This is an excellent paper:
The paper is written in easy to understand language and helpful balance sheet graphics. It does a particularly good job in simplifying several technical issues. As Cullen Roche notes, the money multiplier is dispatched to the ash can of history, where it belongs. It is reassuring to see this sort of recognition coming out of the central banks as regular production now, although that has been the case to some degree for a while now. And Ramanan points to some interesting post Keynesian references and influences in the paper.
The paper is impressive in that it also makes a number of insightful points apart from the issue of the money multiplier – points not often seen elsewhere – and treated here matter-of-factly and effectively. Moreover, its scope extends well beyond money creation and into a wider description of the dynamics of money circulation and bank risk management.
The section on quantitative easing in particular is excellent because (unusually) it immediately identifies a fundamental aspect of QE overlooked by most commentators – which is that QE routinely creates broad money as well as bank reserves. I suspect future economic history books will look back on this QE episode and point to a general failure by present day analysts and economists to consider this balance sheet aspect more thoroughly in figuring out just how QE works.
QE is not just about bank reserves. In fact, the bank reserve effect is arguably the least important feature of QE – although that opinion may not exactly warm the cockles of monetarist hearts. The paper appropriately refers to reserves as the “by-product” of QE (a concept I invoked in a back and forth here with Scott Sumner in his early blogging days, roughly 5 years ago).
There are additional points made about QE that are notable – that the central bank isn’t giving the banks “free money” for example. Again, a full appreciation of this aspect requires an understanding of banking system liability effects of QE – including potential or actual pricing effects on the liability side (this may become more of an issue after zero bound lift off has commenced for those systems that are currently parked next to the zero bound).
In all, the paper takes the reader on an illuminating journey through financial system balance sheets as they are affected by money creation and circulation. This includes an interesting section on the so-called hot potato effect (Nick Rowe might appreciate that.) It refers several times to the same 1963 paper by James Tobin as I reviewed here. In that regard it touches on the dynamic balance sheet interaction between banks and non-banks.
I have a different perspective from the paper on one subject previously discussed on this blog. This risks revisiting old ground, but it has to do with the idea of banks as intermediaries. On the one hand, this is semantics. On the other, there is a point of substance here, semantics or not.
It seems that those who want to banish the use of the term ‘intermediary’ claim this because they understand that “loans create deposits” instead. But the “loans creates deposits” idea has to do only with the creation process itself – and the creation process does not freeze bank balance sheets in a permanent birth state. Proactive liability management in particular and vigorous competition for deposits is an essential part of commercial banking. Banks are in constant competition for a share of deposits that have already been created but are now in competitive play. Demand deposits move around among different banks. Time deposits can move around when they come up for renewal. Bank customers can be surprisingly elastic in the choices they make in response to this competitive froth – particularly institutional customers who deal in wholesale money markets, and retail customers at times as well.
Interestingly, the paper does a pretty good job of describing this sort of thing. The composition of individual bank balance sheets changes from the point of loan and deposit creation. And the purpose of the payment clearing system is not only to facilitate payments from one demand deposit to another, but to accommodate the competitive process for bank liability management more generally. The authors touch on this, so the issue is not about an appreciation of such basic banking activity, but rather the connection between that perspective and the relationship between money creation and bank intermediation.
Here is a separate example. Suppose the Bank of Montreal posts an unusually attractive rate for 5 year mortgages – i.e. very attractive in a competitive sense. The immediate elasticity of the associated mortgage borrowing activity can be quite pronounced. The bank may follow some correlated strategy (for example) in the retail GIC funding market in order to help match the liquidity and interest rate risk exposure on the mortgage (a potential margin squeeze if a fixed rate mortgage is funded with a short term deposit and interest rates go up).
In this example, it is not the mortgage loan itself that created the desired 5 year GIC funding. It is the bank’s strategy to compete for a liability product that is different than the deposit that was created in association with the mortgage. And it is also not likely that the deposit that was created originally will end up itself being a candidate for conversion into the form that the bank actually wants as an offset to its new mortgage loan – because that deposit will probably have left the bank. The mortgage loan will produce a demand deposit that may immediately disappear from the books, with a cheque flying out of the bank to pay for a house sold by someone who now deposits that cheque with the Royal Bank. Meanwhile, the 5 year fixed rate funds that BMO actually wants may come from a Toronto Dominion Bank demand deposit held by a customer who is keeping her eye open to such fixed deposit opportunities. The intermediation effect, to use that word, in this example is in the coming together on the BMO balance sheet of a borrower’s need for money to buy a house and a lender (i.e. depositor)’s desire to lock away some money at a higher rate than she can get on a demand deposit. The intermediation consists of the structure of the balance sheet itself – that the borrower’s liability is not the same as the lender (i.e. depositor)’s asset.
