Uneasy Money

In some recent posts (here, here, and here), I have expressed my admiration for James Tobin’s wonderful paper “Commercial Banks as Creators of Money.” Although the logic of the paper seems utterly compelling to me, it was, and evidently remains, controversial, because it advances the idea that the distinction between what is and what is not money is not a hard and fast one, but depends on the institutional and regulatory arrangements under which banks and other financial institutions operate.

The context in which I have been discussing Tobin is whether bank deposits created by commercial banks, unlike the liabilities created by other financial institutions, are “hot potatoes” in the sense that any individual can get rid of “unwanted” bank deposits (“unwanted” meaning that the individual’s deposit holdings exceed the amount that he would like to hold relative to his current income and wealth), but can do so only by giving those deposits to another individual in exchange for something else that the first individual would rather have instead. Thus, according to the “hot potato” view of the world, the total amount of bank deposits held by the community as a whole cannot be changed; the community is stuck with whatever amount of deposits that the banks, in the process of making loans, have created. What this means is that it is up to the monetary authority, through its control of reserves, reserve requirements, and the overnight rate on interbank loans (or its lending rate to the banks), to create the right amount of bank deposits.

Tobin argued that the “hot potato” view of bank deposits is incorrect, because the creation of bank deposits by commercial banks is not a mechanical process, as implied by the conventional money-multiplier analysis, in which bank deposits automatically come in to existence as a result of, and in proportion to, the amount of reserves provided to the banking system. Rather, profit-maximizing banks, like other profit-maximizing financial intermediaries, make an economic decision about how much of their liabilities to create (and on what terms to make them available) based on the public’s demand to hold those liabilities and the banks’ costs of backing those liabilities, inasmuch as any financial intermediary issuing a liability must make that liability sufficiently attractive to be willingly held by some member of the public. Like any financial intermediary, banks seeking to lend to the public can lend only if they obtain the funds to be lent from some source: either the equity of the owners or funds provided to the bank by lenders. If a bank cannot induce people to hold an amount deposits created in the process of making loans equal to the amount of loans it has made, it must find another source of capital to finance those loans.  Otherwise, the bank will be unable to sustain the scale of lending it has undertaken.

The amount of lending that banks undertake is governed by strict profit-loss calculations, just as the scale of operations of any profit-making enterprise is governed by a profit-loss calculation.  A bank makes a profit if the spread between its borrowing and lending rates is sufficient to cover its other costs of intermediation. And the scale of its lending depends on the demand of the public to hold its liabilities (which affects how much interest a bank must pay on those liabilities, e.g., demand deposits) and the interest rates that borrowers are willing to pay on the loans they obtain from the bank. Subject to essentially the same constraints on expansion as other financial intermediaries, banks do not simply lend without considering what costs they are incurring or what contribution to profits their loans are making at the margin. Because in equilibrium, the marginal revenue to a bank generated by an incremental loan just equals the marginal cost of making the loan, so that banks can decide to decrease their lending just as easily as they can decide to increase their lending, it makes no sense to think that bank-created money is, like central-bank currency, a hot potato. (Aside to Mike Sproul: Sorry, I know the previous sentence sounds like a nail scratching on a blackboard to you, but only one argument at a time.) As Tobin puts it:

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. If bank deposits are excessive relative to public preferences, they will tend to decline; otherwise banks will lose income. The burden of adaptation is not placed on the rest of the economy.

To me this seems so straightforward that I cannot understand why anyone would disagree. But some very smart people – I am thinking especially of Nick Rowe — are as convinced that it is wrong as I am that it is right. In earlier exchanges we have had about this, Nick has invoked the authority of Leland Yeager in arguing against Tobin, and Lee Kelly, in a comment on my recent post citing the favorable evaluation of Tobin’s paper given by Milton Friedman and Anna Schwartz in their Monetary Statistics of the US:  Estimates, Sources and Methods, a companion volume to their Monetary History of the US, specifically asked for my opinion of Leland Yeager’s paper “What Are Banks?”, a paper devoted entirely to criticism of Tobin’s paper.

