Tobin’s essay revolves around the idea that banks are a type of financial intermediary... Curiously, there has been some resistance from heterodox economics types to the idea that banks are financial intermediaries. Why has there been such resistance to this idea?
First, heterodox likes to focus on the notion that banks are “special”, as reflected in the idea that “loans create deposits”. This seems to be a pivot point for a kind of reflexive rebellion against mainstream economics and its analysis (or not) of banking...
Second, failure to see how banks are a type of intermediary flows from what might be described (somewhat tongue in cheek) as “deposit origination myopia” (DOM), an especially exuberant attachment to the mantra “loan create deposits”. Tobin’s 1963 essay is a 50 year old barometer of this syndrome. I think this was roughly Paul Krugman’s interpretation in the context of earlier blogosphere discussions.You should certainly read the whole post, both because it is informative, and also because it's difficult to summarize the heart of what JKH is saying.
To me, when I say "banks are not financial intermediaries" I'm talking about a specific sort of intermediation, namely, the type of intermediation where the entity in question is a match maker and thus can be safely abstracted away when modeling the system, enabling the focus to remain on buyers and sellers, which is where the economic magic happens. The term "intermediary" is vague, and while I'm not using it in a particularly precise way, I am using it in a particularly precise context. JKH and I may be viewing this conversation in different contexts, thus creating what he sees as "resistance" and I would characterize as "obtuseness".
Interfluidity comes to the rescue and makes, what I think, is a very clear characterization of the issue:
If banks are mere intermediaries between savers and borrowers, it may be reasonable to abstract them out of macroeconomic models and simply focus on the preferences of borrowers and savers and the price mechanism (interest rates) that ultimately reconcile those preferences, perhaps with “frictions”. If banks are special, if they have institutional characteristics that affect the macroeconomy in ways not captured by the stylized preferences of borrowers and savers, then it may be important to model the dynamics of the banking system explicitly.
Paul Krugman says banks are not special, most recently citing James Tobin’s famous paper on Commercial Banks As Creators of Money:
In particular, the discussion on pp. 412-413 of why the mechanics of lending don’t matter — yes, commercial banks, unlike other financial intermediaries, can make a loan simply by crediting the borrower with new deposits, but there’s no guarantee that the funds stay there — refutes, in one fell swoop, a lot of the nonsense one hears about how said mechanics of bank lending change everything about the role banks play in the economy.I want to unpack this just a bit. First, please don’t misunderstand the argument. Tobin’s, and by extension Krugman’s, point is not the facile argument sometimes made, that loans don’t meaningfully create deposits because a bank needs to fund the loan when the deposit created by a loan is spent or transferred...
SRW goes on to critique this view because it has unrealistic assumptions of the nonbank sector's preferences, which when relaxed, mean that bank deposits start to matter again.
Tobin’s argument was that this mechanical capacity of the banking system to “create new money” by net-lending ultimately doesn’t matter very much, because the non-bank private sector has a preferred portfolio of assets, of which bank deposits are a single component, and the net-lending of the banking system is constrained and ultimately determined by the non-bank sector’s desires.
I agree with all of this, and let me go back to the context of the debate to highlight what I think is the important point.
We're living through an extended recession -- going on 5 years now -- with high unemployment and no end in sight. It's similar to what Japan has been experiencing for almost 40 years now, and they haven't been able to break out of their funk. The standard remedy has been to flood the banking system with reserves and lower interest rates so that banks will start lending again. The deficit has also climbed higher, but as it nears the debt ceiling you get concerns about the Govt running out of money, etc. Economist say that if this does not work, the next thing to do is to start confiscating deposits through negative interest rates so inflation expectations will kick in and people will start spending. Because the spending/saving decision is fundamentally about time preference, and therefore sensative to interest rates.
The above is potted, but I think reasonably accurate.
So, in this context, the PK/MMT initial insight is that since banks do not lend out reserves, flooding the banking system with reserves will not encourage banks to lend. "Loans create deposits" is less a mantra and more a retort to the pervasive notion that bank lending is reserve constrained ("banks lend out reserves").
