They are all the same.
Do bank runs cause recessions, or do recessions cause bank runs? Both. Neither. They are the same thing.
(This post isn't as clear as I want it to be, because my mind isn't as clear as I want it to be, so read at your own risk.)
I was making a second attenpt to read (as opposed to skim) John Cochrane's excellent paper "Toward a run-free financial system" (pdf). I got distracted at the top of page 8, where John says:
"A run requires that if one investor pulls out, the firm is closer to bankruptcy, giving a second investor greater incentive to pull out.
This is the core externality of run-prone debt. My action to pull out alters your incentives. Externalities do suggest a need for regulation, even once all the unintended disincentives and subsidies have been fixed."
We need to be a little careful here. Let your utility U be a function of my action M and your action Y. U=U(M,Y). (Similarly, let my utility V be a function of your action and my action V=V(Y,M)).
At the equilibrium point, where Uy=0 and Vm=0:
1. If Um =/= 0, we have a (positive or negative) externality, because my action affects your utility.
2. If Umy =/= 0, we have (positive or negative) feedback (our actions are strategic complements or substitutes), because my action affects your incentives.
In bank runs we have both: my pulling out lowers your utility and increases your incentive to pull out too. My pulling out creates a negative externality and positive feedback.
The same is true of the Old Keynesian multiplier. My cutting my spending lowers your utility, and gives you an incentive to cut your spending too.
(And it is not written in stone, despite what Maynard said, that the marginal propensity to spend is less than one. If people expect everyone else to cut their spending by 1%, they might respond by cutting their own spending by more than 1%. If so, the Keynesian multiplier, like a bank run, might spiral out of control.)
The same is true of the Old Monetarist cold potato story (the hot potato in reverse). If I decide to hold more money, by cutting my spending of money below my receipts of money, that means you sell less, and hold less money, which lowers your utility. And it gives you an incentive to cut your spending to try to restore your stock of money.
But is there more than just a formal similarity between a bank run and the Keynesian multipler and the monetarist cold potato? I think there is. To see this, consider a hypothetical counterexample, where these processes would be formally similar but unrelated in practice:
Car banks. Suppose the Jalopnik devil waved a wand and made cars a fungible asset. All cars are suddenly identical, and will always be identical. Car banks spring up. You give your car to the car bank. In return, the car bank pays you rent/interest, and promises to pay you one car on demand. Since most of the time most people don't need a car, car banks become fractional reserve car banks. There's no profit in having cars sit idle. Owning the bank's promise to pay you one car on demand is as good as owning a car, provided the bank can always deliver on that promise.
Fractional reserve car banks would be vulnerable to Diamond Dybvig runs. If you expect that everyone else will withdraw a car from the bank, you will withdraw one too, in case you suddenly need a car and find they have none left in reserve.
But there would be no obvious relation between runs on car banks and recessions. Would a run on car banks cause a recession? Probably not (unless people can't get to work if they don't have a car, but that would be a drop in labour supply and not a drop in labour demand). Would recessions cause a run on car banks? Probably not (if anything, since people drive less in recessions, runs on car banks would be less likely).
And would we want the government to act as car-lender of last resort? Not unless the government has a 3-D printing press, and can print cars for free. And if the government could print cars for free, we wouldn't need car banks anyway. The government would just print everyone a car.
But if cars were the medium of exchange, and unit of account -- if cars, and promises to pay cars, were used as money -- things would be very different. You wouldn't be able to buy things, without a car.
Start with a very simple monetarist model. A fixed stock of money M circulates around the Wicksellian roundabout in exchange for an annual flow of newly-produced final goods and services Y going in the opposite direction. MV=PY.
V might not be stable. If one person postpones his spending, even if just temporarily, the person he buys from might postpone his spending too. We would observe a wave of postponed spending circling around the roundabout. Would the wave die out over time, or get bigger? That depends.
If people think it's just a one-time delay in payment, and a one-time reduction in income, their reactions to the shock will be smaller than the shock that caused that reaction. The wave will die out. The whole point of leaving a flexible buffer zone between you and the car in front is so you don't have to adjust your speed exactly to the speed of the car in front. The whole point of holding a flexible buffer stock of money is so you don't have to adjust your spending exactly to the spending of the people who buy from you.
