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Olafur asks - Are banks intermediaries or money creators?

Written by Olafur Margeirsson Wednesday, 28 March 2012 19:16
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Olafur is the author of the forthcoming Bad Economics from Iceland (tbp Searching Finance November 2012)

The following is extracted from his blog, Icelandic Economics:

Peter Radford has a comment about whether banks are intermediaries or not on theReal World Economics blog, answering my comment where I say Krugman is disastrously wrong in his Banking Mysticism post. His comment is:

"I have just returned from depositing some cash in my local bank. An insignificant amount to be sure, but not the result of my being loaned to by that bank.
So.
Was that deposit a loanable funds sum? Is my bank an intermediary? Or is my deposit simply a recycled amount originating, way back, from a loan? If so, are the decisions of depositors like me completely irrelevant to an understanding of banking? Is that cash not really mine after all, and merely part of a giant flow from one bank to another? Did my decision have no macroeconomic effect?
I agree Krugman ignores – apparently – endogenous money creation. But banks gather deposits as fast as they can? Why? If they can simply create money why would I, as a banker, ever waste my time building branches to attract deposits? Why would I raise or lower interest rates to “attract deposits” if I never needed to?
Chick, in her book “Macroeconomics After Keynes”, pages 236-240, describes a difference between a “banking system” and an older, less sophisticated “bank”. She argues that the notion of being a ‘savings conduit’ (i.e. an intermediary) is outmoded once banking becomes so intertwined it can be called a system. She tries to make a great deal of this.
The issue, it appears is causation: does savings drive investment; or does investment drive savings? Chick sits squarely in the latter camp because of her Keynesian view, while Krugman seems muddled and appears to tend towards the former.
My life as a banker for 20 years would have been a whole lot more simple had I known that I was not running an intermediary. At least in part.
It appears to me – naively obviously – that banking is more complicated than either side in the Keen – Krugman discussion implies. Banks clearly create money. They recycle it too. And that recycling is called intermediation. Which, in turn, can be called being a conduit for savings.
Is this another case of two tribes not wanting to concede that there may be a middle ground?"

There is no middle ground
I am going to argue that there is no middle ground: banks are creators of money, in all instances.

First, transforming cash into bank deposit has, effectively, no effect on your net holdings of money-type assets. Cash is money just as bank deposit is accepted as such. However, there  is a great difference in cash-money and deposits-money in the sense that one of them is vulnerable for sudden lack of trust when depositors don't believe anymore to be able to use the bank deposit as money. That is when we see a classic bank run: people are despairingly trying to SELL their bank deposit to the bank itself and BUY cash instead. And the price therebetween is 1:1.

But that's exactly what you do when you take your cash-money to the bank, just the other way around. You sell it to the bank and instead the bank gives you a bank deposit, which is usable as money, and you get tiny rate of interest on it as well. As long as you think you can access your bank deposit whenever you want to use it as money, you're ok with that deal.

Note also that the rate of interest on the deposit is (should) be lower than the policy rates, which is the price of liquidity assistance from the central bank. The bank will be happy to buy the cash from you and sell you low interest deposit instead, not to lend the cash out (intermediary) but to fulfil either regulatory minimums or bank-specific needs regarding liquid assets. Those liquid assets can be the cash itself (the Austrian dream of 100% reserve requirement ratio) or the bank can sell the cash you just brought in to another bank or even the central bank itself and get liquid (central bank or other bank) deposit instead.

The question each economic unit has to ask himself is how liquid he wants to be. Cash is the utmost liquid asset and you can, as Keynes realised and built his Liquidity-Preference theory on, use it to store your wealth if you do not trust any other assets to hold your wealth in or if you want to make a speculative move on the price of other assets (you standing in the bank-run queue is essentially a speculation on your behalf: you think your bank-deposit asset will collapse in value and therefore you are trying to sell it to get more liquid asset, cash, instead in which you prefer at that moment to store your wealth in).

So when you brought the cash-money into the bank, you indeed had macroeconomic effect: you lowered the rate of interest (by obviously such a low amount it wasn't noticed but I hope you get my point) as you accepted an asset (bank deposit) that is not as liquid as cash. You selling your cash to the bank is a sign of your liquidity-preference being lower than when you held the cash.

My point is that banks are not intermediaries: you are not depositing your cash-money in the bank for it to lend it out to another person, you are selling your highly-liquid cash-money to the bank for not-as-liquid bank-deposit. The bank may well sell the cash you sold to it to the central bank for a liquid central-bank deposit or buy a much more illiquid CDS contract or whatever not, it hinges on the liquidity preference of the bank you just sold the cash to. And since this is a question of liquidity-preference of units but not intermediary process, the banks will ALWAYS create deposits parallel to creating bank-loans. Those deposits are then spent on other assets, both financial and non-financial, but they are always somebody's financial-liability in the system, no matter how you store that wealth, i.e. purchasing power.

An obvious problem that arises from this is "when is a financial asset money?" How the newly created deposit is spent makes a difference on how much "money" ends up in the system. Do you spend it on a savings account (thereby moving a time-deposit, which is M1, into M3)? Or do you spend it on Treasuries? Or corporate bonds? Or stocks?

This was a problem that Keynes realised in the GT but he, as far as my knowledge goes, never addressed it properly but simply said (in footnote no. 66): "...we can draw the line between "money" and "debts" at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for "three months" one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills."

To my knowledge, Treasury bills and Treasuries are generally not included in official money supply measurements.  But that's where bank-deposits, created parallel to bank loans, can end up if the owner of the deposit so chooses. Obviously, we can put "CDS contracts" or "stocks" or any other financial instrument in there as well according to this "definition" of money. And that is suddenly not "money" any more, even thought the debt and the deposit were created at some time in the past.

So banks are not intermediaries, not even partially so. They are simply, as Schumpeter so blatantly stated it, creators of purchasing power.

Peter Radford has a comment about whether banks are intermediaries or not on theReal World Economics blog, answering my comment where I say Krugman is disastrously wrong in his Banking Mysticism post. His comment is:

"I have just returned from depositing some cash in my local bank. An insignificant amount to be sure, but not the result of my being loaned to by that bank.
So.
Was that deposit a loanable funds sum? Is my bank an intermediary? Or is my deposit simply a recycled amount originating, way back, from a loan? If so, are the decisions of depositors like me completely irrelevant to an understanding of banking? Is that cash not really mine after all, and merely part of a giant flow from one bank to another? Did my decision have no macroeconomic effect?
I agree Krugman ignores – apparently – endogenous money creation. But banks gather deposits as fast as they can? Why? If they can simply create money why would I, as a banker, ever waste my time building branches to attract deposits? Why would I raise or lower interest rates to “attract deposits” if I never needed to?
Chick, in her book “Macroeconomics After Keynes”, pages 236-240, describes a difference between a “banking system” and an older, less sophisticated “bank”. She argues that the notion of being a ‘savings conduit’ (i.e. an intermediary) is outmoded once banking becomes so intertwined it can be called a system. She tries to make a great deal of this.
The issue, it appears is causation: does savings drive investment; or does investment drive savings? Chick sits squarely in the latter camp because of her Keynesian view, while Krugman seems muddled and appears to tend towards the former.
My life as a banker for 20 years would have been a whole lot more simple had I known that I was not running an intermediary. At least in part.
It appears to me – naively obviously – that banking is more complicated than either side in the Keen – Krugman discussion implies. Banks clearly create money. They recycle it too. And that recycling is called intermediation. Which, in turn, can be called being a conduit for savings.
Is this another case of two tribes not wanting to concede that there may be a middle ground?"

There is no middle ground
I am going to argue that there is no middle ground: banks are creators of money, in all instances.

First, transforming cash into bank deposit has, effectively, no effect on your net holdings of money-type assets. Cash is money just as bank deposit is accepted as such. However, there  is a great difference in cash-money and deposits-money in the sense that one of them is vulnerable for sudden lack of trust when depositors don't believe anymore to be able to use the bank deposit as money. That is when we see a classic bank run: people are despairingly trying to SELL their bank deposit to the bank itself and BUY cash instead. And the price therebetween is 1:1.

But that's exactly what you do when you take your cash-money to the bank, just the other way around. You sell it to the bank and instead the bank gives you a bank deposit, which is usable as money, and you get tiny rate of interest on it as well. As long as you think you can access your bank deposit whenever you want to use it as money, you're ok with that deal.

Note also that the rate of interest on the deposit is (should) be lower than the policy rates, which is the price of liquidity assistance from the central bank. The bank will be happy to buy the cash from you and sell you low interest deposit instead, not to lend the cash out (intermediary) but to fulfil either regulatory minimums or bank-specific needs regarding liquid assets. Those liquid assets can be the cash itself (the Austrian dream of 100% reserve requirement ratio) or the bank can sell the cash you just brought in to another bank or even the central bank itself and get liquid (central bank or other bank) deposit instead.

The question each economic unit has to ask himself is how liquid he wants to be. Cash is the utmost liquid asset and you can, as Keynes realised and built his Liquidity-Preference theory on, use it to store your wealth if you do not trust any other assets to hold your wealth in or if you want to make a speculative move on the price of other assets (you standing in the bank-run queue is essentially a speculation on your behalf: you think your bank-deposit asset will collapse in value and therefore you are trying to sell it to get more liquid asset, cash, instead in which you prefer at that moment to store your wealth in).

So when you brought the cash-money into the bank, you indeed had macroeconomic effect: you lowered the rate of interest (by obviously such a low amount it wasn't noticed but I hope you get my point) as you accepted an asset (bank deposit) that is not as liquid as cash. You selling your cash to the bank is a sign of your liquidity-preference being lower than when you held the cash.

My point is that banks are not intermediaries: you are not depositing your cash-money in the bank for it to lend it out to another person, you are selling your highly-liquid cash-money to the bank for not-as-liquid bank-deposit. The bank may well sell the cash you sold to it to the central bank for a liquid central-bank deposit or buy a much more illiquid CDS contract or whatever not, it hinges on the liquidity preference of the bank you just sold the cash to. And since this is a question of liquidity-preference of units but not intermediary process, the banks will ALWAYS create deposits parallel to creating bank-loans. Those deposits are then spent on other assets, both financial and non-financial, but they are always somebody's financial-liability in the system, no matter how you store that wealth, i.e. purchasing power.

An obvious problem that arises from this is "when is a financial asset money?" How the newly created deposit is spent makes a difference on how much "money" ends up in the system. Do you spend it on a savings account (thereby moving a time-deposit, which is M1, into M3)? Or do you spend it on Treasuries? Or corporate bonds? Or stocks?

This was a problem that Keynes realised in the GT but he, as far as my knowledge goes, never addressed it properly but simply said (in footnote no. 66): "...we can draw the line between "money" and "debts" at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for "three months" one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills."

To my knowledge, Treasury bills and Treasuries are generally not included in official money supply measurements.  But that's where bank-deposits, created parallel to bank loans, can end up if the owner of the deposit so chooses. Obviously, we can put "CDS contracts" or "stocks" or any other financial instrument in there as well according to this "definition" of money. And that is suddenly not "money" any more, even thought the debt and the deposit were created at some time in the past.

So banks are not intermediaries, not even partially so. They are simply, as Schumpeter so blatantly stated it, creators of purchasing power. 
Last modified on Wednesday, 28 March 2012 20:45

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