Bank lending is constrained however, but not merely by the non-bank sector's desires (although long term that's basically true), but more immediately by capital requirements. The fact that banks can expand their balance sheet to lend, within their capital constraints, do make the "different" and "special" from other forms of intermediaries which merely act as a match maker between buyer and seller (like a mutual fund). You can make a good argument for abstracting away the latter, but you cannot make a good argument for abstracting away the former by claiming that "the non-bank private sector has a preferred portfolio of assets, of which bank deposits are a single component, and the net-lending of the banking system is constrained and ultimately determined by the non-bank sector’s desires."
In fact, I think that this assumption actually highlights why bank lending is important to highlight, and that's because the non-bank sector's preferred portfolio of assets includes net financial assets (booked as equity) which banks cannot supply, and that the private sector's demand for bank deposits is in fact split between a desire for bank deposits balanced by liabilities as well as deposits balanced by equity (liability). In other words, people want cash in their bank account, and that taking on a loan is not the same as building up a nest egg, and this is true even at the aggregate level because you cannot say "for every borrower there is a lender so it's all a wash" because banks are special -- there's that word again -- in how and why they lend.
More later...
To me, when I say "banks are not financial intermediaries" I'm talking about a specific sort of intermediation, namely, the type of intermediation where the entity in question is a match maker and thus can be safely abstracted away when modeling the system, enabling the focus to remain on buyers and sellers, which is where the economic magic happens.
ReplyDeleteOk, but banks still mediate the portfolio choice of the non-banking private sector.
If you take the view you take, the amount of deposits is determined by borrowers - as if depositors (wealth holders in general) do not have a choice of how much they want to hold their wealth in the form of deposits.
There is hot potato in your theory.
It's just that you say that the causality doesn't run from money to prices (rightly) but someone economic unit somewhere is holding more/less deposits than it wishes to hold.
A Monetarist can see loans creates deposits but will use the same argument as yours to argue that prices of goods and services have to rise/fall (in addition to rise/fall in incomes) for an "adjustment" to happen.
You can rightly reject this Monetarist story but will still be left with some self-inconsistencies if you do not ascribe a mediation role to banks.
"as if depositors (wealth holders in general) do not have a choice of how much they want to hold their wealth in the form of deposits. "
ReplyDeleteI suspect there may be far too much focus on the stock here, and nowhere near as much on the flows.
Static vs dynamic analysis?
Oh that "your analysis is so static" again!
ReplyDeleteJust have a look at banks. Banks do so many many intermediary functions.
One example is a commercial paper backstop facility which lenders may like because they are confident that the borrower will have less problems paying back.
Another intermediary role is the many different functions when securitizing loans. Just pick up a securitization document and see all the intermediary functions.
But no, "bank is still not an intermediary".
I think the underlying point is that banks in neoclassical economics are seen as "veils", doing nothing but mediating the inter temporal utility maximization of individuals and their own life is not worth talking of. Which is a strange world.
But nonetheless "bank is not an intermediary" - it's just silly.
In Tobin's own models what banks do and things such as that are important. He doesn't abstract them out of his models.
I just finished watching 8 hours of a Perry Mehrling lecture series on monetary economics which I thought was outstanding. One point he made may be apt to this discussion.
ReplyDeleteHe used the term broker for some intermediaries and dealer for others. Brokers just put parties together and charge a fee, dealers actually own that which they are dealing in and hold cash. They have a balance sheet which can be expanded at will because they can extend credit, which makes dealers a money printer of sorts. Banks are dealers and they use Fed Funds on the asset side and deposits on the liability side as their most liquid entities. I think monetarists and the other non PKE view banks as more broker like, which is wrong.
So they TYPE of intermediary matters.
Greg,
ReplyDeleteIs there any simple way to watch those videos? Somehow registering seems unexciting to me. Or is it the case that one can just watch the lectures and not do other things in the "course"?
The difference between brokers and dealers is slightly related to the present discussion - although not too much. (The fact that banks act as dealers in some markets is important for a monetary economics perspective).
A mutual fund such as a money market mutual fund has a balance sheet of its own and is not a broker - although some firms such as Fidelity offer both services.
The mutual fund is actually the fund house plus individual funds which have their own balance sheets. So at a macroeconomic level, you can see it in the Fed's Z.1 here - for example money market mutual funds:
http://www.federalreserve.gov/releases/z1/Current/z1.pdf
Table L.120.