But if people think this is the start of something new, the wave will get bigger. If you think the car in front has an erratic driver, who is liable to slow down or speed up at random, you leave a larger average buffer zone. You hold a larger average buffer stock of money if you become less certain of the spending of people who buy from you. There is a fall in the velocity of circulation of cars on the Wicksellian roundabout. There is a recession.
You could tell a very similar story in Keynesian language, if you throw in a little bit of Friedman. Suppose a temporary shock causes a drop in spending and income. If people think their drop in income is only temporary, their response to a drop in income will be a drop in spending that is smaller than the drop in income that caused it. The wave gets smaller and dies out. But if people think their drop in income is permanent, they may cut their spending by as much or by even more (consumer durables and other investment accelerators) than the drop in income. The wave gets bigger.
In the simplest version of the Wicksellian roundabout, money circulates in one direction, and newly-produced goods and services circulate in the other direction. But if we add other assets to the mix, especially short-duration IOUs for money that need to be rolled over, it wouldn't change the basic story. I won't buy your (newly-produced) goods because I expect to have difficulty selling my own newly-produced goods. I won't buy your IOUs because I expect to have difficulty selling my IOUs, or re-selling your IOUs. We call one a recession; we call the other a bank run, or shadow bank run. They are all just positive feedback slowdowns on the Wicksellian roundabout.
\Is a bank run the same as a recession? Normally, why don't we think there is a positive feedback between income and expenditure? Because people know their lifetime income, and are able to use financial markets to allocate that income to their preferred path of income over time. So if we do see a positive feedback, that means that current income affects (beliefs about) lifetime income, or liquidity constraints prevent free shifting of expenditure between periods, or both. I'm not seeing an analogy for either of those conditions in a bank run.
The question we need to answer is, are demand constraints necessarily equivalent to excess demand for money? If we think that it's demand that causes output to fall 5 or 10% below trend in a recession, does that mean that, if output stayed at trend, money demand would exceed money supply? It certainly doesn't seem like households are trying to increase their money holdings in a recession. But maybe households' readiness to become more illiquid to stabilize expenditure, is outweighed by businesses' and banks' efforts to become more liquid? What kind of evidence would help us decide?
Posted by: JW Mason | June 12, 2014 at 11:57 PM
Now rereading your post I'm not quite sure what you're arguing. Are you saying that a bank run and a recession are just two names for the same phenomenon, so that if one exists the other also must exist, by definition? Or are you just saying that the basic mechanism of the two is the same, in which case it's perfectly possible to have one without the other?
Posted by: JW Mason | June 13, 2014 at 12:07 AM
JW: "Or are you just saying that the basic mechanism of the two is the same, in which case it's perfectly possible to have one without the other?"
This.
It wouldn't make sense to argue about whether a recession for men causes a recession for women or vice versa. (Not the best analogy, but it will have to do.)
"I'm not seeing an analogy for either of those conditions in a bank run."
If you think a bank run is temporary, and the runners will all run back to the bank tomorrow: you will be less likely to join them; you will be more willing to lend the bank money, or buy its assets in a firesale. Unless you too are liquidity constrained. But if you think it is permanent, and a harbinger of a recession, you won't.
(Thanks for helping me try to get my head clearer on this.)
Posted by: Nick Rowe | June 13, 2014 at 12:21 AM
"Or are you just saying that the basic mechanism of the two is the same, in which case it's perfectly possible to have one without the other?"
This.
It wouldn't make sense to argue about whether a recession for men causes a recession for women or vice versa.
Wait, are you sure that's the analogy you want? Or are a bank run and a recession more like a recession in the US and a recession in Canada? Same underlying mechanism, but you can still say something about which one is more likely to cause the other.
Posted by: JW Mason | June 13, 2014 at 12:33 AM
This isn't entirely on topic, but I thought I’d throw in “Musgrave’s theory of the self-contradiction inherent in fractional reserve”. It goes like this.
1. Banks should not be subsidised. 2. If in an attempt to attain “No.1”, bank capital ratios are raised to the level where bank failures are virtually impossible, then TBTF subsidies and taxpayer funded depositor guarantees can be removed, thus “No.1” is attained. 3. But in that case, in the event that a bank DOES FAIL, then depositors stand to lose out. Thus in the latter scenario, depositors, in that they stand to make a loss (just like shareholders) are effectively shareholders. 4. Thus such a bank is effectively funded entirely by shareholders: it’s a full reserve bank. Ergo there is no such thing as a non-subsidised fractional reserve bank.
