David Glasner wrote a post criticizing Stephen Williamson's view of business cycles. "Are Recessions Efficient," was the title of Glasner's post. The subtitle should be, "responses to productivity shocks," and Glasner rejects that view. I agree with Glasner on that count, however, in the discussion thread, Glasner wrote:
Bill, I actually think that you can’t get the result you are looking for without currency, because as Tobin taught us deposits are not a hot potato so that there is a market mechanism that is either adding to or taking away deposits in response to excess demand or supplies of money. So in that model it is hard to see why whatever disturbance you start with you get an excess demand or supply of money that affects NGDP. You need gold or currency in the model to get the effect on NGDP that you are looking for.
While Tobin's "new view," had some important insights, deposits can be just as much as a hot potato as currency, and while there are market mechanisms that apply to deposits, the ones described by Tobin don't prevent monetary disequilibrium. Adverse effects on NGDP are possible without gold or currency.
Glasner helpfully linked to Tobin's article. To a large degree, most of my criticisms of Tobin's view simply repeat the insights of Yeager, in "What are Banks?" Yeager's point is that that since deposits serve as media of exchange, people will accept them in payment even if they don't intend to hold them, but rather intend to spend them. While deposits issued by competitive banks will pay interest (or perhaps charge service fees,) and those yields could be set at levels that prevent monetary disequilibrium, people will hold them, (and pass them about like a hot potato,) when the yield is too low. And, of course, if the yield is too high, then the cumulative rot generated by an excess demand for money remains possible.
Suppose all money takes the form of deposits issued by a monopoly bank. The bank management decides to expand lending. The borrowers spend the money, and those selling to the borrowers accept deposits in payment.
The Glasner/Tobin argument is that those selling to the borrowers will refuse to sell their products to the new borrowers unless the monopoly bank raises the interest rate paid on deposits enough so that they will permanently increase money holdings.
This is false. In reality, those selling products to the borrowers will accept the additional deposits even if they have no intention of holding them. They accept them because they are media of exchange. They will accept these additional deposits in payment, just like all the other deposits they are accepting in payment, with the intention of spending them.
When those selling to the borrowers choose to spend their excess money balances, do those who sell to them only accept the deposits if they are willing to hold them? Of course not, they also accept them like all the others, intending to spend them as well. The "hot potato" analogy works perfectly.
At least some of the increase in spending will be on output, and so nominal GDP rises. This raises money demand to match the additional quantity. Considering long run equilibrium, this is an increase in the price level only. The real quantity of money decreases enough to match the real demand for money. The real quantity of credit offered by the monopoly bank also decreases enough to match the real demand for credit.
Of course, Tobin is a Keynesian, and emphasized a liquidity effect of an excess supply of money. I find this effect very plausible. Along with our monopoly bank issuing deposits, suppose there is a market for government bonds. At least some of those with excess money balances purchase government bonds, the price of the bonds rises, and the bond yield falls. If the interest rate the monopoly deposit issuer pays remains unchanged, the opportunity cost of holding money falls, and so the demand to hold money rises.
On this view, the "hot potato" impact of the excess supply of money quickly disappears as people hold the additional money balances in place of bonds. The problem, then, is that the bond interest rate that adjusts the demand to hold money to the quantity of money is inconsistent with the interest rate that keeps the flow of saving in balance with the flow of investment.
In other words, if the market interest rate was equal to the natural interest rate before, then this reduction in the market interest rate results in investment greater than saving (both nominal and real,) so nominal GDP begins to rise--shift to a higher growth path.
If we only consider long run equilibrium, the price level rises, the real quantity of money falls, and there is an excess demand for money at the excessively low interest rate. Government bonds are sold, the price of bonds falls, and the bond yield rises. The market rate rises back to the natural interest rate and the flow of saving and investment are now in balance at the higher level of nominal GDP.
Of course, the liquidity effect applies equally well when currency plays a role in the economy. There is an excess supply of currency. Some people use the excess currency to buy government bonds. Bond prices rise and the yields fall. The opportunity cost of holding currency falls, and so, people hold more. (At least, that is the Keynesian argument.)
Now, to add a slight complication, suppose that rather than the deposit interest rate remaining constant, suppose that when the excess supply of money causes bond yields to fall, the monopoly bank lowers the interest rate it pays on deposits. Surely it is plausible that the interest rate the bank sets on deposits would need to be competitive with the yield on government bonds. And so, when the excess supply of money leads to lower yields on government bonds, the monopoly bank lowers deposit rates as well. And so, the opportunity cost of holding deposits does not fall, and the excess supply of money continues to exist. The "hot potato" continues to pass hands, perhaps lowering the yields on government bonds, and so on deposits even more, or perhaps directly expanding expenditures on output.
Rather than an excess supply of money causing deposit interest rates to rise so that people are willing to hold the additional deposits, there is a more plausible market process that causes the interest rate on deposits to fall, exacerbating the excess supply of deposits.
So, where does Tobin go wrong?
If you imagine that real world markets operates as if there were a Walrasian auctioneer, then the interest rate on deposits can be assumed to adjust to keep the demand to hold deposits equal to the quantity of deposits. If all money takes the form of deposits, then the interest rate on money can be assumed to adjust so that the demand to hold money matches the existing quantity.
But there is no wWalrasian auctioneer checking to see if the total amount of money people want to hold matches the total amount that banks want to offer, and if they don't, then calling out new yields on money until the two do balance.
If there were a market where people bought deposits for money, then perhaps banks would need to adjust yields on deposits so that the amount people want to buy matches what the banks want to hold.
However, in the real world, people obtain deposits in payment for the goods and services, or more frequently, the productive services, they sell. They can increase their holdings of deposits by reducing expenditures out of current income. They can reduce their money holdings by expanding their expenditures on current output. (And yes, they can sell or buy other assets too.)
I don't go to the deposit store and buy deposits. I receive an increase in my deposit balance twice each month and I reduce that balance by making expenditures. When the balance is looking too low, I reign in expenditures. When the balance is high, I expand expenditures.
Where does Glasner go wrong? I think it is simple. Suppose that deposits are redeemable on demand for currency, and that the real quantity of currency is in equilibrium with the real demand for currency. If the banking system did generate an excess supply of money, and this increased nominal GDP, then this would create a shortage of currency. The banks would be obligated to supply that currency, and that would force the banks to reverse whatever problem they had caused. In equilibrium, the banks can only create the amount of deposits people want to hold. And it is natural to focus on their ability to pay higher interest on deposits to increase demand, and then to consider the profitability of their business.
But that process doesn't apply if there is no currency.
And if there is an excess supply of currency, then banks will receive additional deposits of currency. The resulting excess reserves will result in banks lowing both the interest rates they charge and pay. The expanded lending increases the quantity of money and the lower interest rates the banks pay on deposits reduces the demand to hold money. Money expenditures on output rise, and this clears up the excess supply of deposits and currency. But it is when the excess supply of currency is cleared up that the problem is solved.
Banking, then, is just an irrelevant appendage to a problem that is centered on currency. The reason is that the deposits are redeemable on demand for the currency.
But that cannot be true if there is no hand-to-hand currency, or if the currency is privately issued on the same basis as deposits.
That doesn't mean that standard monetary economics disappears.
Now, what happens when there is no currency, but there is a competitive banking system, accepting each others checks for deposit at par, and somehow clearing net balances? Does this mean that the competitive interest rate on deposits must be at a level so that the total quantity of money issued by the system matches the demand to hold that money?
No. More on that later.