So mutual funds are not brokers - although the parent company may offer some brokerage services.
On your last point, I don't think it is right to say Monetarists view banks as brokers.
The point is about looking at institutions as veils. Neoclassical economics is about individuals and less role about the institutions.
ReplyDeleteSo if I write a model in which it is as if households directly buy stocks, the criticism of me doing so isn't a good criticism at all. On the other hand if I write a model or give a description in which banks are not there or treated as if they don't have much say than just doing what individuals ask them to do, then the criticism is good.
So although I do think that Tobin may have not emphasized a few points rightly, it isn't so in his work. It's more a criticism of his writing skills than something more. This should be excused because his contributions are enormous.
Of course he had many things wrong at other places - such as marginal this = marginal that and the focus should be different.
And I should say writing skills on a few specific points because generally he was a great writer!
ReplyDeleteRam
ReplyDeleteJust watch the videos you don't have to do the rest.
Much of the money held in banks is in 'Crilly state'.
ReplyDeleteIt is 'just resting in the account' - about to be moved on to the next person in the chain in support of real economic transactions, or asset purchases.
Unfortunately when you snapshot an economy with a balance sheet, all that lot looks just as static as the rest.
Loans created generate ripples in the real economy like stones skipping across a pond.
For me the fun in not in a balance sheet, but in the change in the balance sheet from one instant to the next.
A bank issuing a loan can generate a dynamic flow that increases real output via the movement of deposits, and also the accelerated repayment of other loans.
I'd suggest the intermediary function disappears in classical models, because they don't seem to take into account change over time and what that does.
Again the assertion you are taking a snapshot etc. I remember you saying this in the discussion around Steve Keen but guess what now he has changed his equation.
ReplyDeleteThe mediating function appears in dynamic models such as that of Wynne Godley who himself uses Tobin's asset allocation model - although improving it highly. You have to look at it via Tobin's lens to see this a point I made in the comments of part 1 of this here in this blog.
Now coming to intermediation - just look at securitization. This is a big market in the United States. The amount of securitization is - at least till the crisis - bigger than the banks' size. The banking system has been acting as an intermediary in the whole process because the ultimate buyer of the asset/mortgage backed securities is the whole world.
Even in the process of securitization banks perform so many other intermediating role. Just open a securitization doc to see.
Given the size of the securitization markets, it is wrong to say "banks are not intermediaries".
It is true that people generally - Krugman included - have a wrong notion of how the banking system works and this has to be corrected.
"Again the assertion you are taking a snapshot etc. I remember you saying this in the discussion around Steve Keen but guess what now he has changed his equation."
ReplyDeleteDid you actually bother to read what I wrote, or was that just a knee jerk reaction again because you don't like me for some reason?
I'm saying that the neo-classical models tend to work with snapshot views, and struggle with the concept of time - which is why they can't see what banks do.
Hi Winterspeak,
ReplyDeleteGood post.
My purpose was not to make my “redux” post a direct response to your first one, although I admit I had your post in mind as one that represented a certain point of view within a more general framing of issues about how banking is written about in the blogosphere (as represented in SRW’s listing of links for example). I tried to link to your post in such a way to include it as a worthy but subtle representative in that context. At the same time, I don’t bifurcate between “intermediary” and “special” in the way that you and SRW seem to do, and I think I made that very clear in the post. I think banks are special and I think they are a type of financial intermediary.
The definition of the word “intermediary” may be one of the potential debating points. I suppose it can be defined according to personal preferences for what it can suggest in context. Maybe that’s the only way it can be defined. The question really is how banks work relative to other financial institutions that may or may not be classified in the same general way.
In making the generalization of “intermediary”, let’s keep in mind that there are huge differences between all intermediaries – not just between banks and other intermediaries. So in making the case that banks are “special” and that this somehow disqualifies them as intermediaries, one is suggesting implicitly that there is nothing “special” about any of the other intermediaries relative to the rest. And I would say that they are all special in their own way (e.g. insurance companies versus the rest, as noted by Tobin). That said, I know you are thinking of banks as being particularly special for reasons you outline.