QED.
Posted by: Ralph Musgrave | June 13, 2014 at 03:57 AM
"And it is not written in stone, despite what Maynard said, that the marginal propensity to spend is less than one."
He didn't say it was written in stone. In fact he pretty much said the opposite:
"In particular, it is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.
[...]
"Now, since , these facts of experience do not follow of logical necessity, one must suppose that the environment and the psychological propensities of the modern world must be of such a character as to produce these results. It is, therefore, useful to consider what hypothetical psychological propensities would lead to a stable system; and, then, whether these propensities can be plausibly ascribed, on our general knowledge of contemporary human nature, to the world in which we live." (My emphasis)
GT Ch 18 Section III
Posted by: Kevin Donoghue | June 13, 2014 at 05:18 AM
"There is a fall in the velocity of circulation of cars on the Wicksellian roundabout. There is a recession."
Would the central bank just offset this in your example by increase the supply of cars or M? Can the central bank affect V?
Posted by: dannyb2b | June 13, 2014 at 05:34 AM
JW: "Wait, are you sure that's the analogy you want?"
I'm not at all sure.
"Or are a bank run and a recession more like a recession in the US and a recession in Canada? Same underlying mechanism, but you can still say something about which one is more likely to cause the other."
Assume the US and Canada are identical, except that the US is 1,000 times bigger. Most economists would say that US GDP causes Canadian GDP, but not vice versa. I'm not sure that's right. There seems to me to be some sort of fallacy of decomposition there. So it would be better we leave that analogy aside.
We could say that erratic drivers are more likely to create the initial shock. We could say that drivers who tailgate are more likely to propogate an initial shock. But the underlying mechanism is the same for all drivers. I think that analogy works.
Ralph: Hmmm.
Kevin: good find. Take a very simple old keynesian cross model, for illustration. Suppose we observe fluctuations, but it never collapses to zero. So we know that we cannot have MPC > 1 everywhere. We could say that MPC < 1 everywhere, and that shocks are big, but not big enough to cause Y=0. Or we could say that MPC > 1 for small deviations of Y from Y*, and MPC < 1 when Y is a lot less than Y*. (Which is the opposite of Leijonhufvud's corridor hypothesis.)
danny: the central bank should offset it by increasing M. It can also affect V by either varying the amount of interest it pays on money, or else changing expectations of future M.
Posted by: Nick Rowe | June 13, 2014 at 07:23 AM
"Would a run on car banks cause a recession? Probably not " Wouldn't it though? For the bank to give out interest they need to rent out or lend the cars. Suddenly people withdraw all their cars and keep them idle in their driveways. Wouldn't it at least create recession in miles driven.
Posted by: Benoit Essiambre | June 13, 2014 at 08:16 AM
Are you aware of VrtuCar in Ottawa (a car co-op, not a Car Bank): http://www.vrtucar.com/en/ ?
I'm generally able to get a car when I want one (sometimes I have to go to a 'station' a little further away); but I do wonder if people sometimes reserve a car for busy periods 'just in case' they'll want to use it...
I haven't looked into it, but am curious about the Economics of Co-Ops. Any thoughts?
Posted by: Peter | June 13, 2014 at 08:22 AM
Benoit: a run on car banks would affect things directly related to cars. But recessions are an economy-wide phenomenon.
Peter: I have vaguely heard of such things. I wonder why people don't just rent cars instead?
Posted by: Nick Rowe | June 13, 2014 at 09:12 AM
"Owning the bank's promise to pay you one car on demand is as good as owning a car, provided the bank can always deliver on that promise."
To paraphrase Schumpeter: You can't drive a claim to a car, but you can trade with a claim to money.
So solvent banks can always handle a run by handing out IOU's that people can use instead of base money. Not so with car banks.
Posted by: Mike Sproul | June 13, 2014 at 10:37 AM
I am thinking of a world where money consists of gold coins and credit money issued by banks against their holding of gold coins.
People hold their money in a combination of gold and credit money, but most transactions are in credit money.
Someone decides to increase their money holdings by spending less. Their cash holding increase and they need to re balance by converting some of the credit money into gold coins with a bank.
