I’d agree they might buy other financial assets. Or buy goods. It depends what the counterpart is to them wanting lower money balances. Maybe they want to hold less money, but the same level of overall financial assets. Or maybe they want to hold less money and consume more. It could be either.
(btw, in all this I’ve been thinking of households, but the actions of non-bank financial institutions are rather different.)
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Nick E: re: your response to David: “Maybe they want to hold less money, but the same level of overall financial assets. Or maybe they want to hold less money and consume more. It could be either.”
That seems to be the crux of Nick R’s argument stated differently, no?
“(btw, in all this I’ve been thinking of households, but the actions of non-bank financial institutions are rather different.)”
As an aside, do you think it’s fair to model (to zeroth order maybe) the role of non-bank financial institutions (like shadow banks, right?) as just regular banks that sell shares of equity? Imagine a weird regular bank that sold equity in itself and them limited it’s deposits to the amount of capital it accumulated. Wouldn’t it then essentially be performing the role of a shadow bank? If true that kind of says that regular banks act like shadow banks up to the point where their deposits are equal to their shareholders’ capital… and then they become regular banks beyond that.
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Tom,
Maybe, but I usually find myself thinking that Nick R is too quick to assume that people will spend excess money on goods, rather than other financial assets. I entertain both possibilities, but I tend to think the financial assets is more prevalent.
I’m not sure I understand your question about shadow banks. As a starting point I think I’d model shadow banking as banks that offer deposits, but not checking accounts. And take it from there depending on what things I wanted to look at.
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Nick E. Thanks. OK, so it’s a matter of degree then: you’re somewhere between Rowe and Glasner it sounds like.
Re: shadow banks, I based that idea on this post by Ramanan:
If you consolidate the BSs of the banks and the non-bank financial institutions, it looks exactly the same as if their were no non-bank financial institutions, but the banks had instead sold 10 units of money worth of shares of equity in the bank itself. He and I had an email exchange about that and I think he was OK with that interpretation, but I hesitate to post the contents of his emails, so you’ll have to take my word on that. 😀
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Nick E., it may not seem like it at first, but I think this discussion is very much related to Nick’s previous post entitled “The sense in which the stock of money is “supply-determined”.” In an attempt to understand that post better, I made my own with a couple of charts in it:
http://banking-discussion.blogspot.com/2014/03/nick-rowes-example-from-sense-in-which.html
At the end of that post, and here, I describe what I think could be better nomenclature to describe what is going on. In my post, near the bottom, I provide another link to that discussion here “I comment on that here on Nick’s post.”
Why do I think it’s related? Because I’m very much separating “borrowers” from the general “depositors” there. They could be the same group, in which case the separation is only in terms of markets (like my hair cutter example). But whatever the case, it seems I need something to distinguish what determines the blue downward sloping curve in the upper plot from the red vertical “quantity demanded” curves in the upper plot (or the blue rectangular hyperbolas, or their corresponding real money demands (Y is equivalent to real (quantity of?) demand for money in this example I think since it equals Mdn/P). Nick clearly describes a case where “quantity of money demanded” lags the “quantity of money supplied” but eventual increases in P and/or Y cause the two to eventually coincide. But none of that changes the blue downward sloping “borrower determined supply of loans” curve in the upper plot.
Do you see why I think these issues are related? It seems to me that if there’s no separating the “borrower determined supply of loans” from the general across-all-markets “quantity of money demanded” then there should be no lag: P and or Y should adjust (increase) right away so that (nominal or real?) quantity of money demanded equals quantity of money supplied at all times. Later on P and or Y may further adjust so we move along that line segment I have labeled “Nick’s soln set @ r1” in the lower plot, but we should get to that segment right away.
Any feedback is much appreciated! Thanks.
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JP and David: when I say that people are indifferent *at the margin* between holding deposits and currency, that does not mean they are perfect substitutes. In full equilibrium, I am also indifferent *at the margin* between holding cars and houses.
