Economics and Banking – James Tobin 1963 (Redux)

Introduction

This essay (unlike the previous) is an unfiltered look at the famous 1963 James Tobin paper on banking:

Commercial Banks as Creators of “Money” (1963)

http://cowles.econ.yale.edu/P/cm/m21/m21-01.pdf

The Tobin paper has been the subject of recent vigorous blogosphere discussion. Steve Waldman has included a list of links at the conclusion of his own excellent post on the subject:

http://www.interfluidity.com/v2/4522.html

I have included links to several additional Tobin papers at the conclusion of this essay which may help round out the context. But the focus here is on the 1963 paper linked above.

Tobin’s essay revolves around the idea that banks are a type of financial intermediary. His generic description of bank balance sheet management holds up reasonably well today. 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. In fact, while Tobin focuses on the intermediary character of banking in his 1963 paper, he does not deny that banks are special. He does examine their special nature more intensively in a 1982 essay (noted further below), but the two perspectives are entirely complementary.

Given a set S = {e1, e2}, the element e1 is special in that it is not the same as the element e2, but general in that both e1 and e2 are members of S. Both characteristics are true, and the only question is the qualifying criterion for membership in the set S. And in this case, that qualification has to do with a Tobinesque portfolio management approach as it pertains to both bank and non-bank financial intermediaries, notwithstanding the special characteristics of banking within the intermediary group. The common intermediary quality is the focus of his 1963 essay.

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.

(Krugman has faltered tactically in a number of exchanges with heterodox bloggers because of his apparent dismissal of the relevance of bank accounting. Perhaps there is a potential middle point between presbyopia and myopia in this regard – although positions in some cases appear to be entrenched.)

Neither mainstream nor heterodox economic schools offer a very refined analysis of banking operations. But Tobin’s essay, 50 years old, is insightful on the general framework of banking – certainly more so than “loans create deposits”.

Reserve management is one of many critical functions in banking. The role of bank reserves complements the “loans create deposits” perspective – in that reserves are used for interbank payments, not for deposit creation. That said, heterodox insight on the issue of bank reserves, while constituting a degree of forward progress, is hardly the decisive qualification for understanding what banking is about. This is inherent in the message of Tobin’s 1963 essay. His framing of banks as a type of financial intermediary is a more complete conceptual framework. In that context, the fact that loans create deposits is a minor operational detail that is of very little significance to the strategic management of banks.

Banks are financial intermediaries. So are insurance companies. Banks are special. So are insurance companies. Banks are special because they issue deposits. Insurance companies are special because they issue actuarial claims. Recent blogosphere discussion seems skewed toward the special part in the case of banks. And so the phrase “loans creates deposits” seems to have produced a fresh generation of corresponding banking experts.

Tobin focuses on the set of financial intermediaries and how its constituent members – banks, insurance companies, mutual fund companies, investment firms, etc. – are similar as a group. (Tobin also reveals a great deal in the 1963 paper about how banks are special, without dwelling on this aspect as the main theme.) These similarities have nothing to do with the way in which deposits are issued by banks or used by non-bank financial intermediaries.

Tobin starts his essay with a trifecta – dismissing the false money multiplier story of banking, acknowledging that loans create deposits, and recognizing that banks obtain required reserves after the fact of related deposit creation. These are standard heterodox claims today. Tobin pointed out these facts 50 years ago! But he then sets these observations aside, and moves on to describe banking as a type of financial intermediation.

Before moving further into Tobin’s paper, it may be worthwhile to explore the idea of media of exchange.

Media of Exchange

Commercial banks are “special” at the very least because they issue demand deposit liabilities. Demand deposits are a core medium of exchange for customers of banks. We can think of the medium of exchange for bank customers as a complex of related things: demand deposits, cheques, electronic transfers, banknotes and coins. This may be insufficiently precise for those with more refined sensitivities about definitions, but it suffices here. The instruction to effect an electronic transfer from one demand deposit to another blurs the distinction between deposit and the instruction itself as the medium of exchange. (Marshall McLuhan said the medium is the message.) Is the medium of exchange the demand deposit, the electronic transmission, or the instruction? Are these things in combination a substitute for the physical transportation of central bank money from one bank account to another? To simplify these issues, we’ll refer to bank demand deposits as the core medium of exchange for commercial bank customers, with central bank money, cheques, and electronic instructions affixed to that concept.

Central Banks are “special” as well, for at least the reason that they issue reserve deposits for use by commercial banks in making payments to each other. These reserve balances are the core medium of exchange for commercial banks. Central banks and government treasuries also issue banknotes and coins, which commercial banks hold as inventories in order to satisfy customer demand. Commercial bank customers hold a mix of government money and commercial bank money according to their liquidity preferences.

Commercial banks are in general the only institutions that both use and issue different media of exchange in stock form.

(One interesting exception to this rule occurs within the Euro system. The European Central Bank (ECB) issues TARGET2 balances to the national central banks (NCBs) of the Eurozone. The NCBs use TARGET2 balances as a medium of exchange and issue reserves to commercial banks. Commercial banks use reserve balances as a medium of exchange and issue demand deposits to their customers.)

