Banks, Money, and Debt

"You and I can only lend money if we've got some to lend; but banks can create money and debt simultaneously at the stroke of a pen". Might commercial banks be the cause of the increase in debt over the last few years?

Maybe partly, but basically no. You can't just look at one side of the market for debt; you have to consider both supply and demand. And when you are talking about macroeconomic things, like total amounts of debt and money, you cannot just do partial equilibrium analysis; you have to do general (dis)equilibrium analysis and look at the economy as a whole. It's the only way to avoid fallacies of composition.

This is the third (and last) of three posts on why debt increased.The first post ignored money. The second post introduced money, but ignored commercial banks. This third post introduces commercial banks.

A financial intermediary is a firm whose primary business is borrowing and lending. A bank is a financial intermediary whose liabilities are money, by which I mean a medium of exchange. A commercial bank is a bank whose aim is to maximise profits (unlike a central bank which has macroeconomic objectives). And a fractional reserve commercial bank is one which promises to redeem its money liabilities in central bank money, but keeps less than 100% reserves of central bank money ("fractional" could include 0%). Those are the banks I'm talking about.

So, if you could create money and loans at the stroke of a pen (and banks can, by simply crediting the borrower's chequing account) why wouldn't you do so? And do an unlimited amount too?

There are 3 things that may impose a limit:

1. Capital reserves. Lending is risky. The bank may not get paid back. Banks ought to watch the ratio between their capital reserves and total amount of risky lending, and that ratio may impose a limit on their lending. I'm going to ignore that limit.

2. Currency reserves. If one bank lends Andy $100, by crediting his chequing account with $100, the individual bank may need to have $100 currency in reserves because it is likely that Andy will use that $100 loan to buy something from Bill, and if Bill banks at a second bank the second bank will want to collect its $100 reserves from the first bank. But for the banking system as a whole there is no loss of reserves, unless someone withdraws currency. Currency reserves impose a limit on aggregate bank lending if individual banks desire a reserve/deposit ratio above 0%, or if people desire a currency/deposit ratio above 0%. (This is the limit on expansion of bank lending and money creation typically discussed in ECON1000). That is not the limit I'm focusing on.

3. Profitability. The demand for bank money and the demand for bank loans together determine whether it will be profitable for banks in aggregate to create more money and loans. This is the limit I am focusing on.

Start with the model from my second post. Suppose it's an even year, in which red apples grow well, and green apples grow badly. So the red growers have temporarily high  income, and want to lend; and the green growers have temporarily low income, and want to borrow. So there's debt, because the greens borrow from the reds. And everybody holds (base) money (currency), because money is a medium of exchange and debt isn't.

What happens when we introduce banks?

Banks earn their income from the interest rate spread. Suppose we have a constant money stock, and no real growth, so the inflation rate is zero. So currency pays zero interest, both nominal and real. But debt pays a positive rate of interest. So there's a spread between the interest rates on bonds and currency. If people are willing to hold some of their money as bank deposits, at a rate of interest lower than the rate of interest on bonds (and they should, because by assumption bank deposits can be used as a medium of exchange, and bonds can't), then banks can earn income on that spread. If that spread exceeds banks' administrative costs, profit-maximising banks will expand loans and deposits until at the margin the spread just equals the marginal admin cost.

What does the new equilibrium look like?

Banks create money. The nominal supply of money will be higher, and so the price level will be higher, unless the central bank reduces the supply of currency to keep the price level the same (an inflation-targeting central bank would do so).

The real money supply will probably be higher. That's because bank money either pays interest, or is more convenient in some respects than currency. (It must be better in some respect for some people to hold part of their money as bank money, otherwise they would stick to holding only currency).

Banks create loans. Does that mean the total quantity of debt will be higher? No. Or rather, not obviously. Before banks appeared, reds lent directly to greens. Now some of that lending goes through banks; reds lend to banks, and banks lend to greens. If bank-intermediated lending simply displaces direct lending, the total quantity of debt in real terms will stay the same. (Except each $1 of intermediated lending gets counted twice as debt: once as a liability of the bank; and once as a liability of the ultimate borrower.)