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Ok, but then I don’t understand why you said that people must be indifferent on the margin between currency and deposits because “deposits can be redeemed for currency”. If people are indifferent at the margin between cars and houses, is that because houses are redeemable for cars?
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Tom,
What Ramanan calls shares he means (as he says) things like MMMF shares. That’s what I’m representing as non-transaction deposits. I think what he’s saying is along the same lines as me.
On an initial read, I think your diagrams capture quite well what Nick R is saying on the demand and supply of money. I might need to read through it more carefully and I’m not familiar with Scott Sumner’s point. Here’s my own thoughts on the issue. http://monetaryreflections.blogspot.co.uk/2014/03/the-demand-and-supply-of-money-and.html
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JP: the only difference is in what adjusts to equalise the MU of holding the two assets. For cars and houses, it is the relative prices. For deposits and currency, since both trade at the same price, the banks can adjust the interest paid on deposits, and they will do so if they want to prevent Reflux.
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Nick Edmonds,
That was a very good post! Thanks. I read the exchange between you and Rowe too. You put it very clearly I think. You had an equation like this:
M = k*P*Y
Where M was both “quantity of money demanded” and “quantity of money supplied” in the steady state. In that case I guess k = 1/V.
Now Rowe uses Md = P*Y, so he’s assuming V = 1, and this is really the same thing, except he’s made it explicitly just the demand function for money. Furthermore it’s the nominal demand function for money, because real demand is Md/P, which in this case is Y, right?
Both you and Rowe say that there will be some lag while the quantity of money demanded catches up with the quantity of money supplied (Ms)… “nominal” applying to both quantities I think.
If there’s some lag before Md = Ms, then using your model, doesn’t that say that V immediately drops when Ms is originally increased, since P*Y doesn’t change right away? Then as V returns to it’s original value, this corresponds to P and/or Y increasing until Md is somewhere on the vertical red line labeled “Ms1” in my lower chart.
Re: NBFIs:
Your statement here says it all I think:
“So, we can imagine that what we have called banks in the balance sheet above instead includes all financial intermediaries.”
Well that and the rest of that paragraph.
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Tom,
For various reasons, people might find themselves in a position where the money balances they hold are different to what they want to hold, given their income (current, expected or whatever). But they may not want to make the full adjustment immediately, but rather gradually over time. It depends a bit what the counterpart is. If they want to also hold more or less bonds, say, maybe the adjustment is quite quick. If they want to consume more or less, they will probably spread it. Either way there is some kind of adjustment process.
I don’t really like the concept of velocity, but if we simply take V to mean the ratio of money to income, then measured V will vary through that adjustment process.
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Nick E. Thanks.. I just take V to be the ratio NGDP/M.
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OK, help me out here guys: I feel like this is still left hanging: did Nick Rowe, Nick Edmonds, David Glasner and JP Koning inch a little bit closer to harmonic convergence, or are you all still in your original camps? I can’t tell. It kind of seems like maybe a little more harmony… David saying that for a brief period there can be an excess supply, no? Am I wrong? JP are you satisfied?
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David,
Nick R. says:
“Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It’s asymmetric redeemability.”
I would be interested in your perspective on this concept of “asymmetric redeemability”.
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Wait a minute JKH… stirring up trouble between MMists and between MMists and MM sympathizers (like David here) is my job!
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Nick Edmonds and Tom, The point is that if there is excess cash in the system, and any of it gets into the hand of people holding a lot of bank or installment debt (and why wouldn’t it?), they will use it to pay down their debt. It’s not clear why asset-rich people would use excess cash balances to suddenly increase their consumption spending – it’s not as if they are credit-constrained. A more likely response to excess cash would be reshuffle their asset portfolios.
Nick Rowe, Let’s recapitulate. In your initial reply to this post you said:
“holding the stock of base money constant, assume the beta banks increase the stock of deposits and the interest rate paid on deposits at the same time, so we never observe either an excess supply or an excess demand for deposits **in the market where deposits are traded for alpha money at a fixed exchange rate**. But that is only one of the many markets in which (chequable demand) deposits are traded. There is now an excess supply of deposits (and alpha currency too) in the other markets where those deposits (and alpha currency) are traded against all other goods.”