One of the things I focused on is that banks are portfolio managers on both sides of the balance sheet – and that they practice active liability management in addition to active asset management. Hence the reshaping of the liability/equity profile as a part of balance sheet management. That was to make the point that “loans create deposits” is the start of the story – not the end of it.
One impression I get from your post is that you have overlooked the fact that insurance companies – particularly those with publicly traded equity – are very capital constrained – every bit as much as banks. This was most apparent during the financial crisis. There was one very noticeable and shocking example of that here in Canada in the case of a world class insurance company. And of course AIG was the poster child for an insurance company gone mad (their financial products division did put the entire conventional insurance operation at risk). So banks are certainly not special in being capital constrained.
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ReplyDeleteI could extend that point by noting that while insurance companies do not hold reserve balances at the central bank (excess or required), they do hold liquidity positions which include bank deposits. And while they use bank deposits to make payment for the other financial assets they acquire (basically in the same way banks use reserve balances), they do not acquire risky assets (i.e. most assets) simply as a result of having bank deposits – i.e. they require capital to take on risk. It just so happens that the system of bank reserve balances is particularly closed in scope relative to the system of bank deposits held by insurance companies and others. But what is very similar between banks and insurance companies is an overall risk management framework that distinguishes between liquidity concerns and capital concerns. And that is the most important point behind the idea that banks are capital constrained – not that reserve balances are particularly siren like and tempting in the case of banks compared to deposit balances held by insurance companies.
Again, insurance companies are very special in their liability profiles (a point that Tobin happens to make). And so are pension funds – particularly those that promise annuities on a defined benefit basis. And so are banks. My view, which is consistent with Tobin’s, is that “loans create deposits” is not essential in the context of how banks practice active liability management beyond that – which all financial intermediaries do as well. That said, banks are very special in the way in which they interact with production firm inventory financing – which is fundamentally important to the Godley/Lavoie interpretation of banks. GL notes this is the “core” role of banking, which is fine, but that does not describe in total how they work, particularly in the greater detail of their intermediation process that may extend a bit beyond what GL described in their framework of liability decomposition.
Mutual funds are a somewhat different kettle of fish – because their liabilities are marked to market for the most part – but this special feature doesn’t disqualify them from my own definition of a financial intermediary. The service they provide has mostly to do with economies of scale and “professional” management (OK that’s what they claim). They may come closer to your preferred definition of a financial intermediary, but they are very different not only from banks but from insurance companies.
I think you’re wandering a bit from the core topic with the NFA meme, which is important to everything, but seems to me to be a sidebar to the main issue of banking compared to other financial institutions. For one thing, commercial banks are generally minor holders of Treasury bonds. That said, the NFA distribution of deficit spending (i.e. who actually saves the income created and what happens from then on) is scattered all over the place, and it’s difficult if not impossible to say how that trail compares to the eventual Treasury bond distribution. To see this, it is quite easy to imagine foreign holdings of Treasury bonds in a scenario with a balanced current account, which means the deficit distribution of NFA is different than the Treasury bond distribution. Furthermore, insurance companies contribute no more to NFA than do banks in the way in which you characterize that limitation. Financial assets are offset by liabilities and equity in both cases. So banks are not special in that way either.
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ReplyDeleteBTW, fewer “mainstreamers” are prioritizing the “banks lend reserves” fallacy in their thinking about QE these days, although that meme still exists. For some time, most of them have been talking about asset pricing and signaling and other stuff. I’ve yet to see any convincing argument about what the effect of QE is. Academics continue to spin theory on it, but I don’t think anybody (academic or practitioner) “knows” what it is in any coherent way. However, I don’t see this discussion about banks having that much to do directly with the debate about QE versus deficit NFA production.
That said, there is the QE layer of financial intermediation, which is in effect a section of the banking system balance sheet where increased reserves are offset by increased bank funding of various types – due to the fact that the bonds were originally sold mostly by non-banks. But here again is the point about liability management – the banks have converted some of those original demand deposits into time deposits and even into increased bank equity as the result of the retained earnings improvement that followed behind the original injection of TARP equity and gradual improvement in financial conditions.
