Monetary Realism

Understanding The Modern Monetary System…

Krugman and Tobin on Banking

Paul Krugman cites a 1963 paper by James Tobin in the process of clarifying his own view of how banks should be considered as part of the broader financial system:

“All the points I’ve been trying to make about the non-specialness of banks are there. In particular, the discussion on pp. 412-413 of why the mechanics of lending don’t matter — yes, commercial banks, unlike other financial intermediaries, can make a loan simply by crediting the borrower with new deposits, but there’s no guarantee that the funds stay there — refutes, in one fell swoop, a lot of the nonsense one hears about how said mechanics of bank lending change everything about the role banks play in the economy. Banks are just another kind of financial intermediary, and the size of the banking sector — and hence the quantity of outside money — is determined by the same kinds of considerations that determine the size of, say, the mutual fund industry.”

The object of the professor’s displeasure appears to be a presumed blogosphere meme that allegedly uses the mechanics of bank lending as the rationale for characterizing a unique role for banking within the financial industry and the economy. And while it is possible that some of those he has previously characterized as banking “mystics” are conflating lending mechanics with some fundamental role for banking, others may be making separate but connected points about these two dimensions of banking quite legitimately. So we should unpack these things and then examine the effectiveness with which Professor Krugman’s channeling of Tobin (Krugman/Tobin for short) refutes the importance of either of these dimensions, whether considered separately or jointly.

First, consider the aspect of bank lending mechanics. This no doubt refers to the general statement that “loans create deposits”. So why do people make this simple point? In most cases, it is made in conjunction with a rejection of the old money multiplier idea that the central bank must supply reserves before a commercial bank can make loans. That said, there is indeed an ambiguity in that association, because the money multiplier even as an incorrectly described process itself features “loans create deposits” or at least can be interpreted that way. Accordingly, the full statement in this context should really translate to “loans create deposits without the necessity of prior reserves”. That is the point being made. And why is that point important? Because understanding how banks work is better than misrepresenting how they work, as has been done in economics textbooks over the last several generations by referring to this particular issue using the false money multiplier model. Indeed, such a view is presented in the Robert Hall paper assessed by Mathew Kline, as referenced in the Krugman post. Moreover, understanding this point is essential in even beginning to interpret the effect of the Federal Reserve’s quantitative easing process in a way that is logically correct. This point has been covered enough elsewhere for purposes here.

The Tobin paper itself refutes (in at least one part) the false causality of the textbook money multiplier, which is good to see for a paper written in 1963. So Krugman can’t be refuting anything so far, using Tobin.

Second, consider the claim that banking is unique. I can think of perhaps one blogosphere case where this issue has been tightly bound with “loans create deposits”, and that case is largely a matter of presentation style. But consider the aspect of banking uniqueness more generally. There is definitely a role for banking that is unique in finance and economics. A good description of it permeates the book Monetary Economics by Wynne Godley and Marc Lavoie. This has to do with the critical role of revolving bank loans used in the financing of business inventories. Indeed, this aspect is expressed in a formal way through the interpretation and adaptation of circuit theory within a post Keynesian context. This aspect is essential to understanding the critical role of banks in economic expansion. It is true in advanced G&L models, and it is true in the real world. In general, workers must be paid before they can buy the output of the economy. The rudiments of circuit theory help explain how that happens through bank lending and deposit creation. Economic expansion requires banks. Krugman/Tobin doesn’t touch on this essential process. If it did, it would negate its own conclusion.

Now, consider how Krugman/Tobin attempts to refute the importance of these aspects of banking – whether conflated or separate.

The main point made by Krugman in his post and in the Tobin paper to which he refers is a strangely benign one. The general point made in the Tobin paper is that banking expands in the same way that other financial intermediaries do – according to economic opportunities. But who is denying this in claiming the importance of either aspect of banking above? It is surely an obvious point to those who have unpacked the two ideas that Krugman considers jointly. Somehow, the grand conclusion of Krugman/Tobin seems to be that banks must price their loans and deposits in such a way that banking can be an economically viable enterprise, in the same way that other institutions price their assets and liabilities toward the same objective. Again, who would think otherwise, in that general sense?

Krugman/Tobin seems to imply that those who observe “loans create deposits” are sufficiently short sighted to think that this point having been made is also the end of the process. In other words, that these loans and deposits once they’ve been created should remain on bank balance sheets forever. Who would think such a thing? It is interesting that the perception of the intellectual damage done by “loans create deposits” itself doesn’t consider the possibility that the reverse mechanics are equally obvious to those who make the initial point – i.e. that deposits are regularly used to pay down the loans that originally created them, and that in this specific context it is also true that deposits may be used to “destroy” loans. It is interesting if not amusing that those who don’t directly acknowledge what goes on in bookkeeping terms when a prospective borrower goes into a bank branch and successfully negotiates a bank loan then proceed to double up by looking away from what goes on when the same person returns to repay his loan. The idea that deposits are used to pay down loans is not only common place in real world banking, but it is also fundamental to formal circuit theory and its application within post Keynesian economics. What Tobin would not have been in a position to be aware of 50 years ago is that is that the focus of modern post Keynesianism makes this dynamic crystal clear in a rigorous accounting sense – an accounting presentation that covers a galaxy of institutional possibilities with flow of funds analyses that extend Tobin’s succinct summary of same in much more detail. However, in the hubbub of considering this overall financial flow of funds, we are led to believe by Krugman/Tobin that those who understand that loans create deposits don’t understand that deposits can destroy loans in the process of loan repayment.

In fact, Tobin’s description of this essential process is somewhat roundabout, not really identifying the necessary micro accounting that records such flows as they traverse the banking system. Tobin summarizes the macro flow of funds between different financial intermediaries in adept fashion, but without referring to the bookkeeping that must occur within the banking system when a deposit “leaves” a given bank or “leaves” the banking system in its entirety. For example, a deposit cannot “leave” the banking system without some corresponding reduction in a loan or other asset, or some corresponding increase in a non-deposit liability or equity capital – those types of entries being made within the same banking system that the deposit previously occupied. Indeed, this is an example of a required “quadruple entry” accounting constraint under such conditions. We leave the associated task of detailing the corresponding pairs of double entry accounting as an option for commenters, where perhaps it may be seized upon with enthusiastic fervor. This is not hugely difficult, and it is a good complement to that other necessary requirement for economic coherence – accurate central bank accounting.

Tobin makes the point that the banking system expands in such a way that deposits account for only 15 per cent of household wealth. Something happens relative to a counterfactual in which all new saving flows into deposits created by loans. This reflects a straightforward feature of banking system expansion. Individual loans get repaid (or default) but the system still expands. It’s analogous to the job market. The monthly flow of actual gross job creation and gross job destruction is far greater than the flow of net job creation. And similarly for international capital account flows – the gross flows exceed the net flow that matches up with the current account balance. Again, accounting plays an essential role, and such accounting is the stock/flow in trade for the broader post Keynesian object audience (implied knowingly or unknowingly) of Krugman’s criticism.

So we are led to believe that understanding the expansion process described by Tobin/Krugman dominates the relevance of the observation that loans create deposits – because in effect those who make the point that loans create deposits are assumed not to understand that deposits can and do destroy loans in the process of loan repayment. One might be forgiven for assuming that this is intended to characterize certain provocateurs of “loans create deposits” as being members of a particular savant club.

As a side issue, it is unclear what the importance today is of the point being made by these Tobin papers (mostly Tobin Brainard) with regard to their microscopic examination of the “monetary control” effect of required bank reserves or deposit ceilings in 1963. Required bank reserves are a tax in effect, working essentially through price rather than quantity, as the central bank supplies the quantity of required reserves to the banking system after the deposits that generate the requirement are created. On the more relevant pricing front, required reserves increase the overall expense associated with the economics of making a bank loan. Other expenses include such items as employee compensation, the interest rate paid on deposit funding, income tax, and the cost of equity capital. All of these things need to be taken into account in determining break even pricing for a bank loan, so that all expenses including the cost of equity capital are adequately covered. These are things that determine whether a loan that is being considered is actually made by a bank – not the quantity of immediately available bank reserves (in either required or excess form).

Required bank reserves are a form of “monetary control” (Tobin’s language) that have a tightening effect on monetary conditions, in the sense that they push up the interest rate at which loans can be done on economically viable terms, compared to the counterfactual. And the fact that currency may move back and forth between public holdings and bank reserve holdings as a function of interest rate levels is an intriguing analytical curiosity, and one that complicates the calculus of determining the effect of monetary controls, but one of little importance to today’s monetary system and the implementation of central bank policy. Importantly, risk weighted capital measures along with capital adequacy regulations are the modern banking system’s natural successor to these old reserve requirements. In conjunction with that, some countries at the top of their monetary game (e.g. Canada) have recognized the essential role of bank reserves as settlement balances, and when considering that along with technological advances in payments systems, have decided to eliminate required reserves. Excess reserves and their correct interpretation (pre-2008 and QE) are the only real reserve game in town.

In other words, this all seems obvious in the context of what is being analyzed more broadly by many of those at whom the professor is taking full or partial aim (it’s hard to tell who is whom in the cavalcade of assumed culprits). But dusting off Tobin from 50 years ago (admittedly two excellent papers in reference here) just isn’t absolutely necessary in this context, given an accurate understanding of how the modern banking system operates. And the mere fact that Tobin categorizes banks as one type of financial intermediary obviously suggests that there is a common element in that particular scheme – which is what Tobin describes. Great. We can all agree on that commonality and the way in which it captures the mode of setting economic objectives and the corresponding pricing behavior of financial intermediaries in a general way. But this commonality in no way logically negates the elements of uniqueness in banking or their importance.

All this being said, there are some interesting additional points to be made about Tobin-Brainard, although a detailed review of this paper must be deferred to a future post.

First, it is critical to recognize that the model simplification employed in Tobin-Brainard assumes that all government liabilities pay a zero rate of interest – currency, bank reserves, and debt. While this is no doubt done to make orthogonal points about commercial banking with more clarity, it raises enormous questions about the entire framework for “monetary control” being used in that paper. And it has significant implications for the measured effectiveness of monetary controls in that context. Said another way, the absence of a positive interest rate possibility for the fed funds target rate in such a model invites serious questions about why the primary interest rate in the economy is not considered more realistically in its standard role as a mechanism of monetary tightening and easing – in contrast to the core role that the authors employ in the case of currency used with great leverage in a zero interest rate model. That said, I see no reason why the analysis of reserve and interest rate ceiling effects wouldn’t hold in a more complex and realistic model regime of non-zero government interest rates. But with that change the story surely advances in complexity and emphasis, just as the methodical model development in Godley-Lavoie illustrates a step-wise evolution from a starting point of a simple model that bears some resemblance in construction to that of Tobin-Brainard. This consideration should be combined with the more comprehensive importance of bank capital management in determining the fuller scale of “monetary control” in today’s banking system.

Second, we should note something briefly about the contrast between the Tobin and Godley-Lavoie frameworks for banking analysis. (This is very much a personal opinion.) Tobin-Brainard employs a general equilibrium model of portfolio balancing. I think Godley-Lavoie is compatible with this approach, although Godley-Lavoie seems to dispute this to some degree. At least that is my rough interpretation of it. I think Tobin-Brainard is compatible as a model with the modern approach of banks in their strategic balance sheet management, using risk management, pricing and other comprehensive portfolio strategies. I also think that Godley-Lavoie is an enormously sophisticated and accurate view of the logic of actual bank operations as modelled. That operational view is consistent with depicting outcomes of strategic balance sheet management. I see these two different views therefore being compatible rather than conflicting.

Returning briefly and finally to the Tobin paper on money creation, it is obviously a very good one and an important one historically. But it doesn’t refute the intellectual usefulness of points made by those today who correctly observe that central banks provide required reserves after the fact, or that bank finance is essential to economic expansion. The observation that banks are like other financial institutions is obviously implicit in their categorization as one type of financial intermediary. But that this idea should somehow disprove the relevance of the observation that they are unique according to the intended context and meaning of the phrase “loans create deposits” is very strange. Banks are different in the ways described, and these are important differences for the reasons described.


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195 Responses

  1. Ramanan says

    Seen in the light of this discussion, it seems that Nick Rowe is in constant denial of the fact that his monetarist hot potato story is a fantasy.

  2. JKH says

    That all makes sense. Stocks are the same as or different from flows in the sense that they are cumulative flows. Flows are the same as or different from stocks in the sense that they are differential stocks. Sort of trivial calculus type stuff where sameness or difference depends on what you want to emphasize. Still, its probably more common to talk about the demand for money as a stock demand (i.e. outstanding quantity as per monetarism) than it is to talk about the demand for loans as a stock demand. Yet the logic is probably the same in terms of the calculus of stocks and flows. Maybe we should attribute it to monetarist bias in flow of funds interpretation.

  3. Ramanan says

    Should have said although it makes sense to talk of flow demands versus stock demands, it’s just that Nick Rowe seems to be using that in a strange way.

  4. Nick Edmonds says

    As I said, I think he was thinking about gross flows vs. net flows and I based that on the bit (in his crossed out text) where he says:

    “….just because someone wants to accept money in exchange for an IOU doesn’t mean he wants to hold a bigger stock of money…”

    I interpret this as saying that just because someone accepts a positive flow of money on one transaction doesn’t mean that they want an overall net positive flow of money in the relevant period. Which is a gross vs net issue.

    But maybe he meant something different.

  5. Nick Edmonds says

    Yes, I think some demands are easier to understand in terms of their stock implications than their flow implications. So the demand for money (or inventories) is best understood by thinking of the stock that people wish to hold. My point was really only the perhaps rather the obvious one that if you have a stock demand that implies a flow demand.

  6. JKH says

    what do you think NR means by it?

  7. Ramanan says

    I’d say one can make a distinction between flow demands and stock demands. This is neater for things which are pure flows and have no stock counterparts – such as consumption. So one can think of consumption demand which is a flow demand.

    Such distinction is made for example by Kaldor for defining aggregate demand where aggregate demand is flow demand or “outside demand” in this case while “inside demand” or demand for inventories is a stock demand.

    But for things such as money which is both a stock and a flow (i.e., change in money held) that distinction isn’t that important.

  8. Nick Edmonds says


    Flow demand and stock demand should really amount to the same thing.

    The stocks everyone starts any period with are given, whether that’s loans or money. The flow (net flow that is) determines the stock you finish the period with. You can view the demand as being the demand for a flow or demand for a stock, but one implies the other, so it doesn’t make any difference.

    If anything, I think the relevant distinction in the crossed out bit of Nick’s post is between gross flow and net flow, i.e. just because someone is prepared to receive a gross amount of $1,000 for goods, say, doesn’t mean they want their money balances to increase by that amount.

    Having had a quick look at what you’re doing on your blog, I’d say you’d find Godley / Lavoie invaluable.

  9. JKH says

    Yeah, I think that’s right. You have to be very specific about the institutional setting and circumstances. Its more a matter of using those words in the description of particular cases than trying to define what those words mean in categorical terms. The latter is just too difficult. Maybe it’s like case study in law.

  10. JKH says

    Interesting question – I don’t know. Probably not. You have to be quite invested in the idea that institutional arrangements matter to even pick up the book , and that seems to be a violation of most of mainstream economics (see my quote from Coase above). And it is a fairly significant time investment to try and make it through the entire book. There are a lot of matrices, and many different models. The models are like different slices of the economy under different assumptions, but they’re all coherent with respect to how they fit together as a whole.

  11. Tom Brown says

    Also, just to be clear JKH, is it your view that HPE and Law of Reflux are both partially true wrt common types of money (broad & base)? It’s not fully one way or the other due to a host of factors? Would that be fair?

  12. Tom Brown says

    Do mainstream macro people read it? (not that it will influence my decision to buy it). I googled “Godley themoneyillusion” for example, and one of Sumner’s readers was encouraging him to read it. He didn’t poo poo it… just said it was too complicated… and that he prefers simple models. I guess I was glad his response wasn’t “I would never read that muddled garbage!” I was also looking for evidence of Mark Sadowski referring to it… but didn’t find any. (He sure doesn’t think highly of the RBC people though! Shoot!). I was just curious if a self respecting MMist, traditional monetarist, or NKer would read it.

  13. JKH says

    You should get the book.

  14. JKH says

    On G&L, you’ll see an enormous difference between it and the type of discussion at NR’s. The latter can be very interesting sometimes, but it never seems to end, IMO. It seems like participants are always inventing new models on the run, forever. The overall tone of G&L is very conclusive in terms of some of the logic that the authors know must hold in the relationship between behavior and feasible accounting (i.e. real world) outcomes. They obviously don’t know everything, but its refreshing to get through each chapter and see some decisiveness about the explanation rather than unending brain scratching.

  15. Tom Brown says

    OK… I’m OK with linear algebra and matrix notation if that’s what you mean by “matrix notation.” Thanks for the feedback.

  16. Tom Brown says


  17. JKH says

    Best tested at a barbecue to see if anybody starts refluxing potatoes over the fence and into the neighbours back yard.

  18. JKH says

    I don’t know what he means.

    One thought – once money is created by loans, it becomes a homogenous thing used for transactions. People want a certain amount of it in their asset portfolios but no more. So any excess stock becomes a hot potato (according to the hot potatoists). The demand for the amount of money is the demand for a stock amount within a portfolio. Get rid of the rest.

    The demand for loans is a flow demand in the sense that each new loan creates a flow of new money for a specific purpose. It’s more difficult to say there is a stock demand for loans because the outstanding aggregate portfolio of loans is very heterogenous. And people don’t “use” the stock of loans the way they use the stock of money. The stock of money is subject to a turnover velocity as its being actively used in the economy. The stock of loans is just a record of the origination of loans and money. It’s a record of flow demand whereas money is a “live” stock demand.

    But I don’t think this is a hugely important thing to emphasize.

    On G&L, I think it’s an excellent investment. It’s not a particularly easy read, IMO. There’s an enormous amount of matrix notation throughout the book – which turns out in effect to be expressions that summarize balance sheets and income statements. It’s a lot of macro accounting without debit and credit language, so it can be tedious. But the accompanying text is very rich in insight as to the logic of how the monetary system works. I think anybody that uses it has to spend a long time with it and read it gradually.

  19. Tom Brown says

    … or how about an online game with real money stakes (to get people to play). Anybody use that kind of thing for doing “experimental macro economics?”

  20. Tom Hickey says

    Exactly. Business people — entrepreneurs and managers — read Peter F. Drucker rather than Milton Friedman. And they also read John Kenneth Galbraith, who the economics profession didn’t consider a real economist because he eschewed models in favor of narrative. While theoretical economics was mostly dropped from the curriculum of business schools, accounting, finance, and decision theory were emphasized as especially useful tools.

  21. Tom Brown says

    Is the HPE something that could be tested in a kind of economics laboratory? Seems like a possibility to me. (i.e. get a bunch of students in a room, and run some kind of a “laboratory” test on them… some kind of miniature economy).

  22. Tom Brown says

    Ramanan, JKH, and Nick: Thanks so much for your comments and insights! It’s nice to get some hint from you that “it’s more complicated than they’re making it out to be.”
    And let me tell you something else… you guys are in luck because I had a LONG rambling, philosophical response written out exploring my thoughts on “head of a pin,” varying degrees of hotness in a whole sack of potatoes, where I thought each party had oversimplified or where they were talking past each other (in Glasner’s debates)… including links to examples, bad jokes and everything… and then I clicked on JKH’s Godley-Lavoie link above and whoosh! it was gone! The short version is that I think I understand Nick Rowe a lot better now, but at the same time have a better feel as to his oversimplifications. The same can be said of the other parties to some degree or another. Although I enjoy the “head of a pin” rationalism these MM/NK debates entail, and their fun stories… in the end it doesn’t substitute well for a more rigorous approach. I think the time has come to bite the bullet and look at Godley-Lavoie. But I have NO formal education in economics… is it a book someone like me can just pick up and start reading? … or is there a prerequisite or two or three or four I should start with?

    I’ll leave you all with one last question regarding Nick Rowe’s stance (there are SO many articles to choose from):

    The most interesting part of this post seems to be the part he wrote in strike through and didn’t finish (containing this bit):

    “Does this mean the stock of money is demand-determined? Absolutely not, because the demand for bank loans is a flow demand for loans, and the demand for money is a stock demand for the medium of exchange, and those ain’t the same thing…”

    What do you suppose he was getting at there? What does he mean a “flow demand?”

  23. JKH says

    This is the truth:

    “Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship. The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate.

    That was not the case in the past. When modern economics was born, Adam Smith envisioned it as a study of the “nature and causes of the wealth of nations.” His seminal work, The Wealth of Nations, was widely read by businessmen, even though Smith disparaged them quite bluntly for their greed, shortsightedness, and other defects. The book also stirred up and guided debates among politicians on trade and other economic policies. The academic community in those days was small, and economists had to appeal to a broad audience. Even at the turn of the 20th century, Alfred Marshall managed to keep economics as “both a study of wealth and a branch of the study of man.” Economics remained relevant to industrialists.

    In the 20th century, economics consolidated as a profession; economists could afford to write exclusively for one another. At the same time, the field experienced a paradigm shift, gradually identifying itself as a theoretical approach of economization and giving up the real-world economy as its subject matter. Today, production is marginalized in economics, and the paradigmatic question is a rather static one of resource allocation. The tools used by economists to analyze business firms are too abstract and speculative to offer any guidance to entrepreneurs and managers in their constant struggle to bring novel products to consumers at low cost.

    This separation of economics from the working economy has severely damaged both the business community and the academic discipline. Since economics offers little in the way of practical insight, managers and entrepreneurs depend on their own business acumen, personal judgment, and rules of thumb in making decisions. In times of crisis, when business leaders lose their self-confidence, they often look to political power to fill the void. Government is increasingly seen as the ultimate solution to tough economic problems, from innovation to employment.

    Economics thus becomes a convenient instrument the state uses to manage the economy, rather than a tool the public turns to for enlightenment about how the economy operates. But because it is no longer firmly grounded in systematic empirical investigation of the working of the economy, it is hardly up to the task. During most of human history, households and tribes largely lived on their own subsistence economy; their connections to one another and the outside world were tenuous and intermittent. This changed completely with the rise of the commercial society. Today, a modern market economy with its ever-finer division of labor depends on a constantly expanding network of trade. It requires an intricate web of social institutions to coordinate the working of markets and firms across various boundaries. At a time when the modern economy is becoming increasingly institutions-intensive, the reduction of economics to price theory is troubling enough. It is suicidal for the field to slide into a hard science of choice, ignoring the influences of society, history, culture, and politics on the working of the economy.

    It is time to reengage the severely impoverished field of economics with the economy. Market economies springing up in China, India, Africa, and elsewhere herald a new era of entrepreneurship, and with it unprecedented opportunities for economists to study how the market economy gains its resilience in societies with cultural, institutional, and organizational diversities. But knowledge will come only if economics can be reoriented to the study of man as he is and the economic system as it actually exists.”

    Ronald Coase

  24. Nick Edmonds says

    The problem I have with the hot potato analogy is that gets used as what the philosopher Daniel Dennett calls an “intuition pump”.

    The analogy is usually used within a simple imaginary economy with a very limited financial sector, often just goods and money. In that context, it is easy to be convinced by the idea of people only accepting money so they can pass on it on for real goods – no-one wanting money for money’s sake.

    The idea is not nonsense – I’d even go so far as to say it is a useful conceptual tool. But I think great care has to be taken in extending it to the real world. In real economies, there is a whole spectrum of financial assets, some more money like than others. Importantly this is not a fixed spectrum of assets – it morphs in response to the monetary environment, with new types of assets created or modified in response for need. When we conceptualize the hot potato story, we imagine that both the amount of money in circulation and the amount people wish to hold are given. In the real world, there is too much going on for that to hold.

    So there is some truth behind the hot potato story. But to understand it in a realistic context, it needs a more complete framework. As Ramanan says, Godley / Lavoie provides good examples of exactly that.

  25. JKH says

    interesting discussion there

    but at the end of the day, it seems in considerable part like monetarist angels dancing on the head of a pin

    notice how many of the exchanges end up being disagreements as to the meaning or definition of terms – i.e. circular discussions

    instead of following through on various scenarios in specificity

    ALL of which can and should be depicted in accounting terms

    there are also a few errors, like this one by Glassner in comments:

    “Bill, Sorry, but I don’t seem to be getting your point. The Fed is paying interest on reserves, so banks are more than happy to hold whatever amount of reserves the Fed chooses to create. The reserves are not a “hot potato” because banks are happy to hold any reserves the Fed creates. I am not saying that this results in an equilibrium, just that there is no hot potato effect.”

    overlooks the fact that the Fed must pay interest on excess reserves to set a lower bound for fed funds – and funds would go to zero without that – which means the interest rate argument is moot in terms of its role in anti-hot potato

    (the current difference between 25 bp and 0 is not relevant; its done for operational reasons in consideration of NBFI interest margins)

    But not to be too cynical about technique, because its quite an interesting discussion in terms of content

  26. Ramanan says

    Thanks Tom. Will read.

    I think I am reaching a conclusion that people believe in the quantity theory of money because they do not know the alternative to this hot potato well (even though they don’t know what hot potato itself is well).

    Also is the Basil Moore view which has no Tobinesque mechanisms at all and in which bank deposit holders non-volitionally lend the deposits to banks. A bit artificial.

    Funnily Steve Keen who talks a lot of endogenous money also doesn’t know the mechanisms and there is still excess money. It’s just that he knows it isn’t right to assign causality from money to prices.

    The best way to look at all this is via the models of Godley/Lavoie and one can see these things precisely. Tobin had attempted this but his analysis was not complete plus he had the neoclassical theory of prices and profits.

  27. Tom Brown says

    Thanks Ramanan… doing my best to digest. Interesting comment about what works in macro and blaming gov. I’m reading this right now:
    It seems there’s three opinions there:

    Nick Rowe/Bill Woolsey: bank & base money can be hot potatoes (anti-Tobin/anti-equilibrium/pro-disequilibrium)

    David Glasner: base can be hot potato, bank cannot (pro-Tobin/anti-Yeager/pro-equilibrium)

    Mike Sproul: no hot potatoes (Law of Reflux always works for base & bank/pro-“backing theory”)

  28. Ramanan says

    About Reflux – denying is in the best interest of those who believe in the Monetarist hot potato process.

    Of course while the reflux mechanism works constantly in the background – without anyone noticing, it alone is not sufficient to dismiss the hot potato process. Hence those who believe in the hot potato dismiss it so simply. They could perhaps say that the reflux is true and still maintain their stand but instead simply dismiss it – as if it has no truth.

    Equally importantly in addition to the reflux mechanism there is asset allocation/reallocation process which changes prices of financial assets and the quantity of money and together with the reflux mechanism can be used to say that the hot potato process has no truth. It is a slightly complicated argument – I think I will write a post on this sometime.

  29. Ramanan says

    “The central bank doesn’t control money but via changes in interest rate can control the money supply and hence set the price level. ”

    Oh that was not my claim but phrasing the claim of others.

  30. Ramanan says


    Actually it was more a self “a-ha” for me – as I was trying to find out earlier this week how this fiscal dominance of the central bank story came into existence!

    I wanted to say that such ideas

    ”There is nothing that fiscal policy, commercial banks, or the private sector can possibly do that cannot be offset by the right interest rate policy.”

    from the blog post have existed for long. And the blog post is just some minor changes from the old ideas.

    One of the things about Macro is that they make some claim and if the claim doesn’t work, they blame the government instead of changing the claim. So the idea that monetary policy can do anything has existed for long. The claim just got stronger. And the idea of fiscal dominance is a kind of (strange) explanation of why the claim continues to hold.

  31. Tom Brown says

    Ramanan, thanks for your response! I don’t follow you completely though. First of all, where did the “fiscal dominance” quote come from? I didn’t see it in DOB’s post or here. Also I don’t follow this:

    “So the idea is that their theory itself is right but it’s just that the above qualification could not have been met because of the supposed “fiscal dominance”. ”

    You write:

    “The central bank doesn’t control money but via changes in interest rate can control the money supply and hence set the price level. ”

    I think he’s actually claiming he can control the stock of money in circulation, the price level, AND target inflation and/or NGDP (or something else?) all at the same time: he’s got more that one knob he’s giving the CB to twiddle, so I guess if that’s really the case (and they’re independent) then you supposedly could have more than one control outputs.

    This is what Sumner had to say:
    “DOB, Yes, that looks like a standard Woodfordian model to me. I have no objections at first glance. You simply do monetary policy by adjusting the demand for MOA to control its value, not the supply.
    I work with supply of MOA models because currency doesn’t pay interest.”

    I think that ties into what you’re saying about it being the same old thing, repackaged a bit perhaps.

    “natural rate of interest” … that’s a Wicksell idea (yes, I used Wikipedia!). He writes about it there and in his “banking” post as if this is something actually used in the finance/banking industry. I have no idea (I’m an amateur)… but is that true?

    BTW, what are your views on “The Law of Reflux” as applied to MOE? (Rowe disagrees w/ Glasner & Mike Sproul on this):

    DOB claims banks are NOT special, and he (like Sproul) is a Law of Reflux believer wrt MOE. I’m wondering if that’s what separates them (Rowe is willing to grant banks ARE special, but only because they can create excess supply of MOE and MOE is special… and I think he thinks MOE is special because he thinks the Law of Reflux doesn’t apply to it (paraphrasing): “N goods including MOE, then there’s N-1 money markets, etc.”

    Any of that overlap your views, or are they all out to lunch?

  32. Ramanan says

    oh just kidding about the barbaric relic – basically meant to say that it’s the same old ideas which have existed since then.

    So you know why ideas of “fiscal dominance of the government over their central bank” exist?

    ” There is nothing that fiscal policy, commercial banks, or the private sector can possibly do that cannot be offset by the right interest rate policy.”

    So the idea is that their theory itself is right but it’s just that the above qualification could not have been met because of the supposed “fiscal dominance”.

    The idea is the same but with a different emphasis. The central bank doesn’t control money but via changes in interest rate can control the money supply and hence set the price level.

    Most of the ideas such as NKE, DSGE etc are finally just some minor changes here and there to already existing ideas.

    And note how the post begins with the “natural rate of interest”.