That’s all ‘intermediation’ need mean. It need not contradict “loans create deposits”. And it doesn’t mean that “banks lend deposits”, which is a strange phrase on its own, with some epistemological head scratching associated with it. While “loans creates deposits” ensures a nominal balance in the balance sheet of the entire banking system – quite independently of any bank reserve activity – it doesn’t come close to describing the substance of banking as it occurs at a competitive level, which includes the dynamic management of an asset mix and a liability mix and the two in coordination. And while intermediation may not necessarily be the perfect word to describe this process, it is probably a false argument to exile the word and the idea simply because “loans create deposits” at source. Conversely, the enemy idea of “loans creates deposits” is really not intermediation. It is instead an array of misguided theories such as the money multiplier and loanable funds – but which are also not necessarily logically connected to the idea of intermediation. Let’s not indict an idea that is largely about the dynamics of money circulation already in existence when the actual concept in contention is the nature of original money creation.
An intermediary matches up supply and demand in some way – which is what banks are attempting to do in their proactive asset liability management. For example, they are attempting to create the mortgage that the borrowing customer wants and the deposit that the lending customer wants – both within the constraints of what the bank itself can accommodate and wants according to prudent risk management, product design and pricing constraints. That seems to satisfy a sensible definition of intermediation. This idea need not imply anything untoward about how money is originally created or how the bank reserve system works as banks compete for those assets and liabilities.
I think that this perspective was the theme – broadly speaking – of Tobin’s 1963 essay already referenced. Banks do not lend deposits into existence with nothing more to do from that point on. For one thing, a bank that makes loans can’t operate for long if the demand deposits created along with those loans flee to another bank and nothing else happens. The central bank won’t permit that kind of bank to survive indefinitely – even if it provides some temporary relief through the last resort facility. And there are other risk management considerations as already noted.
“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend.”
Again, I’m not quite sure this is the best definition of what is meant by ‘intermediary’. But the more interesting thing about this quote is that it correctly identifies what is in effect a confusion between NIPA type accounting (for saving) and flow of funds accounting (for loan and deposit creation). These are separate but connected, and the connection has to be right in accounting terms. It is the absence of such a connection along with a thorough treatment of the banking sector that has been missing in mainstream economics. That is a problem post Keynesian economics has responded to by effectively integrating NIPA and flow of funds accounting and analysis in a coherent framework for understanding monetary economics.
But here is an interesting exception where the authors actually depend on the idea of bank intermediation:
“As the pension fund does not hold a reserves account with the Bank of England, the commercial bank with whom they hold a bank account is used as an intermediary”
The authors are referring to a QE transaction in which the Bank of England buys a bond originally held by a pension fund. The pension fund deposits the money in a commercial bank deposit account and the bank is credited with reserves by the Bank of England. This illustrates the broad money effect referred to above. I suppose the authors use the word ‘intermediary’ in this case because money has been created by the central bank. The commercial bank intermediates this process between the depositor and the central bank. But it is not immediately obvious why this should preclude a similar meaning in the case where one bank attracts a newly created deposit from another bank – and leaves the clearing result in the form of reserves. My question would be – why is that situation not intermediation as well? The commercial bank balance sheet profile is the same in both cases – incremental deposits and incremental reserves.
But my intention is not to reduce this issue to semantic angels on the head of a pin – rather to illustrate the dynamics whereby bank balance sheets are routinely and proactively managed well beyond the original point at which “loans create deposits”.
Finally, the paper does quite a good job with a brief overview of how risk management factors into lending and deposit creation. Capital management is referenced somewhat obliquely, and this is an area that could be strengthened in the overall explanation, since risk management is inextricably linked with capital management and decisions on capital allocation. It is a holistic risk capital system in that sense.
But this is a very good paper – and relatively easy to read for such a technical subject. Once again, please have a look at it: