Friday, September 27, 2013

A Bank is still not a financial intermediary: redux

I wrote a recent post on whether or not a bank was a financial intermediary referring to an old Tobin paper. In response, the indomitable JKH retorted:
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... 

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.
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.

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...