Regarding the PKE/MMT “initial insight” - you may have missed the point I made that Tobin understood this 50 years ago and that he covers this in his essay. Also, he understood that banks are capital constrained, and captured that fact in his essay as well - in the equivalent idea that they require a spread in order to cover all costs, which includes the cost of capital.
I’m not quite sure what you mean by “deposits backed by equity”. Remember that households have an NFA position that is quite different than the private sector NFA position. The household NFA position is positive even before taking into account the government generated NFA position. The composition of household NFA as a sector is obviously heterogeneous across different households. It includes households with substantial NFA and those with little if any or negative NFA (perhaps with positive real estate). And the distribution of loans and deposits is complex within that micro NFA distribution. This was part of SRW’s thesis in effect. But my point here is that the distribution of deposits is paralleled in some way by the distribution of holdings of insurance policies and pension claims and other types of intermediary liabilities. It’s all very complex to generalize. So there’s not much reason to zero in on deposits for that reason.
Anyway, I think we agree generally on how banks are special with regard to “loans create deposits”. I’m just saying that’s not a complete story of how the financial system can be analyzed top down, in which banks can be seen to undertake a portfolio management process that is pretty common in overall framework to that of all financial intermediaries. And that’s what Tobin was writing about.
"Did you actually bother to read what I wrote, or was that just a knee jerk reaction again because you don't like me for some reason?"
ReplyDeleteWell your comment was aimed for me so why are you taking back what you said.
You clearly said:
"Unfortunately when you snapshot an economy with a balance sheet, all that lot looks just as static as the rest."
and this was a continuation of your first comment aimed at me as can be sseen from the fact that you quoted me there.
Winterspeak,
ReplyDeleteClearly there are examples of financial institutions that you consider to be just financial intermediaries. Presumably those that are little more than conduits fall into that category, i.e. those where the investment decision of the intermediary is essentially the same as the decision which would be taken by the end investor.
However, I'm interested in whether you think there can be financial institutions that are not banks, but are also not just financial intermediaries. It seems to me that there are other non-bank financial entities that have institutional characteristics that affect the macroeconomy in ways that are not captured by the stylized preference of borrowers and lenders.
Not sure if this is useful:
ReplyDeleteI think a lot of us who object to the "intermediary" usage are actually objecting to an implicit notion that banks are *transparent,* ignorable intermediaries -- that one can just look at the patient lenders and impatient borrowers, assuming that what happens in between (in the banks) is immaterial.
Sure they're intermediaries. Of course they are, in various senses. But they're also active agents, non-intermediary in any useful sense, with their own agendas independent of their saver/depositors.
The banks do most of the lending to the real sector, and their incentives and reaction functions are completely different from real-sector lenders (who are at least roughly trying to optimize lifetime consumption preferences; banks aren't). So the patient lender/impatient borrower model misrepresents and distorts the dynamics of the system.
When the real sector pays down its debts to the financial sector, the financial sector doesn't spend more on newly produced goods and services as a result (as real-sector lenders would do, to some greater or lesser extent).
The patient/impatient meme is pretty silly, IMO. Tobin didn't say anything like that. And to the degree that a chunk of bank liabilities are still demand deposits, they have a pretty high velocity. That's not about being patient.
ReplyDelete"And to the degree that a chunk of bank liabilities are still demand deposits"
ReplyDeleteI'd go further than that. I'd say to the degree that liabilities have a lower maturity than the loans they back, or can be traded.
So there are always 7 day deposits maturing, 30 day deposits maturing and funding bonds being traded. The underlying liquidity machines that cover off all this mean that there is little if any suppression of actual demand from the 'savings'.
I find Steve's comment about "patient" and "impatient" interesting in the context of this Krugman paper on debt deflation. http://www.princeton.edu/~pkrugman/debt_deleveraging_ge_pk.pdf
ReplyDeleteThe paper has patient and impatient consumers with different time preferences, which is pretty essential in the context of the model to explain the existence of debt. However, the level of debt and hence the cause of the deleveraging is determined by a separate exogenous debt limit. The debt limit is not modelled, but it struck me on reading it, that this could easily be interpreted as being determined by bank behaviour. This would mean that the model is effectively explaining a debt deflation recession by distinguishing between the desire to save and the desire to lend.
This looks to me like a bit of genuine Keynesian economics creeping into a New Keynesian model.