  33. Tom Brown says

    “barbaric relic” Lol… are you referring to Sumner’s phrase about the gold standard recently?

    It’s kind of unique monetarism though… monetarism w/o any money. Or maybe that’s old hat to NKers?

    So what would be your top three comebacks to that? Or where’s the 1st place he goes off the rails?… other than wholesale rejection reality that is.

  34. Ramanan says

    Monetarism plus Barbaric Relic!

  35. Tom Brown says

    O/T: Michael Woodford fan (DOB) designs a fiat currency:
    Sumner has no objections. Thoughts?

  36. Cullen Roche says

    This also feeds into the whole “balance sheet recession” concept that I really latched onto in the last 5 years. If you understood why banks were so crucial to providing liquidity for this on demand contribution to AD then you understood why a broken banking system would contribute to a weak economy. And if you understood that then you understood why it was so important for someone else to pick up the slack. The US Govt did that for 4 years and corporate America has done it increasingly in the last 18 months.

    You didn’t need IS/LM models, QTM, Tobin or anything to understand this. In fact, those views seem to give people a more muddled view of all this stuff….

  37. Cullen Roche says

    There seems to be a few different lines of thought on the purchasing power issue and “specialness” of banks. For instance, does the issuance of t-bonds by the govt add to aggregate demand? Well, if you take the MR view then deficits add NFA and redistribute existing money (Peter buys a bond and the govt sends his deposits through to Paul, a recipient of spending). Peter has a bond and the same net worth AND Paul has deposits he didn’t previously have. Does that add to aggregate demand? I’d say yes. What about when a corporation issues common stock? It’s actually a similar transaction. The co issues shares to Peter who sends his deposits on through to the co who then spends them into Paul’s account. Did that increase aggregate demand? I’d say yes. We didn’t need banks involved in any of this.

    BUT, I’d argue that there’s a difference between banks and these forms of non-bank securities issuance. You can just about ALWAYS go to the bank and obtain new funds to spend. You can’t always go to the govt and corporate America for new securities or even to the secondary market to sell existing securities. So there’s an element of on demand aggregate demand issuance that banks have power over. That is, I could go to the bank right now and get a loan to buy a car that would add to aggregate demand. But if the govt isn’t spending or corporate America isn’t spending then there’s no new issuance involved and spending by them is just redistribution of existing money (without the financial asset creation).

    I don’t think adding NBFI’s into this simplistic view changes the story much. New asset issuance can potentially increase aggregate demand whether it’s a NBFI, bank or non-bank corporation. But I’d argue that banks hold a certain specialness because it’s the on demand readiness to provide liquidity that makes them special. This isn’t true for all economic agents and I’d argue that banks play an overwhelmingly special role in this process.

  38. Tom Hickey says

    Auto manufacturers realized that vehicles were the new mortgage and they were giving a lot of profit to the banks by not self-financing, so they set up financing subsidiaries like GMAC. Now it is customary in the US to buy a vehicle from one of the major dealers and finance it at a lower interest rate than banks offer, as well as on more attractive terms and perhaps with less stringent credit standards.

    Does this add to AG? Seems so.

    If their analysis was correct this policy made it more affordable and simpler to purchase a vehicle for many people, thereby increasing sales while also reaping the interest on loans, which would otherwise have gone to banks. Win-win for the automakers and customers — until some of the finance arms of the automakers got into trouble.

  39. Ramanan says

    Purchasing power has a specific meaning but people tend to use it in a strange way so I am going to avoid the usage.

    Yes direct lending by an NBFI can affect aggregate demand just like bank lending can.

  40. Fed Up says

    So can NBFI’s increase purchasing power overall?

  41. Ramanan says

    No they cannot. But sometimes they do offer check facilities.

  42. Fed Up says

    ““shares” are like deposits.”

    Can shares be used to buy goods/services?

  43. JKH says

    In the category of things that I don’t understand, that’s one of the most impressive analogies I’ve ever heard.


  44. Ramanan says

    And I think the confusion there lies in generalizing statements.

    So if there is some relationship between many variables, it may or may not survive when you generalize the model.

    To exaggerate a little, what is being done there is like taking lecture notes on projectile motion and concluding that any particle thrown anywhere in the world will have a horizontal acceleration of zero.

  45. JKH says

    And to the degree that non-bank lending does affect aggregate demand, it reinforces the way in which Krugman/Tobin is correct – this is a way in which banks are not special. Not being special in one way doesn’t require not being special in all ways.