I just re-read Yeager’s paper, and I still find it unpersuasive. There are too many problems with it to cover in a single blog post. But I will note in passing that in the discussion of definitions of money by Friedman and Schwartz that I mentioned in the previous paragraph, Friedman and Schwartz, while indicating agreement with the gist of Tobin’s argument, also criticized Yeager’s approach in his paper “The Essential Properties of a Medium of Exchange,” which foreshadowed much of the discussion in “What Are Banks?” So it is complicated. But I think that the key point is that, by failing to make explicit how he conceived that the price level and nominal income were determined, Tobin left his analysis incomplete, thereby allowing critics to charge that he had left the price level and nominal income undetermined or specified, in Keynesian style, by some ad hoc assumption. This misunderstanding is evident when Yeager makes the following criticism of Tobin and his followers:

Proponents of this view [Tobin et al.] are evidently not attributing “the natural economic limit” to limitation of base money and to a finite money multiplier, for that would be old stuff and not a new view. Those familiar limitations operate on the supply-of-money side, while the New Viewers emphasize limitations on the demand side. They deny crucial differences (to be explained below) between banking and NFI (non-bank financial institutions) systems regarding limits to the scales of their operations.

This paragraph is hopelessly, if not deliberately, confused. Arguing like a lawyer, Yeager attributes an absurd position to Tobin based on the label (New View) that Tobin et al. chose to describe their approach to analyzing the banking system, an approach based on economic incentives rather than the mindless mechanics of the money multiplier. Having thereby attributed an absurd position to Tobin, Yeager proceeds to discredit that absurd position, even though the quotation above in which Tobin distinguishes between currency and “bank-created money” demonstrates that he explicitly rejected the position attributed to him. And contrary to Yeager’s assertion, rejection of the money-multiplier as an analytical tool certainly was a New View, a view that Yeager spends most of his paper arguing against. The money multiplier is a reduced form embodying both demand (for reserves, by the banking system, and for currency, by the public) and supply; it is not a description of the profit-maximizing choices of banks to supply deposits at alternative prices, which is what we normally think of as a supply curve. To treat it as a conventional supply curve or as an analogue to a supply curve is just incoherent. And then, apparently oblivious to the mutual inconsistency of his criticisms, Yeager, in the paragraph’s final sentence, criticizes the New View for denying “crucial differences” between banks and non-bank financial institutions “regarding limits to the scales of their operations,” a denial completely independent of what New Viewers think about base money.

A few paragraphs later, Yeager launches into a diatribe against the New View based on the following thought experiment:

Suppose, then, that a cut in reserve requirements or expansion of the monetary base or shift of the public’s preferences from currency to deposits initially gives the banks more excess reserves.

To Yeager it seems obvious that this thought experiment demonstrates that the banks, flush with excess reserves, start lending and expand the money supply, raising nominal income and prices rise and thereby increasing the demand for money until the demand to hold money eventually equals the enlarged stock of nominal money stock. Yeager somehow thinks that this thought experiment proves that it is the banking system that has generated the inflationary process.

Even applied to the banking system as a whole, something is wrong with the idea that a decline in yields obtainable will check expansion of loans and investments and deposits. That idea overlooks Knut Wicksell’s cumulative process. As money expansion raises nominal incomes and prices, the dollar volume of loans demanded rises also, even at given interest rates. The proposition that the supply of money creates its own demand thus applies not only to cash balances . . . but also to money being newly supplied and demanded on loan. An unconstrained cumulative process can even lead to embodiment of inflationary expectations in interest rates as described by Irving Fisher. The great inflations of history discredit any notion of expansion being limited as marginal revenues fall in relation to marginal costs. The notion rests not only on an illegitimate imputation of a systemwide viewpoint to the individual banker, but also on a more or less tacit assumption of rigid prices.

The obvious point to make is that Yeager’s thought experiment postulates either an increase in the monetary base or a reduction in the demand (via a reduction in reserve requirements or via a shift in the public’s demand from holding currency to holding deposits) for the monetary base. Thus, according to the New View (or an appropriately modified New View), the equilibrium price level and level of nominal income must rise. The rise is the consequence of an excess supply of currency (monetary base) which Tobin explicitly acknowledges is a hot potato. End of story. Yeager’s outraged remonstrations about Wicksellian cumulative processes, inflationary expectations and the lessons of the great inflations of history are simply beside the point. Throughout the paper, Yeager accuses Tobin of being confused about the difference between the incentives for the banking system as a whole and those of the individual banker, but confusion here is Yeager’s.

One might say that the approach that I follow:  to determine the price level in terms of the demand for currency and the stock of currency, while allowing the quantity of bank money and its yield (i.e. the interest rate paid by banks to depositors) to be determined in terms of the demand for deposits and the cost of supplying deposits, leads to exactly the same conclusion one reaches via the traditional money multiplier analysis: the price level and nominal income go up and the quantity of bank deposits increases. But actually there are some subtle differences. According to Yeager, it is the increase in the quantity of bank deposits that generates the increase in prices and nominal income. That would seem to imply that the quantity of bank money should be rising more rapidly than the quantity of liabilities produced by non-bank financial institutions. The money-multiplier analysis also implies no change in interest rates paid to depositors, while, if inflation leads to increased inflationary expectations and increased nominal interest rates, the New View predicts that the interest paid on deposits would rise as well. According to the New View, there would be no change in the relative quantities of bank and non-bank deposit liabilities; according to the money-multiplier analysis, the amount of bank deposits should rise faster than the amount of non-bank deposit liabilities even though non-banks would be increasing the rate of interest paid on their deposit liabilities while banks did not increase the interest paid on their deposit liabilities.

In connection with the “more or less tacit assumption of rigid prices” that he attributes to Tobin, Yeager adds the following footnote:

Basil Moore, who wavers between the new and traditional views, recognizes that if all prices were perfectly and instantly flexible, an unregulated banking system could not reach a stable equilibrium.

This is just wrong; a stable equilibrium is assured by fixing the nominal quantity of currency even with a completely unregulated banking system. What can possibly be meant by “perfect and instant price flexibility” is simply a mystery to me. The only meaning that I can possibly attach to it is that full equilibrium is continuously maintained, with no trading at disequilibrium prices. Why an equilibrium with a fiat currency and a determinate price level is inconsistent with an unregulated banking system is not explained, nor could it be.

The same confusion emerges again in Yeager’s discussion of how the supply of money creates its own demand. Yeager writes:

This process that reconciles the demand for money with the supply is the theme of what J. M. Keynes called “the fundamental proposition of monetary theory” and Milton Friedman called “the most important proposition in monetary theory.” Briefly, everyone can individually hold as much or as little money as he effectively demands, even though the total of all holdings may be exogenously set; for the total flow of spending adjusts in such a way that the demand for nominal money becomes equal to the exogenous supply.

Of course, the adjustment process can work perfectly well for currency and be irrelevant for bank money; currency is a hot potato, while bank money is not, so that the nominal supply of bank money, unlike the nominal stock of currency, adjusts to the nominal demand.

In a footnote to the above passage, Yeager invokes the authority of Harry Johnson:

Harry Johnson has charged opponents of monetarism with confusion over how nominal and real quantities of money are determined and with “a tendency to discuss monetary problems as if nominal and real money balances are the same thing, and as if ordinary value theory could be applied to the behaviour of money.” The Yale theorists [i.e., Tobin et al.] “are . . . alert to this confusion but by-pass it either by assuming stable prices and confining their analysis to the financial sector, or by building models based on the fictional construction of a money whose purchasing power is fixed in real terms, thereby avoiding confusion in the analysis at the expense of creating it with respect to the applicability of the results.

Any confusion Johnson may have detected could be eliminated simply distinguishing between the price-level analysis carried out in terms of the demand for, and the stock of, currency on the one hand, and the analysis, given the price level determined by the demand for and stock of currency, of the quantity (in both real and nominal terms) of bank money and the competitive interest paid by banks on deposits. In his subsequent work on the monetary approach to the balance of payments, Johnson showed himself to be perfectly content to decompose the analysis in this fashion.

There is more to say about Yeager’s paper; perhaps I will come back to it on another occasion. But any further comments are unlikely to be much more favorable than those above.