This is your version of what would happen in response to banks offering to pay depositors an increased rate of interest to depositors after experiencing a reduction in their marginal costs of intermediation. Competition forces banks to pass forward the cost reduction to depositors by increasing the rate of interest paid on deposits. I don’t understand how banks suddenly increase the stock of deposits at the same time that they increase the interest paid on deposits. Under our assumptions, banks are offering depositors an increased interest rate on their deposits, they are not reducing their lending rates. So if the stock of deposits increases, it is because depositors take some of the cash they were holding as currency and convert the currency into bank deposits. The banks then use the additional currency as reserves, and banks use the added reserves to buy higher-yielding assets, e.g., Treasury bills, so the monetary base falls (in a world without reserve requirements) by the reduction in the stock of currency. For the stock of currency or base money to be held constant, as you want to assume, the central bank must engage in open-market operations to neutralize the shift from currency into deposits, creating an excess supply of currency at the current level of prices and nominal GDP.
Your assertion that there is an excess supply of deposits does not follow unless the central bank neutralizes the reduction in the demand for currency by engaging in offsetting open-market purchases to inject new base money into the economy. Immediately after the creation of new base money, there is an excess supply of base money. Nothing has happened to the quantity of beta bank money after the shift from currency to deposits. So you are asserting that ipso facto an excess supply of base money (currency) entails an excess supply of beta bank money.
After I pointed this out to you in response (perhaps not that clearly), you replied as follows:
“I see the temporal sequence the other way around. Money is not like refrigerators. A producer of refrigerators must persuade people to want to hold more refrigerators *before* he can increase the stock of refrigerators in public hands. A commercial bank can persuade someone to take a loan in the form of a deposit without needing to persuade anyone to want to *hold* more deposits. The borrower does not plan to hold any more demand deposits than he did before, except very temporarily; he plans to spend the loan, almost immediately. This is where the Tobin in this paper forgets the Tobin of the Baumol-Tobin inventory-theoretic approach. The whole point of holding an inventory is so you can have temporary fluctuations in the level of that inventory above and below the average desired level. The extra deposit is created, and only later, after that deposit is spent, do we ask whether anyone would want to hold extra deposits or would prefer to hold extra currency instead. And remember too: if the new loan has been spent, the hot potato effect has already started working, because someone who sold whatever the loan was spent on has observed an increase in his sales of goods.”
This response shifts the discussion away from the assumptions that I thought we had agreed upon, namely that after a reduction in marginal intermediation costs, beta banks increase the interest rate that they pay on deposits. The comparative statics are clear, the reduction in intermediation costs implies an increase in the interest paid on deposits; currency is converted into deposits; that’s it. Nothing happens to the rate of interest charged for loans, so how is bank lending relevant to this example? And even if it were relevant, what does bank lending have to do with the temporal sequence? It was you who posited an immediate increase in the interest paid on deposits and the quantity of bank deposits (with no mention of the lending rate). The increase in deposits is fully accounted for by a conversion of currency into deposits with no change in lending.
You also responded to my reluctance to accept that an excess supply of currency necessarily entails an excess supply of deposits as follows:
“We have no choice in the matter. The “theorem” is straightforward. If people are indifferent on the margin between holding currency and deposits, and they must be given that deposits can be redeemed for currency, then if they prefer some other goods to currency they must prefer those other goods to deposits too.”
This is a tricky point, but if you want to insist on this point, then the implication is not that there is no reflux of deposits, but that there is reflux of currency through deposits. Excess currency gets converted into deposits, and then the deposits get refluxed out of the banking system. To avoid the conclusion that the central bank can’t affect the price level, you have to posit, as Earl Thompson did, that the value of the currency is really determined by the real tax liability of the economy relative to the amount of currency demanded at peak tax periods to discharge tax liabilities, or else posit that there are various frictions, so that reflux does not eliminate all the excess cash so that some of it gets spent, allowing for some degree of price and income effect. The latter would be an acceptable, but not very satisfying, way out of the problem. Alternatively, there is Fischer Black’s idea that the price level and the inflation rate are indeterminate and depend entirely on expectations. It would then be changes in exchange rates , reflecting changes in expectations that account for movements in price levels and inflation. And, finally, there is also Mike Sproul out there who thinks that the value of currency depends on the value of the assets potentially backing all the outstanding currency (sorry, Mike, if I’m not summarizing your view correctly). In other words, it’s really complicated.
Tom, Does that reply to Nick clear things up for you? I hope not.
JKH, Actually, it seems fairly straightforward and unproblematic to me, but perhaps I am missing something. Is there something in particular that you want me to address?
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David,
“Tom, Does that reply to Nick clear things up for you? I hope not.”
You hope *NOT*!! What are you trying to do to me here David?! 😀
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“I feel like this is still left hanging: did Nick Rowe, Nick Edmonds, David Glasner and JP Koning inch a little bit closer to harmonic convergence, or are you all still in your original camps?”
Lol, I was wondering the same thing. Plenty has been said over the last few posts, I’m still trying to digest it all.
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David,
Actually, I have quite a problem with it, and have been discussing it at length at Nick Rowe’s post. In fact, I’ve had a problem with it for 5 years, going back to Nick’s 2009 post on it.
I appear to be alone in this regard – as in the only one on the planet who questions the soundness of the idea so far.
So I will defer on it for now. Several of your commenters here may grimace noticeably if I plunge back into it in this space.
Thanks. Perhaps I’ll do a post on it plus some related things a bit later on.
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JKH, don’t feel bad: Nick know what it’s like to be one man against the world too… and Scott wishes he could join him, but he just can’t this time:
http://econlog.econlib.org/archives/2014/03/one_multiplier.html
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David,
How are you using the word “cash” there? For paper reserve notes, coins and checkable-deposits?
I don’t see why the monetary base falls unless the “higher-yielding assets” the aggregated banks buy are from a non-bank CB-deposit holder (e.g. the Treasury selling bonds), or from the CB itself (e.g the CB selling assets). And in the former case (Treasury selling bonds), those reserves will likely be returned right back to the aggregated banks again as soon as the government spends to proceeds from its bond sales into the private sector.
Nick did say that base money was held constant (here’s Nick)
not currency, so again the aggregated banks can only get rid of reserves in three ways:
1. Currency to depositors (which doesn’t change MB)
2. To another non-bank CB-deposit holder (which may likely return the reserves right back to the aggregated banks once it spends the proceeds of a bond sale, thus not changing MB, e.g. the Treasury)
3. To the CB itself, which will reduce MB, but this can be easily prevented by the CB just by the CB not engaging in any open market sales.
So I don’t see why the CB must necessarily perform OMPs here to keep MB constant, unless the Treasury runs a surplus (but why would they do that if they’re selling bonds?), or the aggregated banks buy their “higher-yielding assets” from some other non-bank CB-deposit holder which does NOT turn around and spend the proceeds into the private sector in short order.
So it’s possible reserves could leave the aggregated banks to a non-bank CB-deposit holder and stay there, but how likely is that?
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Under the assumption that the Treasury spends every dollar that it takes in in revenue immediately, and dividing the economy into just four sectors: Treasury, CB, aggregated commercial banks and aggregated non-bank private sector, I demonstrate what I say above in an interactive spreadsheet in the center of this post:
http://brown-blog-5.blogspot.com/2013/08/banking-example-11-all-possible-balance.html
You can change the values in the green cells at the top to see what happens. But basically, if the banks hold reserves > 0 and
B = bank held Tsy bonds
C = cash in circulation (not bank vaults)
F = CB held Tsy bonds (assuming that’s their only asset)
L = non-bank private sector loans
Then if the banks hold reserves > 0
Banks’ reserves = F – C > 0
non-banks’ deposits = L + B + F – C
non-banks’ cash = C
MB = F
M1 = L + B + F
If bank reserves are = 0 (i.e. F = C) then nothing changes, except F = C, so we can simplify a bit:
Banks’ reserves = 0
non-banks’ deposits = L + B
non-banks’ cash = C
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… of course I’m not modeling non-bank held time deposits at the commercial banks there!