There is an important parallel to be drawn between central banks and commercial banks as issuers of media of exchange. Both issue media of exchange to their respective clientele using asset swaps. For example, central banks can issue new reserve balances to commercial banks through asset repurchase agreements or by lending directly to banks. (In recent years, with quantitative easing, the US Federal Reserve has issued additional reserves by acquiring bonds originally held mostly by non-banks. Credits to commercial bank customer accounts are accompanied by an increase in bank reserve balances at the Fed.) Commercial banks typically issue new deposits by lending directly to customers or acquiring other market assets (usually liquid securities of third parties). While the process of medium of exchange creation is sometimes described as “ex nihilo”, both entities – central banks and commercial banks – expand their balance sheets by exchanging the medium of exchange for an asset of equivalent deemed value.

Customers of commercial banks can disburse funds from newly acquired deposits in order to pay for things by using cheques, electronic transfer, or conversion to central bank money. The creation, destruction, and transfer of bank deposits works according to the rules of accounting. Individual banks issue new deposits in conjunction with the transfer of funds from other banks. The deposit at the origin of the transfer is destroyed as the new one is created. The issuing bank receives central bank reserve credit as payment from the counterparty bank. System deposits remain unchanged in this type of transfer. This is perhaps the most basic of all banking transactions, but it is interesting because the medium of exchange (the source bank deposit) is being used to acquire the medium of exchange (the destination bank deposit). Indeed, it is reflected this way in macro flow of funds accounting.

A financial intermediary category is defined according to the kind of liability business it is in. Banks are allowed to create the medium of exchange as a liability. Other intermediaries for example offer insurance or pension policies or mutual fund shares.

The core asset business of a bank is lending and the core liability business is deposits. The core asset business of an insurance company is a financial asset portfolio of securities and the core liability business is the issuance of insurance policies and pension promises. The core asset business of a mutual fund company is investment in financial securities and the core liability business is mutual fund shares. And so on. (We use the term “investment” here in its vernacular meaning of financial investment in stocks, bonds, and money market securities.)

The banking system as a whole expands its balance sheet in a single step. The coincident swapping of a newly created demand deposit liability for a new loan asset is the iconic example of such system expansion. This produces new medium of exchange.

By contrast, the NBFI system (non-bank financial institutions) as a whole expands its balance sheet in two steps. An insurance company can swap an insurance policy liability for a demand deposit asset. Using the same demand deposit, it can subsequently acquire a corporate debt or equity security as an addition to its portfolio of assets, which in total “hedges” the actuarial claims it has issued. The net result is that the NBFI balance sheet will have expanded by the value of the insurance policy as a liability and the matching value of the financial asset. No new medium of exchange is produced in these two steps.

The net effect in the case of both banks and NBFIs is that balance sheets are constructed according to asset swaps. That is the essence of financial intermediation.

Financial Intermediation

In the case of both banks and NBFIs, the role played by the medium of exchange in balance sheet expansion is just the beginning of the story. It is the operational front end of a larger and more complicated management process. That process is inherent in Tobin’s portfolio management paradigm. It is the theme of his 1963 paper.

Tobin views those who acquire the liabilities of banks and other financial institutions as “would be lenders” in a counterfactual economy without financial intermediaries:

“…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.”

Tobin’s general description of banking holds up well today. Commercial banks manage credit risk, liquidity risk, and interest rate risk, among other types of risk. They have systems for the measurement of risk and for the allocation of capital to those risks and to the individual banking businesses that incur them. There is an overarching oversight process that includes risk committees and asset-liability committees (ALCOs) undertaking regular systematic reviews of risk exposures. Strategy decisions are made about target asset-liability mixes and pricing parameters. There are internal funds transfer pricing systems to ensure that current market interest rates are reflected immediately in the interest margins that result for each separate banking business according to current asset and liability pricing. These various management components survey and steer the financial intermediation effect in its totality. Moreover, all types of financial intermediaries manage their balance sheets with such techniques of portfolio management, risk management, asset-liability management, and capital allocation.

Just as the bank lending officer ignores the reserve position in making lending decisions (a point made often by heterodox observers), risk and asset-liability managers ignore “loan create deposits”. The deposit origination process is simply not relevant to the portfolio management approach. It is an operational feature of minimal importance – according to Tobin’s strategic portfolio management description – and in fact. For example, the critical credit risk characteristic of an individual loan has nothing to do with the fact that loans create deposits. Banks are concerned with risk to net interest margins, not the fact that demand deposits are created endogenously.

The relationship between the strategic portfolio management approach and the operational endogenous money phenomenon can be explored by examining what happens to the medium of exchange after a commercial bank has issued it. What is its life cycle, so to speak? How is it used, and what becomes of it? Tobin explores this sort of thing by resorting to the analogy of the “widow’s cruse”.

Tobin’s “Widow’s Cruse” Analogy

Tobin refers to a “widow’s cruse” in describing commercial bank deposit creation. A somewhat archaic and awkward analogy, it suggests an unlimited supply of something. His point is that banks do not enjoy such a widow’s cruse capacity for deposit creation and balance sheet expansion. The widow’s cruse fails in the case of commercial banks.