Via the mechanism Nick describes this could simultaneously
1. Start a recession as others react to the initial decrease in income.
2. Start a bank run as others react to the withdrawing of gold from the banking system.
Whether or not we get a recession and/or a bank run depends upon the strengths of the reactions. If people think the initial shock is just a blip it will soon peter out. If people think its a sign of bad things to come they will help magnify the 2 effects with their reactions.
Posted by: Market Fiscalist | June 13, 2014 at 10:52 AM
Mike: OK, car banks are not the same as money banks, for precisely that reason. But if I don't need a car right now, then owning an option for instant delivery of a car is as good as owning a car sitting in my garage. Except the former pays me rent, until I exercise my option. Fractional reserve car banks would be better, except for the risk of runs.
(BTW, did Schumpeter talk about coats keeping you dry, and IOUs for coats not keeping you dry? Or is my memory off?)
TMF: That is a clearer way of putting it than mine, I think. Yep.
Posted by: Nick Rowe | June 13, 2014 at 12:17 PM
Not a run on cars but a run away from them. If for some reason cars became seen as fantastic investments and everyone wanted more of them to lend out, and valued them higher and invested more in the expectation of even higher prices, and suddenly that expectation changed to where no one wanted to invest and everyone wanted to sell, causing car prices to crash. (I am thinking here of the 2000 recession with the investments being equities.)
Posted by: Lord | June 13, 2014 at 01:02 PM
Lord: OK, but in that case both the price of cars, and the price of promises to pay cars, would crash equally. So the car bank's reserves and liabilities would both fall in value by the same percentage. The equity in a fractional reserve car bank would be worth more, because its other assets would not be in cars, and would presumably be worth the same. It is a rise in the price of cars that would make a fractional reserve car bank insolvent (unless it invested in shares of car producers).
Posted by: Nick Rowe | June 13, 2014 at 02:12 PM
I think banking panics may have a fundamental difference from the cold potatoes and recessions. We tend to think of the latter as continuous variables; the decrease in output or in money balances may vary continuous. Our models don't easily generate a critical threshold or discontinuity. Banking, however, has very specific liquidity and solvency constraints. Their binary nature in our models naturally give very strong discontinuities. As a result, the utility function from our use of banking services may be discontinuous; we get a pretty flat level of utility from the bank so long as it does default, but defaults cause a large discrete drop in utility. With a function like that, I might not care about your actions.....provided that they don't break the bank.
Posted by: SvN | June 13, 2014 at 02:26 PM
Yes, no insolvancy without debt, just a wealth transfer from purchasers to sellers when cars were expensive, but dashed expectations of gains and dashed wealth of purchasers could result in recession, if large enough. A run on producers but of investment and away from production rather than banks, inventory adjustment? Not sure how to describe it.
Posted by: Lord | June 13, 2014 at 03:30 PM
Simon (SvN): Hmmm. Good point. But if you have multiple banks, while there may be a discontinuity for each individual bank, there will be multiple small discontinuities for the system as a whole. Smooth -- multiple small steps -- smooth.
Posted by: Nick Rowe | June 14, 2014 at 04:01 AM
"But if cars were the medium of exchange, and unit of account -- if cars, and promises to pay cars, were used as money -- things would be very different. You wouldn't be able to buy things, without a car."
The analogy might be better if access-to-a-car would be "money", not the car itself. Thus, the car owner places his car in the car-bank and receives both interest and a promise of access-to-a-car at any time. On the other hand, a borrower goes to the car-bank and purchases access-to-a-car for a period of time. Now two individuals have access-to-a-car.
Because we have two individuals, both with access-to-a-car, access-to-a-car can be traded to a third individual, just like money can be traded.
It just occurred to me that this model sets up conditions that can be used to compare two banks, each bank using a dramatically different unit of account.
Posted by: Roger Sparks | June 14, 2014 at 10:26 AM
"And if the government could print cars for free, we wouldn't need car banks anyway. The government would just print everyone a car."
You don't live in the U. S., do you? ;)
Posted by: Min | June 14, 2014 at 01:05 PM
Roger: "The analogy might be better if access-to-a-car would be "money", not the car itself."
Yep, or better yet: if both were money.
Min: I don't get it?!
Posted by: Nick Rowe | June 14, 2014 at 02:21 PM
"But if you have multiple banks, while there may be a discontinuity for each individual bank, there will be multiple small discontinuities for the system as a whole. Smooth -- multiple small steps -- smooth."