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David,
I don’t my view is very different from yours.
“The point is that if there is excess cash in the system, and any of it gets into the hand of people holding a lot of bank or instalment debt (and why wouldn’t it?), they will use it to pay down their debt. It’s not clear why asset-rich people would use excess cash balances to suddenly increase their consumption spending – it’s not as if they are credit-constrained. A more likely response to excess cash would be reshuffle their asset portfolios.”
I can see myself making pretty much the same point in an exchange with Nick R, and this is sort of what my own post was about.
I think this discussion can get a little confused by an ambiguity about what we mean by commercial bank money, i.e. do we mean just transaction accounts, or something very broad including term deposits. If we are talking about the former, then in my view any excess supply or demand for money is very likely to lead to a switch into other assets, rather than changes in spending habits.
If we are talking about the latter, then I think it might be reasonable to associate an excess demand or supply with some kind of change in spending habit, simply because such holdings represent a significant part of household, non-housing, non-pension wealth.
So, could it happen that the asset-rich suddenly decide to consume more and to fund that by reducing their bank deposit balances? Yes, I think that is plausible. Might they do so by running down their transaction account balances? Less likely.
Because the former involves reducing bank deposits (or at least attempting to), I would have to say it implied an excess supply of such deposits. I have to say though that on the whole that is not the way I personally would go about describing what was going on.
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JKH,
“So I will defer on it for now. Several of your commenters here may grimace noticeably if I plunge back into it in this space.”
I was already beginning to grimace.
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David,
I can’t resist.
My view is that deposits and currency are symmetrically redeemable in an institutional framework that features an asymmetric distribution system for currency (commercial banks are agents for the central bank). My impression is that the world ex myself is arguing that the second point is more important than the first, but I don’t know why.
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Nick E.,
Sorry!
Completely coincidental – didn’t see your comment before posting.
Can you believe that?
I swear this is true.
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JKH,
No worries. I’m sure I’ll be up for round two on this, after a brief time out.
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What’s the emoticon for grimacing?
Nick E. you write:
You live in the UK right? I just googled “transaction deposit” and it’s the same as a “checkable deposit.” But what do you mean by “bank deposit balances?” Something other than “checkable deposits = transaction deposits” I guess right? Do you mean time deposits (savings accounts)? I usually take an unmodified “bank deposits” to be just a checkable deposit. Or as Nick Rowe writes a “chequable deposit.” Some say “demand deposit” for this. Is the terminology slightly different in the UK, US and Canada? (I’m in the US in case that wasn’t obvious)
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JKH, I’m going to predict that you will come up empty looking for sympathy for your view of asymmetric redeemability from David Glasner… but we’ll see!
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Tom,
Yes. When I say “transaction deposit” I mean the same thing as “checkable deposit” and if I just say bank deposit, I do tend to mean a wider measure including savings accounts.
I think my UK focus doesn’t help here, as the main money supply measure there is M4 which is quite wide, including repo and bonds out to 5 years. So apologies, if I’ve not been too clear on occasion on what I meant.
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No problem… nobody’s “right” on the terminology… I just wanted to be sure I understood you. I like this Wikipedia article:
http://en.wikipedia.org/wiki/Money_supply
The 1st table is good but US specific. They cover some differences with the UK here:
http://en.wikipedia.org/wiki/Money_supply#United_Kingdom
I already encountered the difference regarding M0 in a bit of confusion with Frances Coppola. In the few countries they cover the specifics of, the UK is the only one with a different definition of M0. Of course there’s what?… another 180 countries or so they don’t cover.
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Tom,
I’m not looking for sympathy, of course. Just another clear thinking input (along with the two Nicks) as a check on my reasoning. I think this sort of triangulation may help determine whether or not I’ve gone through a wormhole. To be honest, I’m not even sure which outcome I prefer. I feel quite comfortable in my current state of otherness on this issue.