Commercial banks are constrained in their deposit expansion both within their own banking intermediary category and against competing intermediary institutions such as insurance companies, pension funds, mutual funds, and investment firms. A number of factors impinge on the volume of bank deposits that can be produced and survive in final stock form. These factors operate at the original point of deposit creation, and subsequent to that point.

First, in order to create deposits, banks first must have suitable opportunities available to expand their assets. New asset originations must satisfy criteria for assuming the credit risk that is inherent in lending and asset acquisitions. Acceptable asset opportunities must be combined with a required return on equity capital. Loans are priced according to the cost of funding (including the cost of equity capital) and associated administrative expenses. The required margin translates to a capital constraint (quantity and price) rather than a reserve constraint. (Where required reserves are applicable, it is the cost rather than the availability of reserves that is a factor.) Moreover, the quantity of capital is sometimes a scarce resource. Banks can only take on new risk if they have excess capital. And this depends on their level of retained earnings and their access to new capital if required. And even in the presence of excess capital, banks may choose to use it in share buybacks rather than new asset acquisitions if the cost of equity capital is too high relative to available asset opportunities. A bank that decides on a share buyback is momentarily unconstrained by the quantity of capital but constrained in the supply of asset opportunities that meet required return on equity hurdle rates.

Second, the contractual nature of loan agreements require that they be repaid. This is a source of natural “reflux” of the medium of exchange, since demand deposits are extinguished when loans are repaid. The banking system balance sheet and medium of exchange expand on a net basis over time to the extent that asset acquisition and the corresponding “efflux” of the medium of exchange exceeds this contractual reflux.

Third, the ultimate fate of the demand deposits initially generated by asset expansion is generally uncertain even within the banking system. Banks compete within their own intermediary group for all of their desired liability forms, including demand deposits. Banks expect the deposits created by their own new lending activity to end up at other banks as the result of the borrower’s use of funds elsewhere. Individual banks are subject to continuing competitive pressures from other banks in retaining existing deposits. Demand deposits thus pose a risk in terms of both liquidity and interest rate exposure, because they can migrate easily to other banks and/or require higher interest rates to retain in the event of monetary policy tightening.

Moreover, the banking system as a whole requires demand deposits as a source of funds to convert to other liability forms. In order to avoid excessive risk, banks will attempt to convert demand deposits opportunistically to alternative funding forms such as time deposits, debt, and equity capital – so as to strengthen the risk profile of the overall funding structure for the balance sheet. (The cases of issuing new equity capital and generating equity internally through retained earnings both require demand deposit conversion.) The banking system is thus proactive in reshaping the risk profile of the original demand deposit flow created by lending and other types of asset acquisition. The default assumption that banks just sit on the fruits of their demand deposit creation is incorrect.

Fourth, the banking system competes with other financial intermediaries for desired liability forms. If an insurance company issues a new policy, it is competing with a bank that issues a demand deposit liability. This is fundamentally true in the sense that – in a counterfactual financial system without insurance companies – agents would be forced to construct their own insurance cash flows using bank liabilities. Tobin also illustrates the case where demand deposits are used to acquire insurance policies (for example). Insurers as a consequence then seek to acquire financial securities as assets and banks sell some of their liquid securities in response to that demand, resulting in the destruction (reflux) of demand deposits originally issued by the banking system. All intermediary institutions manage their balance sheets in such a competitive context, and they have considerable influence and control over their balance sheet compositions through product design, active pricing, and risk management.

Thus, Tobin essentially distinguishes between a strategic view of banking and an operational view. An operational or monetary view of banking focuses on micro transaction details – things like bank reserves and “hot potato” and “reflux” monetary behaviors. But such “hot potato” and “reflux” effects operate ubiquitously and continuously in financial markets. It’s called the flow of funds – involving the partial success and failure of the widow’s cruse in ongoing flux. As described above, the cruse can fail through limited expansion at origination, contraction at termination, internal conversion, or net sale of assets from the banking system.

Once deposits are created, the liability side of an individual bank balance sheet is in play. Funding is at risk, unless locked in from a liquidity management perspective. In the ongoing process of financial intermediation and balance sheet management, the maintenance of funding dominates the process of loan creation or extinction. Banks need to retain and attract a share of demand deposits (and other liability forms) once they have been created. They need them as an item in the ongoing liability mix and as a source for conversion into other liability forms or equity. No bank can afford to hemorrhage its share of the medium of exchange liability form as a stock item on the balance sheet.

All intermediaries are subject to such liquidity and other risks. In that sense, it is arbitrary to type a mutual fund or insurance company as a financial intermediary and a bank as not. If anything, the liquidity risk inherent in demand deposit liabilities emphasizes the importance of individual banks retaining and attracting them – notwithstanding their ability to create them. Their ability to create them is constrained by the economics of credit risk and capital management. Their ability to retain them is constrained by the effectiveness of their liquidity management. A time deposit provides liquidity and interest rate protection since it can’t be moved to a competing bank until it is converted to the medium of exchange at maturity. Debt and equity provide similar liquidity protection. Once new money is created, it becomes the object of competition within the banking system.

The Chicago Plan and its variations argued for the confiscation of demand deposit capacity from commercial banking and the ring fencing of demand deposits with a 100 per cent reserve requirement. These types of proposals tend to overlook the fact that banks have a self-interested motive to convert much of the demand deposit base that originates from lending to other liability forms for purposes of risk management. And in all of this, the operational characteristic of deposit creation is essentially irrelevant, given subsequent competition for desired liability forms.

The Interface of Government and Commercial Banking

Tobin distinguishes between the “fountain pen money” of commercial banks and the “printing press money” of government. The paper’s focus is the former. He makes the distinction between the natural reflux channels for commercial bank money, as described above, and the core “hot potato” characteristic of government money. But what he is really talking about in the latter case is the consolidated government financial position. This is the position that is popularly appreciated now in heterodox circles as the “net financial asset” position (NFA) held by the non-government sector. This position is created over time by government budget deficit efflux and surplus reflux. To the degree that the budget is exogenous, the private sector portfolio that results is a “hot potato”. But this may be debatable to the extent that there is an argument for the “deep endogeneity” of the government fiscal position.

In this context, Tobin does not illuminate the decomposition of NFA into its component parts – bank reserve balances, banknotes and coins, and government bonds. In particular, he does not discuss the scenario of open-ended structural reflux from commercial bank deposits to banknotes and coins. And that is understandable, since his paper is about an ongoing functional and viable commercial banking system.

Two related papers

Financial Intermediaries and the Effectiveness of Monetary Controls (with William Brainard, 1963)

http://www.princeton.edu/~pkrugman/tobin_brainard.pdf

The Commercial Banking Firm: A Simple Model (1982)

http://dido.econ.yale.edu/P/cp/p05b/p0564.pdf

These papers along with the one discussed here constitute a consistent treatment of the banking system as a type of financial intermediary in competition with others, and with individual banks operating as active portfolio managers.

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140 Comments on "Economics and Banking – James Tobin 1963 (Redux)"

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Tom Brown
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1. Does any of this analysis change when at the ZLB? Especially in regard to part of the motivation for banks to attract and retain deposits?

2. It sounds like you’re saying that gov bonds contribute to the “hot potato” as well as currency and Fed deposits. True?

3. Can you elaborate on this a bit?: “But this may be debatable to the extent that there is an argument for the “deep endogeneity” of the government fiscal position.”

JKH
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1. Good question. The Tobin article was not scripted for a QE environment of course. But within the banking system now, the effect would depend in part on the distribution of excess reserves and how individual banks viewed their liability management strategies in view of that. (For example, at one point, foreign banks operating in the US held a lot of the excess reserves.) Still, banks don’t want to leave all their deposits in demand form due to liquidity and interest rate risk. They still want time deposits to match off some of their asset exposure with longer terms to maturity. And it also the case that the increase in bank deposits originally generated by QE was helpful ultimately in recapitalizing the banks from private sector funds – since demand deposits are used to fund both internal and externally generated equity capital (a point I made in the post).

2. As I said in the post, Tobin was in effect taking a view of “NFA” in total (reserves, currency, and bonds) as a hot potato. In a way, you can think of the excess reserve component as a very cold hot potato – it’s not good for much more than interbank settlement, and there’s much more than needed for that purpose.

3. Yes – “deep endogeneity” refers at least in part to the fact that automatic stabilizers come into play in determining what happens to deficits.

ATR
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On 3 – I think he means that the government doesn’t fully exogenously force NFA’s on the private sector. For example, if the economy picks up, taxes rise, and private sector NFA’s are reduced.

ATR
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With respect to your critique of “DOM” as a cause of the reflexive reaction against the concept of a bank as a financial intermediary, you may be interested in this post of mine – http://macromoneymarkets.blogspot.com/2013/09/why-calling-banks-financial.html. In the context of this debate, it was my way of pulling back from my own past tendencies to perhaps focus too myopically on this feature of banking. It’s much more narrow than your post, but maybe helpful as an added perspective. I’d say much of our overlap comes down to your statement “In the ongoing process of financial intermediation and balance sheet management, the maintenance of funding dominates the process of loan creation or extinction,” which is beautifully worded. At the same time, there are perhaps some features of my post that may even push a bit (just a bit) against the nature of the ‘specialness’ you ascribe to banks in the media of exchange discussion, or at least the way that you discuss it. That said, I don’t necessarily disagree with what you’re saying, but when discussing deposits as so-called “media of exchange” (and whether “media of exchange” is a helpful classification in the first place), perhaps a bit more attention should be given to the credit qualities of deposits (their being IOUs for currency, and how that impacts the way people use them) and what banks are doing to facilitate the transactions. As JP Koning replied, a good summary of my post may be that what is “special” more broadly about banks is the concept of credit creation, but credit creation is not (or does not have to be) limited to the activities of traditional commercial banking. Moreover, your statement that I quoted above ultimately places importance on the final media of settlement, which is another way to for me to suggest… Read more »
Cullen Roche
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ATR, Nice comments. I’ve been lurking and just wanted to clarify my thinking on this stuff so you can understand where I am coming from and why. I view this stuff pretty differently than most orthodox economists who build a vertical hierarchy of money that starts with gold or reserves. This, I believe, is a remnant of the gold standard when bankers would literally hold reserves of gold and then loan out claims on the gold. The whole money multiplier concept stems from this sort of thinking except the orthodox economists neglected to correct their models for the fact that the banks don’t hold reserves and just multiply them, but actually create a more important medium of exchange in their own liabilities. I think the system has become almost entirely private and dominated by bank money. The idea that bank deposits are claims on reserves or cash is defunct in my opinion. I don’t want cash and I can’t use reserves. I am not holding some reserve at the bank that I want to go remove. In fact, my only claim at the bank is the deposit asset I hold there. And if I want to even claim cash I need a bank account FIRST. In other words, modern economists get this whole story precisely backwards by building a model around reserves or cash. As for perspectives – I think the thing that’s unique about MR is that most of us are simple market practitioners or professionals OUTSIDE of economics. I think that’s actually our biggest strength. We approach all of this from the perspective of our experiences and expertise and not the perspective of a textbook model we learned in a grad school. I think that’s a big strength. It rubs some orthodox economists the wrong way, but maybe… Read more »
Tom Brown
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What does Cullen do in his free time?

1. Chop wood
2. Run up mountains
3. Eat burritos

sounds like a full life to me!

JKH
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nice post!

remarkably similar motivation

BTW – just a thought regarding your focus (here) on the interbank rate: remember than the interbank market collapses to a net zero flow of funds effect within the banking system (interbank assets equal interbank liabilities, at least assuming a closed economy), so this may be of limited use in explaining the balance sheet position of banking relative to other intermediaries. Also, as far as the fed funds rate is concerned, that acts as a reference or anchor rate for interest rates not only within the banking system but across all financial intermediaries, insofar as all other rates are essentially credit risk and term structure extensions of the funds rate (or what is reasonably close to the same thing, the overnight treasury bill rate).

ATR
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Awesome post, JKH. The operational and strategic details behind banking that you bring to the table, and the way you tie it all together, is much appreciated. I think you also nail what the insightful and accurate components of Tobin’s paper. However, as great as Tobin is, I don’t think the paper is flawless, and in general, I personally find it a bit hard to decipher in places. For example, in my opinion, that’s a huge clarification you’re making in the “The Interface of Government and Commercial Banking” portion of your post – and well done, I might add. Tobin should have been much clearer. As another, more substantive example, I struggle with what he is trying to say on page 6. It seems he is suggesting that in order for banks to continuously expand their balance sheets in order to profitably fund new loans, they would be forced to pay ever-rising prices for other financial assets in the private sector’s portfolio in order to convince them to stay in deposits. In this conceptualization, I understand why he is saying banks do not have a widow’s cruse: despite the feature of loans creating deposits, “the ongoing process of financial intermediation and balance sheet management, the maintenance of funding dominates the process of loan creation or extinction.” In other words, banks still have to fund their loan creation business, and this form of funding becomes ever-more expensive, and thus at some point, no longer profitable. However, I do not think this is a completely accurate description of the real world. It leaves out central banks as funding sources, as well their ability to fix the cost of funding in the interbank market and at the standing facilities. Yes – solely relying on the interbank market as funding for loans may become… Read more »
JKH
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ATR, Thanks very much for your comments – very interesting and helpful. “However, as great as Tobin is, I don’t think the paper is flawless, and in general, I personally find it a bit hard to decipher in places.” I totally agree with you on this. It is not an easy read and not easy to understand. And it may well be less than perfect. The challenging thing is that he’s saying some things that are important to an understanding of the overall flow of funds in the economy, and how banking and the other financial intermediaries fit in. I’ve attempted to say things in my own way, but in such a way that I hope is not inconsistent with what he is saying, because I think he’s basically correct in his overview. In doing so, I may have said more than what he has said in certain areas, and less in others, but again hopefully not terribly inconsistent. I can say a lot more about the details, but will defer for now as the comments play out (hopefully). One way of thinking about it is that each type of intermediary and each institution aims for an “ideal” balance sheet mix in some sense. If you assume that bank loans and deposit creation “starts the ball rolling”, then it would seem to follow that if banks held a widow’s cruse, nothing would be left for the other intermediaries. But the fact that different intermediaries specialize in different liabilities means that they do end up with something. Then you just have to back up that outcome into the kinds of facilitating flows of funds that allow that to happen. Again, if you assume that banks start the ball rolling by producing the medium of exchange, something has to happen to cause… Read more »
ATR
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JKH- I’d concede that you have a stronger grasp of this paper than I do. Maybe this would clarify my confusion on Tobin:

Agree that in the real world, suitable lending opportunities and capital can be a constraint. But let’s just say there is an inexhaustible pool of creditworthy borrowers that banks would be willing to lend to at 10%, and let’s just assume they’d lend to them as long as their funding costs were below 5%. Let’s say that initially, banks have to pay depositors 3% to retain sufficient deposits to fund their lending. My interpretation of Tobin was that for banks to continuously expand their balance sheets to lend to the entire pool, they would have to pay ever-rising prices for other financial assets in order to keep the deposits. Eventually, the cost of this might exceed 5%, and thus lending is no longer profitable. Or, alternatively, banks would have to continuously increase the interest rate on deposits to retain them, and once the interest rate on deposits exceeds 5%, they’d stop lending. I’m saying that if you introduce a central bank that keeps the interbank rate below 5%, then banks would keep lending.