Yes, theory says aggregating over lots of discontinuities can give you something smoothish in the limit.....IF the individual units are independent. But now suppose you have a positive feedback, so that triggering the discontinuity on one unit increases the prob. of triggering it in another......(remember, the main point of your post was precisely such externalities)....now we instead have the possibility of "domino" effects; that a small shock may sometimes set in motion a much larger reaction than the size of the unit directly affected. Methinks there's an empirical literature that claims to have documented and studied such things....and they don't seem smooth.
Posted by: SvN | June 14, 2014 at 03:19 PM
SvN: Yep. "Too Big To Fail" is one of the stupidest memes out there. "Too Interconnected To Fail", or "Too Similar To Fail" would be better. 100 small banks, all doing the same thing, are the same as one big bank. If one fails, they all fail.
Posted by: Nick Rowe | June 14, 2014 at 07:26 PM
" I wonder why people don't just rent cars instead?" I wonder why people borrow short,medium or long term. Own equities,chequing accounts,savings accounts, T-B or bonds? Same thing.
"Min: I don't get it?!" QE Nick?
"100 small banks, all doing the same thing, are the same as one big bank. If one fails, they all fail." In banking terms, yes. In political terms, as their managers would be paid 1/100 the bonus of the big bank, no. Try imagining "A wonderful life" about Lloyd Blankfein...
Posted by: Jacques René Giguère | June 14, 2014 at 09:09 PM
Nick,
Very interesting.
From an accounting perspective, your original Wicksellian roundabout is an income dynamic – i.e. GDP oriented.
Your bank run version of this extends it to non-income flow of funds in the first order of things. For example, the act of making a bank loan or the act of pulling money out of a bank in and of itself has no income effect.
It’s the knock on effect of such non-income flow of funds transactions that may end up affecting income in the second order of things. Bank runs hoard money which drops velocity. Hence “the same” type of dynamic in the end as the pure (Keynesian?) income effect, but with a different measurement starting point.
This is a point I usually make about the accounting. The “loans create deposits” chant has to do directly only with non-income flow of funds. Making a loan in and of itself does not affect income. Only if the money that results is spent on new goods and services, will income be affected.
Flow of funds (sources and uses of funds statement at the micro firm level) is the broadest accounting framing. It captures both the effect of GDP flow on balance sheet equity and asset positions (in summary form) plus the pure monetary effect of non-GDP transactions such as bank loans or bank runs.
So when you say there’s no difference, I think in effect you’re broadening your original Wicksellian roundabout from a pure income focus to a broader flow of funds perspective. That flow of funds perspective includes both pure income effects in summary form plus all of the detailed balance sheet changes that may or may not have knock on pure income effects. You're doing a broader Wicksellian flow of funds model I think.
My impression is that 'Monetary Economics' by Godley and Lavoie expands the Keynesian income framework in much the same way - to broader flow of funds effects. That includes looking a marginal propensities from both income and wealth sources. I think you know all about that though.
Posted by: JKH | June 15, 2014 at 06:48 AM
Jacques Rene: Yep. The politics would be different. More chance of regulatory capture as well? (But then Canada, with a small number of big banks, seems to have had better regulation than the US??)
JKH: thanks.
"So when you say there’s no difference, I think in effect you’re broadening your original Wicksellian roundabout from a pure income focus to a broader flow of funds perspective."
Yes. You think right.
But I also think that we should broaden our perspective on "what is a recession?" to include falls in the volume of trade in *all* goods, including things like land and old houses and maybe financial assets too, and not just trade in newly produced final goods and services. Money flows one way round the roundabout, and everything else flows round the other way. And a recession is when everything (or most things) slows down, and not just the subset that is included in GDP. My old post arguing that we should talk about the "Trade Cycle".
Posted by: Nick Rowe | June 15, 2014 at 08:06 AM
Nick,
I missed that trade cycle post.
Very interesting also.
That's a pretty profound difference in view about how to think about macroeconomics.
As in: "They all started out in the wrong place"
Explains a lot though in how you look at things.
Posted by: JKH | June 15, 2014 at 10:45 AM
@Nick
In the US there are members of Congress and Senators who don't believe that the gov't should give cars or anything else away for free, especially to people who don't deserve it. ("All those others", as Nixon so eloquently put it.)
Posted by: Min | June 15, 2014 at 01:04 PM