- On money creation.
- Some misconceptions.
- Why money is less special than commonly thought.
On his blog, John Cochrane argues that banks could, and should be 100% equity financed. His points are:
(1) There are plenty of safe assets—government debt—out there and banks do not need to “create” additional safe assets—deposits.
I share this view partly. First, I don’t know what amount of safe assets are sufficient from a social point of view. Second, I don’t consider government debt to be a safe asset. Third, debt has safety and liquidity properties. The question is not only whether assets/liabilities provide sufficient safety but also whether they serve as means of payment in the same way that base money and deposits do. The key question then is: Do we need inside money? I don’t think that macroeconomics has a convincing answer to this question at this point. But I note that some preeminent macroeconomists (NK) argue that banks can create means of payment better than some governments. If this is true then John’s first argument partly misses the point (although he addresses a related point later).
In spite of these reservations, I share John’s view that in the aggregate, safety cannot be created by means of financial intermediation. Projects and claims to future tax revenue generate returns. The financial system can slice and distribute these returns in different ways (creating safer claims by rendering other claims less safe) but it cannot create safety in the aggregate.
(2) Households and firms no longer need assets (i.e., liabilities of financial institutions) with a fixed nominal value in order to make payments.
I agree. As John writes:
In the past, the only way that a security could be “liquid” is if it promised a fixed payment. You couldn’t walk in to a drugstore in 1935, or 1965, and trade an S&P500 index share for a candy bar. Now you can. (And as soon as it is cleared by blockchain, it will be even faster and cheaper than credit cards.) There is no reason your debit card cannot be linked to an asset whose value floats over time.
(3) If society really needs more “safe” claims such claims can be created on banks rather than in banks. As John writes:
Let the banks issue 100% equity. Then, let most of that equity be held by a mutual fund, ETF, or bank holding company, and let those issue deposits, long term debt, and a small amount of additional equity. Now I have “transformed” risky assets into riskfree debt via leverage. But the leverage is outside the bank.
I agree. In an article (2013) I have described a proposal by BIS economists that relies on equity financed banks and levered bank holding companies to help solve the too-big-to-fail problem.
(4) Why should less “safe” bank liabilities lead to a credit crunch?
I share John’s puzzlement with the often heard claim that fewer bank deposits would go hand in hand with less credit. I believe that this claim mostly reflects confusion about the interplay between national saving and investment on the one hand, and bank balance sheets on the other. There is no mechanical link between the two but of course, there are many indirect links.
All in all, I am as skeptical as John about the view that bank created money obviously is important. I think that bank created money has some useful roles to play but they are more subtle. At the same time, I believe that bank created money is likely to stay with us even if it is not socially useful. Proposals to ban inside money therefore are unlikely to succeed (see my writing on Vollgeld).
In its April 2017 Quarterly Report, the Deutsche Bundesbank discusses the role of banks in the creation of money. Findings from a wavelet analysis indicate that in Germany, money and credit move in parallel in the long run.
In an appendix, the report mentions possible welfare costs of curbing maturity transformation, with reference to Diamond and Dybvig’s work. This is not convincing. Unlike in the typical (microeconomic) banking model, aggregate central bank provided money need not be scarce, so there is no a priori social need for the private sector to create money.
Jonathan McMillan proposes a systemic solvency rule which stipulates that
[t]he value of the real assets of a company has to be greater than or equal to the value of the company’s liabilities in the worst financial state. (p. 147)
That is, the financial assets of a company have to be financed by equity. This reminds of Kotlikoff’s limited purpose banking, see here and here. McMillan (who is actually two persons, a banker and a journalist) argues that Kotlikoff’s proposal
is a step in the right direction to address the boundary problem, [but] it creates an overwhelming public authority [that monopolizes monitoring]. Moreover, it does not solve the boundary problem. Limited purpose banking requires the regulator to differentiate between financial and nonfinancial companies. … Finding clear legal criteria to categorize a company as financial is impossible. (p. 140)
Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance. The size of these haircuts would be a “tax on alchemy”. They would be set at tough levels and could not be altered in a crisis. The central bank would have become a “pawnbroker for all seasons”.
The key part of this quote is “could not be altered in a crisis.” Central banks and governments have always found it very difficult to commit not to support systemically (or politically) important players ex post. This problem lies at the heart of many problems in the financial system and elsewhere. By assuming that central banks could commit under the proposed arrangement, the proposal abstracts from a key friction.
In jusletter.ch, Corinne Zellweger-Gutknecht argues that the legal status of central bank reserves is more equity- than debt-like—at least as far as the Swiss National Bank (SNB) is concerned. According to Zellweger-Gutknecht, reserves constitute debt only if the SNB is legally obliged to redeem them in exchange for central bank assets.
If the SNB purchases dollars against Swiss Francs in an open market operation, it creates reserves which are equity-like. But if it acquires dollars against Swiss Francs and is committed to engage in a reverse transaction in the future (a swap), then it (temporarily) creates reserves which are debt-like.
In a recent Vox blog post, Zoltan Jakab and Michael Kumhof argue that macroeconomic models where banks intermediate loanable funds get it seriously wrong.
In the intermediation of loanable funds model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers … [but in reality] [t]he key function of banks is the provision of financing, meaning the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor.
This difference has important implications. Compared to intermediation of loanable funds models, money creation models predict larger and faster changes in bank lending and real activity; pro- or acyclical rather than countercyclical bank leverage; and quantity rationing of credit after contractionary shocks. New loans in loanable funds model are accompanied by additional savings and thus, higher production or lower consumption. In money creation models, in contrast, they simply reflect an expansion of banks’ balance sheets that is only checked by profitability and solvency consideration. Moreover, “the availability of central bank reserves does not constitute a limit to lending and deposit creation. This … has been repeatedly stated in publications of the world’s leading central banks.”
A large part of [money creation banks’] response [to a contractionary shock], consistent with the data for many economies, is … in the form of quantity rationing rather than changes in spreads. … In the intermediation of loanable funds model leverage increases on impact because immediate net worth losses dominate the gradual decrease in loans. In the money creation model leverage remains constant (and for smaller shocks it drops significantly), because the rapid decrease in lending matches (and for smaller shocks more than matches) the change in net worth. … As for the effects on the real economy, the contraction in GDP in the money creation model is more than twice as large as in the intermediation of loanable funds model, as investment drops more strongly than in the intermediation of loanable funds model, and consumption decreases, while it increases in the intermediation of loanable funds model.