Rowe on Banking

Nick Rowe has an excellent post on what he calls the orthodox and the heterodox views of how bad banks cause problems.

What he calls the heterodox view is right out of Yeager. Banks create money and so can lend money into existence. An individual can correct a shortage of money by spending less. The result for the economy as a whole is lower nominal expenditure.

Perhaps banks that have taken losses and so have too little net worth will fail to lend enough money into existence. If banks fail to lend enough money into existence, there can be a shortage of money, and lower nominal expenditures. Rowe does a great job laying out the problem.

Some complications are that banks fund their activities with a variety of liabilities, only some of which plausibly serve as money. Further, banks hold a variety of assets, with different legal requirements for capital. Further, it is plausible that the amount of capital required to reassure depositors is different for different sorts of assets.

A capital constrained bank can fund more of its asset portfolio with monetary liabilities--checkable deposits. It can shift its asset porfolio from commercial loans to short term, low risk securities. Short term government bonds are obvious. In the U.S. there is a zero capital requirement for government bonds, and it would be sensible for banks too keep little capital to the degree Treasury Bills make up a large portion of their asset portfolio. Interest rate risk suggests that some capital is necessary if banks hold long term government bonds, but perhaps less than commercial loans.

My only criticism of Rowe is that he leaves out currency. Bank money is tied to currency by convertibility. The government monopolizes the issue of currency and pays a zero nominal interest rate. As Yeager explained in 1956, if nominal interest rates get very low (and certainly at zero) any excess demand for securities results in a spillover excess demand for money. (It is like the land example. What if people want to save by purchasing land, and there is an excess demand for land. Suppose frustrated land buyers just hold onto money? There is a spill0ver from the excess demand for land to an excess demand for money.)

Since bank money bears interest, and can have negative yields, then as interest rates fall on securities, the interest rates banks are willing to pay on monetary liabilities decreases as well. That reduces the demand for money, and fixes the problem. Tying in the key role of currency, however, shows that if interest rates on deposits get much below zero, the excess demand for securities near zero shifts into an excess demand for currency.

Either the connection between bank money and currency has to be broken, or else the monopoly issuer has to fix the excess demand for currency. If the excess demand for money exists because it is a spillover from an excess demand for securities, then having the central bank create additional currency by purchasing those same securities in excess demand cannot fix the problem. If the central bank wants to provide a perfectly liquid and zero risk asset at a zero nominal interest rate that serves as the medium of redemption for all the rest of the medium of exchange, then it needs to purchase longer term and higher risk securities. The central bank must bear additional risk--interest rate and/or credit risk.

And that is the rest of the story--how Rowe's orthodox and heterodox views can be made consistent.