In order to get an increase in real debt (ignoring the double-counting issue), we need ultimate lenders to want to lend more (which means consuming fewer apples themselves), and ultimate borrowers to want to borrow more (which means consuming more apples themselves), at the same time. A rise in the rate of interest would do the first but not the second, and a fall in the rate of interest would do the second but not the first. How can banks do both? How can the introduction of banks make lending more attractive to the lenders, and borrowing more attractive to the borrowers?

The answer is clear. If the lenders lend to banks, their loans are a medium of exchange, and so are more attractive than direct loans. This can lead the red savers to save more, and lend more, even at a lower rate of interest. And a lower rate of interest can lead the green borrowers to consume more, and borrow more. It is exactly as is the banks, for a fee, could stamp direct debt with a certification of moneyness and make it more attractive to the saver and lender who was buying it. It's like removing an illiquidity tax on borrowing and lending. Or reducing transactions costs.

If either ultimate borrowing or ultimate lending were totally interest-inelastic (as they would be if consumption were totally interest-inelastic) introducing banks would not affect total real debt. But if both depend on interest rates or liquidity, then introducing banks will increase real borrowing and lending.

That's the long run effects of banks, when prices are flexible. What about the short run, when the price level is fixed?

It's a bit bizarre to think of the introduction of banks as a short-run experiment. Suppose instead that banks expand, because their administrative costs fall, for example.

Well, if the central bank takes no offsetting action, the money supply will expand, and so aggregate demand will expand, and output and employment will rise. The effects will be much the same as if the central bank increased the money supply, by printing more currency. Since that was covered in my second post, let's suppose the central bank does take offsetting action, and reduces the amount of currency in order to prevent any expansion in aggregate demand (and subsequent rise in prices).

The answer is then rather boring. As administrative costs fall, profit-maximising banks will compete to expand their loans and deposits, and spreads will fall. Banks' lending rates will fall, and borrowing rates (on deposits) will rise. Red lenders save more and deposit more with banks; green borrowers consume more and borrow more from banks. Just the same as the effect of introducing banks, writ small.

OK. Last post from me for a while on debt, and what caused it to increase. Time for a change.

Comments

[Too Much Fed]

"In order to get an increase in real debt (ignoring the double-counting issue), we need ultimate lenders to want to lend more (which means consuming fewer apples themselves), and ultimate borrowers to want to borrow more (which means consuming more apples themselves), at the same time."

What if productivity and/or cheap labor allow for more production of apples? Which leads me back to ...

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/08/money-and-debt.html

"I can't think of any way the Fed could shift both the supply and demand curves of loanable funds to the right, except perhaps by making everyone permanently richer."

"Hmm... I am thinking I did not explain that correctly then.

Regular supply demand curve for apples; excess supply of loanable funds which is limited on the demand side by the interest rate and proper underwriting.

Supply curve shifts for apples (both a fall in price and an increase in quantity traded). Fed lowers interest rates which allows for more debt (there is plenty of supply of loanable funds). The rest buy more apples with currency denominated debt (future demand) assuming current wage income or increasing wage income in the future. Does that shift the demand curve (ADD: for APPLES)?

If so, both the demand and supply curves for APPLES shift (I think to the right).

Sound better?"

Jon said: "I guess that didn't really make sense. What I was really thinking was about is more in tune with excess reserves. Excess reserves and vault cash determine the supply of bank loanable funds at a given moment. OMO are large in comparison."

For banks, does the fed have a good bit of "control" for the supply of loanable funds by "control" of bank reserves?

[Too Much Fed]

From:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/08/money-and-debt.html

"Introducing corporations into the model would make little difference. A corporation is like an apple growers' cooperative, except they pool their capital rather than their land or labour."

"I think it could make a big difference. The gov't allows policies to oversupply the labor market. Workers have borrowed in currency denominated debt against current wage income/future wage income. The corporation can now cut wage income to increase corporate profits. Now, the workers can't make the payments on the currency denominated debt."

[Too Much Fed]

"Well, if the central bank takes no offsetting action, the money supply will expand, and so aggregate demand will expand, and output and employment will rise. The effects will be much the same as if the central bank increased the money supply, by printing more currency."

If I'm reading that correctly, here is where we disagree. If the (fungible) money supply expands because of debt (or maybe bank loans), then the current supply of apples meets some future demand for apples.

If the (fungible) money supply expands because of printing currency then the current supply of apples meets current demand for apples.

[Too Much Fed]

Now for the big question.

If a whole economy experiences a productivity shock and/or a cheap labor shock (so that the supply curve shifts to the right),

http://www.raybromley.com/notes/noteimages/equilibrium/incrsupplyeq.jpg

what should happen?

Price deflation?
Print more currency?
Print more bank reserves and/or other means to attempt to create more private debt?
The fed becomes desperate and "gets" congress to "produce" public debt?

[Nick Rowe]

Suppose that productivity permanently doubles (2 apples grow wherever 1 grew before). Suppose the central bank doubles the money supply too (otherwise there will be deflation).

Then, approximately: income doubles, consumption doubles, savings doubles, dissaving doubles, borrowing and lending both double, debt doubles. And the debt/income ratio stays the same.

Again, it's not surprising if debt increases in proportion to income. Nor is it anything to worry about. What we need to explain is why debt grew faster than income.

[Declan]

"In order to get an increase in real debt (ignoring the double-counting issue), we need ultimate lenders to want to lend more (which means consuming fewer apples themselves)"

No, we don't.

Let me try to explain my viewpoint one last time (if it helps, after your last post I went googling, trying to identify what 'name' my views on this topic go by, and it seems like it is known as the theory of 'endogenous money'. Seems to be a fairly widespread, yet not mainstream view, which suggests there must be an accepted mainstream critique as to why its not true, but I couldn't find one in my searching) ...

So, I decide I'd like to buy a house, and the person selling the house is demanding I give them 500 apples, which I do not have. So I go to the bank, which does not have 500 apples either (because no 'ultimate lender' has lent them any, being unwilling to cut back their own apple consumption, presumably). However, this is not a problem, the bank simply conjures 500 apples with a wave of their magic wand, and hands them over to me, in return for my promise to return them with interest at a later date.

I give my 500 apples to the seller of the house and then they give the conjured apples back to the bank in return for the bank's promise to give them back at any time and to pay interest in the meantime. After all, other than putting the apples in their apple vault (unsafe and unsanitary!) what other choice does the house seller have? The bank pockets the spread on their apple lending/borrowing and all is well.

Now, you could characterize this transaction as the seller of the house lending the bank the apples so that I could borrow the apples, but it doesn't seem like a very accurate characterization, given the chain of cause and effect, does it? And it suggests that the ability of the bank to lend is constrained by the willingness of people to hold deposits/lend them money, when in fact it is the ability of people to hold deposits that is constrained by the willingness of people to borrow. The key is to realize that it is the act of borrowing that creates the money. When it comes to (credit) money there is a sort of reverse Say's law - demand creates its own supply.

[Patrick]

Three posts on debt, plus the Lombard Street reading assignment ... Geez, Professor, can I have an extension :)

[Nick Rowe]

Declan: the question we need to ask is this: if there were no bank, wouldn't the seller of the house have been willing to give you a mortgage to buy the house? "You take my house now, and promise to pay me 500 apples plus interest over the next 30 years". If the seller is equally willing to accept and hold your promise to pay and the bank's promise to pay, you should get the same result either way.

My argument in the post is that there is a difference, but only because your promise to pay won't work as money, but the bank's promise to pay will work as money. So the house seller is more willing to hold the bank's IOU than your IOU (at the same rate of interest).

(The "endogenous money" view can mean many things, but in this context I associate it with a "Post-Keynesian" perspective.)

Sorry Patrick. Extension granted. I think I need a break from debt too!

I was going to do a post on the Junker Fallacy, but then decided it was too close to debt. Maybe I'll go canoeing instead!

[Nick Rowe]

Declan: a follow-up. There is one big difference between a medium of exchange and any other form of debt that I didn't go into in the post, because it would have led me off onto another of my favourite topics.

The seller of the house would never have any unwillingness to accept bank money in exchange for the house (as long as the price was right) because he can always spend it on something else that he does want. But if he were unwilling to *hold* the bank money (and nobody else were willing to *hold* it either) but wants to spend it, then we cannot be in equilibrium, macroeconomically. There is an excess supply of money, and an excess demand for goods. And that excess demand for goods will create a boom in the short run, and an increase in the price level in the long run (unless the central bank takes offsetting action).

I did a post a while back on "Why an excess demand of the medium of exchange matters so much". It's the same here, only we are talking about excess supply instead (so everything goes in the opposite direction), and it's bank deposits that are the medium of exchange.

[Nick Rowe]

Sorry Declan. I'm not being as clear as I want to be. Time to go to bed.

[Nick Rowe]

One last try to explain it clearly:

Ignore investment. In equilibrium, aggregate desired consumption of apples must equal production of apples. Which means that aggregate desired savings must be zero. So the desired savings of the ultimate lenders must equal the desired dissaving of the ultimate borrowers. So in macroeconomic equilibrium desired borrowing must equal desired lending.

We now compare two different equilibria: the first without banks; the second with banks. If the second has more borrowing, but not more lending, they can't both be equilibria.

[Declan]

Yes, that's clearer after your 11:11 comment Nick, I guess we agree that the 'moneyness' of the bank IOU is an inducement to people to 'lend'/'accept money deposited in the bank as payment'. In my mind, that difference makes the supply of credit basically unconstrained (by anything other than demand from good acceptable credit risks) at a given interest rate.

I don't really have any argument with your later comments (which if I'm interpreting correctly, argues that if banks lend/create 'too much' money, people will have to find something to do with that 'extra' money (besides paying interest!), other than to note that it seems like as long as that extra money is used to inflate asset-bubbles, nobody seems to mind too much (until they pop, anyways).

(feel free to ignore my comment if you're sick of talking about debt! - I appreciate all the thought you've put into the posts so far, its been very thought provoking)

[Nick Rowe]

Declan: "I don't really have any argument with your later comments (which if I'm interpreting correctly, argues that if banks lend/create 'too much' money, people will have to find something to do with that 'extra' money (besides paying interest!),..."

You are interpreting it correctly.

And the big problem, it seems, is that small changes in trivial things, like banks' admin costs, or optimism/pessimism, etc., can cause banks to change and either expand creating a boom, or contract creating a bust. So the central bank has to keep changing conditions in the opposite direction.

Definitely off canoeing now.

[Jon]

Commercial Banks--as opposed to the Central Bank--money creation is more likely to be a case of supply and demand canceling. The exception is the extent to which they allow the term-of-payment to lengthen.

[Too Much Fed]

"Suppose that productivity permanently doubles (2 apples grow wherever 1 grew before). Suppose the central bank doubles the money supply too (otherwise there will be deflation).

Then, approximately: income doubles, consumption doubles, savings doubles, dissaving doubles, borrowing and lending both double, debt doubles. And the debt/income ratio stays the same.

Again, it's not surprising if debt increases in proportion to income. Nor is it anything to worry about. What we need to explain is why debt grew faster than income."

You're ignoring how the central bank doubles the fungible money supply and the fungible money supply's composition. What if the central bank gets the fungible money supply to double with ALL bank loans and no currency?

"income doubles". Not sure which definition you are using there but what if wage income does not double but corporate income MORE than doubles? Ignoring wealth/income inequality?

Can more bank loans based on currency shift the demand curve for apples to the right while productivity growth also shifts the supply curve to the right so that price inflation of apples is about 2%?

[Too Much Fed]

I am also beginning to think that we have different definitions of money supply (money supply vs. fungible money supply).

[Too Much Fed]

I need an explanation of what "bank money" is. And, what is the difference between "bank money" and currency? Thanks!

I am thinking that "bank money" is actually some form of currency based debt because there is an interest rate attached.

[Too Much Fed]

I believe the talk of debt denominated in anything other than currency (like apples) is meaningless because of legal tender laws.

A quick google search led me to this (not sure if it is 100% correct).

http://en.wikipedia.org/wiki/Legal_tender#In_the_United_States

"On the other hand, coins made of gold or silver may not necessarily be legal tender, if they are not fiat money in the jurisdiction where they are preferred as payment. The United States Coinage Act of 1965 states (in part):

United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes and dues. Foreign gold or silver coins are not legal tender for debts."

[Greg Alton]

"It is exactly as is the banks, for a fee, could stamp direct debt with a certification of moneyness and make it more attractive to the saver and lender who was buying it."

Banks do in fact do this, under various different names, although less commonly now. This is what Banker's Acceptances or avalization achieve (and many other different forms of discounted notes, Wechsels, trade notes and the like, with slightly different twists in time period and locale). Banker's Acceptances were literally someone else's debt with the Bank's stamp signifying that it 'accepted' the debt/note as its own - transforming one poor money substitute into a better one. These were amongst the principal instruments banks used.

The part that I haven't pulled together in my own thinking about this is that, it seems to me, securitization and CDOs and other vehicles - remanufactured into AAA - were similarly designed to achieve "moneyness" that would allow them to substitute for money in certain cases. Until they didn't.

And it seems to me that the history of the banking/monetary policy conundrum is intimately related to this issue: money-substitutes being "innovated" into existence and then proving to be rather poor substitutes in a crunch.

[Nick Rowe]

Greg: "And it seems to me that the history of the banking/monetary policy conundrum is intimately related to this issue: money-substitutes being "innovated" into existence and then proving to be rather poor substitutes in a crunch."

That's very much how it seems to me too. But another aspect of the long history of financial innovation is that the things that people panicked over in the past become eventually accepted as normal, and the panic is about the new things. There used to be redemption panics, where people would rush to redeem paper money for gold. They can't now, of course. and instead everyone rushes to convert everything else into paper money. But paper money is surely the least 'fundamentally' valuable of all assets, since it is only valuable because everyone expects everyone else will value it.

I would insist on a distinction between a true medium of exchange and money-substitutes, but otherwise agree with you. The history of financial innovation is the attempt to make fundamentally illiquid things liquid, and most of the time it works, and it's a major social/economic benefit that it does work. But liquidity always seems to have that double equilibrium feature: it's liquid because people trade it frequently, and people trade it frequently because it's liquid. I too was trying to get my head round this, in a few posts I did here several months back.

(And I hadn't realised, until your comment, that my "stamping" metaphor was not just a metaphor.. Good point.)

Too much: There is debt denominated in apples (in the sense that the amount of money you must pay is proportional to the price of apples), and there is debt where you must actually pay it off in apples. My post requires only the first. And TIPS bonds are exactly like that (only the CPI basket, not just apples). But for some futures contracts, as I understand it, you can insist on delivery of oil (or whatever), or pay a penalty if you don't. Another thing we discussed here in the past, and their relation to so-called legal tender laws. But off-topic here.

"Bank money" = (roughly) what's in your chequing account. Currency = notes and coins. But we can imagine a world (it used to be real) in which commercial banks issued notes and coins. The distinstion I am making in the post is between central bank money and commercial bank money.

"Can more bank loans based on currency shift the demand curve for apples to the right while productivity growth also shifts the supply curve to the right so that price inflation of apples is about 2%? "

Delete the bit about bank loans in that sentence, and that is exactly what the Bank of Canada tries to achieve: make the demand for apples grow just slightly faster than the supply of apples, so inflation is 2%.

The functional distribution of income (between labour, capital, land etc.) will affect debt insofar as it affects the personal distribution of income (between people) in such a way that it affects differences across the population in savings/spending decisions.

Jon: sorry, but you lost me on that comment.

[Too Much Fed]

""Can more bank loans based on currency shift the demand curve for apples to the right while productivity growth also shifts the supply curve to the right so that price inflation of apples is about 2%? "

Delete the bit about bank loans in that sentence, and that is exactly what the Bank of Canada tries to achieve: make the demand for apples grow just slightly faster than the supply of apples, so inflation is 2%.

The functional distribution of income (between labour, capital, land etc.) will affect debt insofar as it affects the personal distribution of income (between people) in such a way that it affects differences across the population in savings/spending decisions."

I think we are getting CLOSER TO THE TRUTH. Sorry, but I do NOT want to delete the part about bank loans because households are doing the borrowing.

How about can more bank loans based on currency (BECAUSE the central bank has allowed more bank reserves or some other means to lower interest rates) shift the demand curve for apples to the right (BECAUSE households have taken on bank loans based on currency and the ability to pay with current/future wage income) while productivity growth also shifts the supply curve to the right so that price inflation of apples is about 2%?

Can you see the difference between printing currency (current demand) and "printing" bank reserves to attempt to increase household bank loans based on currency (future demand brought to the present)?

About the functional distribution of (I assume NATIONAL) income (between labour, capital, land etc.), can you see if labor experiences negative real earnings growth and borrows to maintain their standard of living in the present how that can create positive real "earnings growth" for capital thru excess corporate profits?