🙂
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David, I second Tom’s comment @ April 3, 2014 at 9:41 pm.
I’m not sure how the monetary base falls in your example. The only way this could happen is if the central bank did open market sales, no?
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Tom,
M0 isn’t used in the UK any more. Statistics were last produced for it in 2006. But it did use to include reserve balances. They still publish stats for reserve balances and currency, of course.
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Nick E, sure enough… The Wikipedia article does say M0 is no longer published (I didn’t notice at first). And I thought those were a list of differences with the US, but that is (was) the whole list, so you’re down to one measure there… M4?
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Tom, If it’s not cleared up for me, why should it be for you?
JKH, Well, I have my own issues to think about, but perhaps somewhere down the line, I’ll be able to figure out what your issues are.
Tom, Sorry for the imprecise use of terms, when referring to excess cash, I think I had in mind excess deposits.
Yes, you are right. I was getting ahead of myself there, assuming that the banks would exchange their reserves for treasuries held by the Fed. So where we wind up is with an excess supply of reserves, which would tend to force down the interest rate charged for reserves in the interbank lending market. So I was mistaken in asserting that the monetary base would fall unless the central bank made open-market purchases of Treasuries. How the system would adjust to the existence of excess reserves and a reduced rate in the interbank lending market is not immediately obvious to me, I can think of a number of possible scenarios. Perhaps I will try to do a post about that.
Nick Edmonds, I agree that there is an ambiguity in which bank deposits we want to include in the definition of money, but in principle a definition of terms should not make any difference in what actually happens in the real world. I think people holding different kinds of bank deposits tend to switch them around a lot, so that if there are excess balances in transactions accounts, their initial response is to shift them into another slightly less liquid bank account and if they perceive later that that account is too large they convert it into some other type of non-bank asset.
JKH, Aren’t you just adding a gloss on Nick Rowe’s characterization, pointing out that there are certain legal obligations that the central bank has to ensure that commercial bank deposits are always exchanged at par with currency? That seems to be a matter of convenience rather than an essential characteristic of the relationship.
JP, You are right, I was wrong. See my reply to Tom above.
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David, thanks for the reply.
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I asked a simple question “why not call it the broad to base ratio instead of the money multiplier?” at Scott’s, and Mark really dug in!… so if you’re interested in the history of the phrase “money multiplier” here’s Mark:
http://www.themoneyillusion.com/?p=26518&cpage=1#comment-327879
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David, I’m wondering if this is what you’re getting at …
If we were to (plausibly) assume that banks:
(a) match asset & liability duration
(b) pays (term) deposit interest slightly better than Tsy term structure (and the “public” agrees)
(c) makes loans at (b) + (fixed) NIM (and “borrowers” agree)
… can there be an excess supply of commercial bank money?
I think your answer is No, because (a)-(c) shows the public should be satisfied to hold bank assets with a term structure similar to comparable financial assets (Tsys). Further, there is no reason to believe that the distribution of income is out of match with the distribution of willingness to hold assets as prescribed.
I think Nick may be saying the answer is yes, because “the typical receivers of money” are somehow different than the typical asset holder.
Does this sound like the crux of the disagreement?
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jt26, tell me more about your theory so I can understand it:
“(a) match asset & liability duration”
This means that the average remaining loan duration is similar to the remaining time till maturity of the bonds, CDs, and time deposits they issue?
“(b) pays (term) deposit interest slightly better than Tsy term structure (and the “public” agrees)”
You’re saying the interest they pay on their assortment of time-deposits (all with different maturity dates), is slightly better than competing Treasury bonds/bills/etc? What do you mean “the public agrees?”
“(c) makes loans at (b) + (fixed) NIM (and “borrowers” agree)
… can there be an excess supply of commercial bank money?”
what does “make loans at (b)” mean? What’s a “(fixed) NIM” and why do borrowers have to agree?
“(a)-(c)” means “(a) through (c)?”
Also, does any of this have anything to do with “Walras’ Law?” Is “Walras’ Law” a real law of economics, or more like “Say’s Law”… something that would be nice if it were true?
Yesterday I sicked Jason Smith at “Information Transfer Economics” on this and he brought up Walrus’ Law… and now I see that he has another comment up, which I should read before posting this one, but I won’t… Here’s Jason’s comment which I’ll read next:
http://informationtransfereconomics.blogspot.com/2014/04/the-downward-trend-in-real-interest.html?showComment=1396643923518#c8329807734943634005
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A few more thoughts after reading the post and some of the comments again:
“It is only because the central bank is keeping the quantity of currency constant that an excess supply of currency comes into existence.”
That’s an assumption in a particular scenario in part of the discussion, but this (and similar things said) really puzzles me about the whole debate. By what means or assumptions do either Nick or David believe that the central bank can actually stop the public from converting currency to bank deposits? There is no way that a CB can prevent this at an operational level. It may be able to influence the pattern of currency flows through monetary policy in the long run, but they can’t forcibly stop it at any time – in the short run or the long run. It seems to me that the very idea of “reflux” is operational. Much of the discussion translates to interpretations of money flows that must be seen as operational in the short term – and feasible on that basis, I presume.
BTW, this is a major thing I don’t get about monetarism in any of its forms. This sort of feasibility of “control” over currency flows appears to be a persistent contention of monetarism. And it’s terribly wrong in my view. It’s also a defining chasm between the treatment of this sort of balance sheet adjustment by monetarists versus some post Keynesians. It’s occurred to me now that my view on this issue of “asymmetric redeemability” (that it’s wrong) has everything to do with this particular point.
“About the immediate effect of an excess supply of commercial bank money, I don’t exclude the possibility that some people might increase their spending to reduce their bank balance, the point is that there will be an incentive for banks to allow their deposit liabilities to go down rather than continue to lend as much as they were lending before the demand for deposits fell. There is an economic process whereby the quantity of deposits adjusts to the amount that people want to hold. A deposit once created does not have to endure forever.”
This makes good sense to me – and I view it simply as a compromise between an extreme version of Rowe (no Tobin) and an extreme version of Glasner (full Tobin). That’s what I think the whole debate amounts to – a compromise – a recognition that there is partial Tobin balance sheet adjustment and partial flow out into spending. And I think it’s impossible to theorize usefully a whole lot beyond that. Another way of saying it is that Nick’s hot potato gets passed in two disparate directions – spending and bank balance sheet adjustment. But we don’t know the mix of that diffusion.
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JKH,
“there is partial Tobin balance sheet adjustment and partial flow out into spending. And I think it’s impossible to theorize usefully a whole lot beyond that.”
Is there some test we could devise to let the empirical evidence decide how much of each is happening?
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JKH, when David wrote this:
“It is only because the central bank is keeping the quantity of currency constant that an excess supply of currency comes into existence.”
I don’t think he captured what Nick intended, because Nick wrote this:
“This is what I would want to say: holding the stock of base money constant, assume the beta banks increase the stock of deposits and the interest rate paid on deposits at the same time, so we never observe either an excess supply or an excess demand for deposits **in the market where deposits are traded for alpha money at a fixed exchange rate**.”
So Nick was talking about holding BASE MONEY constant (i.e. reserves + currency held by the non-bank public), and David was talking about holding the quantity of CURRENCY constant. David didn’t specify if this currency was held by banks or non-banks or both. But in any of the three of those cases, that was explicitly no what Nick was talking about.
So, when you write this JKH:
“By what means or assumptions do either Nick or David believe that the central bank can actually stop the public from converting currency to bank deposits?”
I never had the sense that Nick was postulating that this could happen, only David, and again, I don’t think David captured the scenario Nick was after with that, since Nick was talking about holding base money constant, not currency.
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Nick Rowe, it’s unclear to me what exactly you meant when you wrote this:
“If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods.”
