Matt Yglesias has a new sub-stack on money and banking, with the following title and sub-title:
How banks create money out of thin air
The two missions of the Fed are intimately linked
Since most colleges have a course on “money and banking,” the statement in its subtitle isn’t particularly controversial (although I don’t entirely agree.) But consider d first the concept of banks “creating money”.
If you define money as including bank deposits (as most people do), then it is obvious that banks play a role in the money creation process. Because the “banks making money out of thin air” arguments involve a lot of confusion, let’s start there. I’ll start with an analogy with the restaurant industry. What drives the growth in the nominal size of the restaurant industry?
1. Nominal GDP growth.
2. Growth in the share of the NGDP constituted by the for-profit restaurant industry.
3. Non-profit organization maximizing the growth of the restaurant industry.
Suppose that in 2000, the restaurant accounted for 5% of GDP. If the GDP was $10 trillion, the restaurant industry would be $500 billion. Now suppose the NGDP doubles to $20 trillion in 2020. All else equal, the restaurant industry will double to $1 trillion.
Other factors (both supply and demand side) can impact restaurants as a share of GDP. Immigration could add to the supply of restaurants with tasty new menus. More working women and rising real incomes could encourage people to eat out more often. Suppose these factors push the restaurant industry to 6% of GDP. In this case, the industry would grow to $1.2 trillion in 2020.
And finally, a restaurant might decide to expand even though it would reduce its profits. They could offer larger portions to attract more customers, selling meals at a loss. I don’t think this factor is very important overall, but it’s a theoretical possibility.
The banking sector is similar, with three factors determining the nominal size of bank deposits (i.e. bank “money”):
1. Nominal GDP growth.
2. Growth in the ratio of deposits to the NGDP in the banking sector maximizing profits.
3. Non-profit organization maximizing the growth of bank deposits.
The first factor is easy to explain. In the United States, the Fed determines the NGDP. If the NGDP doubles over time, it will tend to double the equilibrium quantity of bank money. This is related to the concept of “speed”.
We all know that speed is not a constant, as the ratio of deposits to NGDP changes over time. Many factors cause this ratio to change, but the only ones worth thinking about are the factors that influence the profit maximization ratio bank deposits to the NGDP. Yglesias offers a typical thought experiment:
Alternatively, you can ask a bank for a loan secured by the equity in your home. The way it works is that the bank will enter in a spreadsheet “John owes us $X, the loan being secured by his house”. Then, in another spreadsheet, they will put an additional X dollars into John’s bank account.
When you get a loan like this from the bank, they don’t tell you “wait a few hours, we need to grab some extra deposits before we can lend you money”. Partly because, just as deposits “in” the bank are, for the most part, not physically located anywhere, you are not expected to get your loan in the form of physical money. These are just spreadsheet entries. The bank goes from having no entries about you on their spreadsheets to having an entry about the money in your bank account and another about the money you owe them. The act of lending you money created the bank deposits. And by taking out the loan, you transform yourself from someone who has a lot of home equity but no money to someone who has a lot of money but less home equity. You and the bank worked together to create money.
I don’t find this kind of thought experiment particularly helpful, since it’s not clear if this trade is supposed to be profitable. When I think of the factors that affect the ratio of deposits to the NGDP, I focus on those that have an impact on the equilibrium size of the banking sector. Consider the following example:
An economic boom leads banks to spot more opportunities to make profitable loans. When loans are made, borrowers receive a bank deposit in the manner described by Yglesias. But then the borrowers withdraw the money to pursue their goals. Here there are several possibilities. One possibility is that the same shock that caused more equilibrium loans also makes people want to hold proportionately more bank deposits overall, even at the same interest rate. If not, interest rates may rise during the boom. Increasingly profitable businesses are willing to pay higher borrowing rates, and banks may then offer depositors higher rates as an incentive to keep money in banks rather than switch to alternatives such than mutual funds.
In this case, you can think of new loans leading to new deposits. But one can also consider a shock where people become more inclined to deposit money in the bank (perhaps due to more generous deposit insurance). This influx of funds into banks drives down interest rates, which increases the number of profitable loan opportunities. As Paul Krugman once said when he exasperated MMT’s tedious arguments, “it’s a simultaneous system.”
If there is no economic “shock” that affects the equilibrium size of the banking sector as a percentage of GDP, is it still possible for a banker to create money out of thin air? Yes, if they are willing to lose money. A banker might suddenly decide to give a loan to someone with bad credit risk, thus “creating money”. But why would they do that?
To summarize, when thinking about banks creating money, I would focus on two main factors. First, the Fed determines the NGDP, and monetary neutrality implies that monetary policy that raises the NGDP will have a proportional effect on all other nominal aggregates in the economy, including the nominal size of the restaurant industry. and the nominal size of bank deposits. Furthermore, specific economic shocks can cause the profit maximizing ratio of bank deposits on the NGDP to change over time, and this is probably what most people mean when they talk about banks “creating money”. ‘money “. In general, booms tend to lead to positive money creation, and vice versa. Deregulation can also lead to money creation, while a financial crisis can reduce the money supply.
So far, there is nothing strange or different in banking. The same types of factors that determine the nominal size of the restaurant industry also determine the nominal size of the banking sector. So why does Yglesias think banking is special and the Fed should control both monetary policy and banking regulation?
Under the gold standard, banking shocks have often had a large impact on the NGDP, while restaurant industry shocks have relatively little impact on the NGDP. The central bank might want to regulate the banking sector to prevent a banking crisis from reducing the money supply and the NGDP. Yglesias fears that this problem will arise even under a fiat money regime:
A lot of people made a lot of ignorant criticism of the 2007-2008 bailouts. As bailout advocates have always argued, if we had allowed more banks to fail, we would have had a bigger decline in lending activity and an even bigger contraction in aggregate demand – more unemployment, a deeper recession, etc. Dean Baker has always offered the non-ignorant counter that whatever contraction resulted from bank failures, you could have just done more stimulus to compensate. I think the counter-cons is that you “could have”, but no one was actually going to. We had bank bailouts, interest rate cuts and fiscal stimulus, and it was all pulling in the same direction, and the problem was that it wasn’t enough.
I’m not convinced the Fed wouldn’t have compensated for a more severe banking crisis, but it’s a defensible argument. I’m also not convinced the Fed had to be involved in the bailout, but I guess there are also arguments that the Treasury couldn’t or wouldn’t have done such an effective job without it. help from the Fed.
As I said above, I don’t think recognizing the reality of endogenous currency necessarily leads to radical political conclusions.
“People put deposits in the bank, then the bank lends the deposits” is a good approximation of how things work in most cases, although the reality is more complicated.
One thing that follows, however, is that the roles of central banks as banking regulators and as agencies of macroeconomic stability are necessarily blurred.
I’m not sure it’s necessary, but maybe it’s unavoidable.
In any case, Yglesias tackles the central problem in his Substack article, without all the nonsense that is often seen in debates about “endogenous money”. From a certain point of view, everything is endogenous. But waving around the term “endogenous” like a magic wand doesn’t solve any interesting monetary questions.
Here is a Buffalo bank from the golden age of banking architecture:
