Paul Krugman last week wrote yet another response on the issue of “how banks work”. This time he has decided to cite the two papers that he relies on to “think about the role of banks in the economy”. The first is a thirty year old paper on bank runs that, although interesting, isn’t relevant to the topic at hand. The second is a fifty year old paper written by James Tobin and William C. Brainard that is directly related to the relationship of the “monetary base” (briefly put, physical currency and coins plus settlement balances in checking accounts held with the central bank) to the overall level of loans. However, the authors make pains to point out in the beginning of the paper that
This paper is addressed to these questions, but it treats them theoretically and at a high level of abstraction
This is important to emphasize. Krugman’s thinking on the relationship between settlement balances (also called bank “reserves”), deposits and loans is primarily determined by one fifty year old theoretical, very abstract paper written by theoreticians. In other words, the people who actually implement monetary policy or are in the business of banking have had little to no influence on Krugman’s thinking about banking. A priori indeed.
There is more here to unpack however. James Tobin is actually quite a famous economist (known best for the idea of a “Tobin tax”, a tax on spot currency transactions) who didn’t die after co-writing this paper. In fact, he won a Nobel prize in 1981 and didn’t die until 2002. Nor did he think that he had sufficiently dealt with the role of banks and monetary policy because he continued to develop his ideas in these areas for decades afterwards. Thus Tobin himself wouldn’t agree that “Tobin and Brainard got it all straight half a century ago”. One truly seminal paper Tobin wrote on the topic is “The commercial banking firm: a simple model”. In this 1982 paper (nearly 20 years after the paper that Krugman cited), Tobin lays out a series of views that stand in stark contrast to views expressed by Paul Krugman.
In a post calling the belief that banks “create money” “Banking Mysticism” , Krugman states that:
First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand
Compare this statement with the statement of James Tobin, who Paul Krugman claims to have learned how banking works from:
When a bank makes a loan to one of its customers it simply credits the amount to the borrower’s account. In the first instance, therefore, the bank’s deposits are increased dollar for dollar with its loans. As the borrower spends the proceeds by check, some of the recipients will leave the money on deposit with the lending bank, while others will deposit their receipts in other banks or convert them into currency. As these recipients spend their balances and in succeeding generations of transactions, the lending bank will lose more and more of the deposit created by its initial loan
Thus, the one paper Krugman relies on “to think about the role of banks in the economy” was written by someone Krugman would derisively call a “banking mystic”. Such are the ironies that emerge from ignorance. There is more to learn from this interesting paper. First let us go back to Krugman’s argument.
In the “Banks and the Monetary Base” post, Krugman poses a thought experiment:
Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.
Krugman’s argument here is confusing. In the thought experiment, his hypothetical bank tries to lower the amount of settlement balances it has by buying a security. This can only work in the aggregate if some other bank desires to hold more settlement balances or will use settlement balances to reduce its indebtedness to the treasury/central bank. Otherwise the banking system as a whole has more settlement balances than it desires. In no sense do “banks lend out the newly created reserves”. Saying that a completely incorrect description is a “shorthand” isn’t logically coherent. Further this process (if the banking system as a whole has more settlement balances than it desires) will lead to the inter-bank loan rate (the fed funds rate) to fall to the Interest On Reserves (ior) rate unless the central bank intervenes to preserve its interest rate target.
In the “Banking Mysticism” post and elsewhere Krugman argues that “currency is in limited supply — with the limit set by Fed decisions”. This is obviously not true -as confirmed by a simple glance at the New York Federal Reserve website.
Depository institutions buy currency from Federal Reserve Banks when they need it to meet customer demand, and they deposit cash at the Fed when they have more than they need to meet customer demand
Even if one desired to be charitable and say by “currency” Krugman meant settlement balances held with the central bank, this is still incorrect. The central bank provides all the settlement balances needed to get banks to lend to each other at the targeted inter-bank loan rate. One can see evidence of this every couple of weeks when an actual central bank practitioner gives a speech (you can subscribe to the speeches here). Take for example this speech given by an Australian central banker on the same day as Krugman’s blog post went live:
As with our regular open market operations, it will not be the Bank’s aim to simply supply overnight funds to those individual institutions that are short, or absorb overnight funds from those that are long cash. That is what the interbank cash market is for. As I mentioned a minute ago, the Reserve Bank’s operations are designed to put the appropriate amount of settlement funds in the system as a whole so that, in managing their individual ES accounts, ADIs [deposit-taking institutions] will transact with each other at the cash rate target
This means that whenever deposit-taking institutions want more settlement balances, the central bank will provide them on demand (either through lending or through open market operations). Thus, in no sense is “currency is in limited supply — with the limit set by Fed decisions”. The loss of settlement balances through out-flowing payments has no impact on lending unless the additional cost of borrowing more settlement balances makes lending unprofitable (quite unlikely). Note that the cost of settlement balances can vary wildly (as they did under Volcker) but they must ultimately be supplied at some price if payments are going to clear between banks. If you want to argue otherwise you have to argue that the central bank is willing to let the interbank loan market collapse and checks to stop clearing if some arbitrary amount of settlement balances is seen as “too many”.
Interestingly, the argument that it is the expected cost of acquiring additional settlement balances that matters is in James Tobin (1982). From the abstract:
In case withdrawals exceed its defensive position in liquid assets, the bank incurs extra costs in meeting reserve requirements, penalties in borrowing or losses in disposing of illiquid assets.
Thus it is not the quantity of settlement balances that impacts the loan decision of an individual bank, but the expected spread between the cost of liabilities and the return on assets. Being a good neoclassical, Tobin believes that the “profit maximizing bank” will equate expected marginal cost and expected marginal revenue. I think that is nonsense but at least we’re having the right conversation- one about the costs of liabilities and the return on assets rather then the quantity of settlement balances and deposits. Anyway, who are you going to believe? The Central bankers and the sole expert Krugman relies on to understand banking, or Paul Krugman?