What does “holding constant the stock of alpha money” mean? Does it mean
1. Holding the stock of base money (i.e. reserves + currency held by non-banks) constant?
2. Holding the just the stock of currency held by non-banks constant?
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JKH, also one other thought on this:
“By what means or assumptions do either Nick or David believe that the central bank can actually stop the public from converting currency to bank deposits?”
How about overnight rates at 0%, a 100% reserve requirement, and negative IOR?
The banks would be forced to pass the cost of maintaining a deposit on to depositors, who would then be incentivized to withdraw their deposits as cash: banks would rather borrow reserves (for which they’d pay nothing) and send them out the door as cash than they would hang on to them (which would cost them the negative IOR rate).
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JP Koning does an EXCELLENT recap of this whole argument over on his blog which I highly recommend:
http://jpkoning.blogspot.com/2014/04/rowe-v-glasner-round-33.html
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First, this is a very good discussion and I want to thank to all participants for arguments here. However I have one question that seems to be confusing discussion here: “What do you exactly mean by reflux”?
Normally reflux would mean people returning money they don’t want to hold for backing asset. Borrowing term from David – private sector similar to banking should be profit maximizing. So I assume that people will return money if asset that is backed up by this money is worth more than any alternative – like purchasing anything else or holding deposits as a buffer.
But in context of this debate for me reflux means exchanging deposits for currency. If we assume that currency and deposits are substitues in terms of how they operate (payments etc.) the only occasion where I can see this happening is if the bank is not being prudent or illiquid and its deposits may lose ability to be traded on par with currency.
So to say it in other words – if we have inprudent banks that created a lot of deposits and does not have ability to defend deposit-currency parity a bank run happens. And to my knowledge during bank runs people want to trade deposits for currency as opposed to paying of their debts.
Now I know that my argument here may be weak due to fallacy of composition however I think it also holds on aggregate. It is more on an intuitive level but I think that people who end up holding a lot of deposits at any given time are probably not the same people that are owing bank a debt.
Or to say it differently, people holding deposits may purchase multitude of things – including debt. Why should it be profitable for these people to get rid of their deposits by purchasing debt?
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David,
Nick writes the following above:
“What I had in mind was something changing so that individual banks found the old equilibrium no longer profit-maximising, so they found it profitable to expand loans and deposits even if they needed to increase interest rates on deposits to dissuade people from swapping those deposits for central bank money and prevent the Law of Reflux kicking in.”
You give a great example of why banks may need to increase the interest rates they pay on deposits ([marginal] intermediation costs go down):
“…under the assumption that marginal intermediation costs have fallen, one could posit that the profit-maximizing response of beta banks would be to increase their interest payments on deposits to support an increase in their, suddenly more profitable than heretofore, lending.”
Can you come up with a similar concrete example of “something changing” which would support banks finding the old equilibrium no longer profit-maximizing, and thus pushing them to expand loans and deposits? Thanks!
(BTW, I ask Nick this same question as an off topic question in his latest post, but I thought you might have a good example too).
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David, I try to come up with my own example (that I ask about in my comment above) here:
http://jpkoning.blogspot.com/2014/04/rowe-v-glasner-round-33.html?showComment=1397005294113#c809789614390463886
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“Our disagreement concerns a slightly different, but nonetheless important, question: is there a market mechanism whereby an excess supply of commercial bank money can be withdrawn from circulation, or is the money destined to remain forever in circulation, because, commercial bank money, once created, must ultimately be held, however unwillingly, by someone?”
False dichotomy. Money created by commercial banks is also destroyed by them, so it is not destined to remain **forever** in circulation. For instance, a bank writes off a bad loan. In doing so it reduces the amount of money that it can spend by the amount of the loan that remains to be paid. That amount of money is taken out of circulation. Likewise, as a bank loan is paid off, part of each payment goes to reducing the remainder of the loan. That part of the payment the bank cannot spend. It, too, is withdrawn from circulation.
“Second, even if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money”
Hold on! Are there not periods of time, years, even decades, where that does not happen? We cannot simply assume that the banks will be willing to supply money for the IOUs that the public is willing and able to supply.
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