Am I way off in my interpretation here?

JKH
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The question I think is to what extent can the banking system issue liabilities that substitute for the liabilities of other financial intermediaries and then acquire the assets that would otherwise be held by other financial intermediaries. So think of that across insurance companies, mutual funds, etc. and what kind of pricing banks would require in order to do that, let alone getting into the liability businesses of other intermediaries. Basically, other things equal, they need to pay up on deposit interest rates (and other types of liabilities) and/or bid up the price of assets in order to induce the flow of both liabilities and assets into the banking system.

The interbank rate is just one reference rate. The liabilities in question here have to be issued to households and corporations, and must include more than just simple demand deposits given the nature of the liabilities of the other intermediaries that the banks are attempting to replace in this counterfactual. The banks can’t just offer a simple demand deposit to compete with an insurance policy or a mutual fund share. The counterfactual you’re considering is a rather massive upheaval in the financial landscape I think.

ATR
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Okay – I may or may not be having an epiphany here that is allowing me to get on the same page as you (and Tobin). However, I really need to convert your descriptions to simple, concrete examples to make sure everything is coherent (to me). Say we start a monetary system literally from scratch, and someone wants a $100 loan to ultimately buy a $100 insurance policy, and that insurance company wants to buy $100 in equity from another company. So you end up with a bank with a $100 loan asset and $100 deposit liability; a person with a $100 insurance policy and a $100 loan liability; an insurance company with $100 in equity securities and a $100 insurance claim liability; and a firm with a $100 deposit and $100 in shareholder’s equity. Let’s just assume there is one bank, but deposits can be withdrawn as cash, and it would cost the bank x% to get this cash from the central bank. The bank builds this potential cost into the interest rate on their loan. In a more complicated example, we could talk about them deciding to pay a certain percent on their deposits, or drive conversion to time deposits, etc. for reasons you discuss in the post. In any case, at these prices and whatever interest rates, let’s say the private sector is happy with this portfolio of assets and don’t desire new loans. Are you saying that, given this scenario, in order for the bank to increase its quantity of their assets and liabilities (deposits), they need to purchase either the $100 insurance policy or $100 equity security at higher a price and/or increase their deposit interest rate to acquire these assets at the same price (or maybe a combination of the two approaches)? Say they… Read more »
JKH
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A couple of loosely related points:

a) Tobin uses examples of intermediaries that are fairly close to each other in terms of substitutability of liabilities – i.e. “savings banks” versus commercial banks – which may have been appropriate for 1963 choices more so than 2013, given the proliferation of big “universal banks” in the modern system. I’ve used more differentiated intermediaries like insurance companies and mutual funds, which makes the choice of intermediary liabilities somewhat stark.

b) Tobin also tends toward referring to liquid asset sales as the compensating asset mechanism for a shift between intermediary liabilities. I think this is true at the margin, but not on a secular expansion basis. So I’ve broadened this to the list of factors I included in the post, because its unrealistic to assume that bank portfolios are the source of the assets that other intermediaries require as they expand their balance sheets.

ATR
Guest
Thanks for clarifying the example. I think I am getting it. Let me know if my comments in this post demonstrate I am in fact understanding this issue better… “Your scenario of continuous demand sort of goes against that kind of empirical norm assumption – in a way it contradicts some going in assumption about the existence of competition in the first place.” Let me try to restate where I was coming from and then try to more accurately acknowledge where I went wrong – and this is quite embarrassing. I started from a place where I was thinking of graphs that have shown the quantity of bank credit increasing over time. As such, I labeled this “a continuously increasing demand for loans.” I was thinking of “continuously increasing demand” from the standpoint of a nominal increase in bank credit, without comparing it to nominal increases in other financial assets. However, I now realize this line of thinking is not that helpful at all and if anything misleading. In the context of understanding competition among financial intermediaries, I should be thinking of bank credit as a percent of all other financial assets through time. I think this is the point you’re stressing – things need to viewed in a *relative* sense to other financial intermediaries. “Continuously increasing demand” from this more informative angle means deposits becoming an increasing share of financial assets. Tobin suggests this isn’t what is happening: deposits are staying around 15%. But if we wanted to construct a counterfactual in which they did increase, then something else would have to have changed – such as through shifting prices of financial assets to generate the corresponding portfolio reallocation. “Regarding your continuous demand assumption, remember that Tobin makes a point of noting that the trend absorption of saving in… Read more »
JKH
Guest
That all looks OK to me – i.e. you understand my point – but please know that I don’t claim to know exactly what Tobin is saying in all cases – just attempting to restate it in my own way because it sounds generally OK to me. His going in assumption is the existence of a system of competing financial intermediaries, of which banking is one. To some degree, their liabilities are substitutable and their assets are substitutable, but certainly not entirely. He does make the point for example that demand deposits are special but so are insurance liabilities – and the differentiating characteristic has more to do with liquidity and interest rate (or expected return) characteristics than with the fact that deposits are created from loans. He then considers what it would take for banks to start attracting inflows from other intermediaries. It would take more attractive interest rates on bank liabilities for one thing – and if customers of other intermediaries start cashing in their claims and moving over to bank liabilities, those intermediaries would have to sell (or mature) their assets and banks would end up buying them. But banks are not positioned to do this indefinitely because margins and ROE would end up being squeezed. It just takes a higher deposit rate to compete with an insurance policy or a mutual fund share. And there’s a limit to this sort of thing precisely because these different types of liabilities serve different purposes. It’s a pretty simple idea that’s happening all the time at the margin in a complex flow of funds world. But what happens at the margin shouldn’t be extended to an indefinite process. I think in your example, the share is 50 per cent rather than 25 per cent – consider share in the… Read more »
ATR
Guest

Actually, please see my comment below. I slightly modify my interpretation of Tobin on Page 6, in a very important way.

ATR
Guest
So two more points. First, this debate really needs to be placed in historical context. It should be known that the “loans create deposits” view of credit had been acknowledged long before Tobin, at least since the 1800s, when it was an important topic for British central banking. Thus, Tobin is responding to a particular lineage of intellectual history in his paper that he disagrees with, and there is a lot to unpack there. Secondly, I want to reiterate the points I made above about the natural rate and a general equilibrium approach to money. I am fairly certain this is the position from which Tobin is writing, and so indeed, many assumptions are going unstated – but they can be identified through the explanations and language that Tobin is using. To the extent that these subtle hints are motivating certain participants’ adverse reactions to the Tobin’s paper, there is a legitimate point of contention here, although some of these participants may not be communicating them clearly and/or making tactical mistakes on other dimensions (as you noted was the case with Krugman). It also needs to be known that one of Tobin’s major contributions was to incorporate money into the general equilibrium models that had been denominating the econ profession. This is why Mehrling views Tobin as one of the founders of “monetary Walrasianism,” and in this way, he could definitely be considered “neoclassical.” Tobin united money with the concept of general equilibrium by inserting into these models the portfolio choice theory that has been discussed here. While this theory may have independent and significant value to understanding the world, it should be placed within the greater context of Tobin’s world view. Tobin recognized that the central bank could control interest rates, but he believed that it was the central… Read more »
ATR
Guest

Tom – I think this is just semantics, and/or I should have been clearer. What he is saying is that the central bank has no choice but to set the interest rate to the natural level, unless it is willing to let the economy spiral into oblivion. In this sense, the interest rate is “endogenous.” Along the lines of how JKH used the concepts of “operations vs strategy” here, there is an analog in the broader topic of monetary policy. From the perspective of pure monetary policy operations, the interest rate can be viewed as exogenous (this is what Nick Rowe is referring to as the short-run). However, from a strategic perspective, Nick Rowe views it as endogenous, since the strategic perspective has in mind a model that tells the central bank what it must do to achieve its objectives.

I’m going to do a post on operations vs strategy in the context of monetary policy. There are some good resources out there that make these distinctions and define terms clearly, and if these conventions were adopted in the blogosphere, there’d be much more clarity in these debates.

Tom Brown
Guest

BTW, where should I look to see your future post on this subject (I have another comment awaiting moderation here).

ATR
Guest

Okay, I put the post up. Not sure how helpful it is or will be ultimately… I think it is a nice way of viewing things, however.

http://macromoneymarkets.blogspot.com/2013/10/monetary-policy-implementation-vs.html

JKH
Guest
Nice post. Your framework looks well thought out. A couple of quick fire comments (which probably don’t do justice to the thoroughness of your post): The vocabulary framework is a difficult challenge. I find there’s usually more natural fluidity in the use of terms than is “fixed” by a chosen framework for their meaning. E.g. another way of breaking it down is between policy and strategy, with strategy subdivided between strategy formulation and strategy implementation. And strategy formulation can be fluid between the policy making group and the implementation group. So I think of the connections as being fluid. E.g. the FOMC is a policy and strategy setting group; the New York Fed open market desk is an implementation arm. But the desk certainly has a “strategy” for implementing the timing of its actions even on a daily basis, within higher parameters assigned by the FOMC. I think the models are inputs at the policy/strategy formulation level. Moreover, there is a parallel organizational concept in commercial banking, inherent in starting with the top-down risk and ALCO committees that I referred to in the post. Bindseil: “In principle, monetary macro-economists in central banks do not need to understand monetary policy implementation and, symmetrically, implementation experts do not need to understand much about monetary policy strategy and the transmission mechanism.” I think this is dangerous, and not true, at least not to the degree inherent in the statement. Try telling that to the head of the New York Fed SOMA desk (who I believe has been known to make speeches about the connection between policy/strategy formulation and implementation). And the same caveat holds for the commercial banking parallel. Finally, IMO, NGDP has about as much chance of being elevated from indicator status to target status as does the possibility of returning to… Read more »
ATR
Guest
Thanks. Not my framework though – Bindseil’s :). “The vocabulary framework is a difficult challenge. I find there’s usually more natural fluidity in the use of terms than is “fixed” by a chosen framework for their meaning.” These are good thoughts for sure. As I noted, I’m sure alternate versions can exist and be just as valid. That said, I do think there may be some value in an appropriate level of ‘fixing’ to the extent it allows people to stay on the same page – i.e., for clarity and ease of use. Your suggestions makes sense, although it seems to ultimately come down to allowing one to use the particular word ‘strategy’ in context of what the open market desk does. I don’t disagree with the way you’re conceiving it, but it does seem to be somewhat of a semantic choice at maybe some loss of clarity? Anyways, I have no need to be wedded to any one particular approach at this point. Really just threw this out there since it is not discussed much, and thought it was interesting coming from a central bank operations guy himself. So I appreciate your comments and critique, and will continue to mull them over. Ultimately, I think it comes down to clearly defining the terms at the outset, but perhaps I’ll find your way is more useful in the end. “I think this is dangerous, and not true, at least not to the degree inherent in the statement. Try telling that to the head of the New York Fed SOMA desk (who I believe has been known to make speeches about the connection between policy/strategy formulation and implementation). And the same caveat holds for the commercial banking parallel.” Agree it is definitely a controversial and provocative statement. Also agree it is… Read more »
ATR
Guest

BTW, what do you conceive of as being in the realm of ‘policy’ vs the others in your framework? Perhaps I’ll put some graphics in my post, clearly connecting all these thoughts together. Same with Fullwiler’s conceptualization, which uses tactics, strategy, and policy.

ATR
Guest

Great, thanks, I’ll see what I can do.

JKH
Guest

I don’t have it as formalized as you or Fullwiler have developed.

But I’d say roughly that the monetary policy framework for central banking is the organization of thinking for monetary policy as macro risk management – inflation risk, employment risk, use of indicators, use of the policy rate, use of QE at the zero bound, etc. The strategy is the specific application in the context of the prevailing economic environment at a point in time. I would include the FOMC post-meeting statement as a core description of strategy. The implementation of strategy then follows at the level of the open market desk. You’ll note that the FOMC statement typically refers to instruction provided to the open market desk.

Similarly, the comparable policy framework for commercial banking is the organization of thinking for bank risk management – liquidity risk, credit risk, interest rate risk, market risk, etc. A key part of it is the methodology for risk measurement and capital allocation. The strategy is the application in the context of the prevailing economic environment. A bank ALCO (asset-liability committee) is analogous to the FOMC in this regard, in the case of non-credit risks (a separate process is used for credit risk). ALCO strategy is handed off to the bank’s Treasury function (and other portfolios where relevant) to implement.

While acknowledging the detailed thinking that’s gone into Fullwiler’s framework, I don’t particularly care for it. For one thing, I dislike including the term “tactics” in this sort of conceptual approach. (Maybe he uses “tactics” for the implementation of strategy – not sure.)

Some of this is semantics – but remains interesting as a way of describing how all this stuff works.

Roger Sparks
Guest

ATR
Thanks for your post.

http://macromoneymarkets.blogspot.com/2013/10/monetary-policy-implementation-vs.html

I would recommend it, for several reasons, principally for pointing out the gap between theory and practice . The issues you discuss range well beyond this however, and the discussion serves to help the reader embrace the tentacles of central bank monetary practice.

ATR
Guest

Thanks. I’d note however, that it seems that the gap is in the process of closing, although the pace at which it is probably varies depending on your perspective.

ATR
Guest

Also, JKH, the footnote was in large part inspired by your reflections on popular economic methodology in the past. You may find the corresponding quotation and part of the post to be interesting in this respect.

ATR
Guest

I recently started a blog. I linked to it in another comment that is waiting in moderation, since I have already written a post that’s related to this discussion: http://macromoneymarkets.blogspot.com/2013/09/why-calling-banks-financial.html .

Tom Brown
Guest

I don’t disagree w/ that. It seems to me that if the CB is really targeting an exogenous target inflation rate, that doing it through adjusting overnight interest rate targets every six weeks is just a technical detail. If sufficient “sensors” existed in this feedback control loop to make good instantaneous estimates of the inflation rate at any point in time, then the six week fixed overnight rate could be dispensed with as an intermediate target and inflation targeted directly in terms of daily or hourly OMOs.

Actually JP Koning and commentator “DOB” (who’s a fan of NK models along the lines of Woodford I think) get into a discussion related to this here (ignore my comments!… DOB and JP carry the bulk of this thread):

http://jpkoning.blogspot.com/2013/09/woodfords-forward-guidance-vs-forward.html?showComment=1379521718202#c2136775628713703705

Tom Brown
Guest

ATR, just to be clear though, both Sumner and Rowe agree with this statement (the statement is actually Rowe’s):

“Tom: thanks, but that’s not quite right. Under inflation targeting the quantity of money is endogenous in both the short run and the long run. It’s the nominal rate of interest that is exogenous in the very short run (6 weeks or less, for the Bank of Canada anyway), but endogenous in the long run. ”

1st comment here:
http://brown-blog-5.blogspot.com/p/links-to-remember.html

So that says to me that with some OTHER exogenous target (say the inflation rate or NGDPLT), that the rest of these variables including the quantity of inside and outside money and interest rates or endogenous: it’s a feedback loop, so there’s a circular causality. Only the “exogenous” target is not part of the loop.

Tom Brown
Guest

Should read “rates are endogenous” not “or”

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