Saturday, December 5, 2009

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.


  1. Thanks Bill!

    Yes, Yeager is the main source. But also Clower, and Laidler. I never know what to call this approach. I called it "heterodox", partly because it is nowadays non-orthodox, but also to gently tease the post-keynesians. It's sort of monetarist. But not all monetarists think like this, and I don't know if Yeager and Clower would call themselves monetarists.

    Regarding your later comments, I can't help but think that while some people may face zero interest rates (and are indifferent between money and other assets), a lot of people and firms don't. They are borrowing constrained, and have an excess demand for the medium of exchange.

  2. Off-topic. By the way, you run a very good blog here. When you post comments on other blogs, like WCI, your name does not link back to this blog. If you log in to Typepad, and fill in the link to this blog where it says "webpage", you might get more people following you back here, by clicking on your name.

  3. Nick,

    FYI. I read your comment to Bill about linking back to one's blog by clicking on one's name and I clicked on your name but it did not take me to the WCI. Just thought you would like to know.

  4. Thanks anonymous! let me try again.

    I can't get Google to do it. And I can't seem to be able to sign in with TypePad. Curses!

  5. "My only criticism of Rowe is that he leaves out currency. Bank money is tied to currency by convertibility."

    Good point. This also suggests that under gold standard gold is real money and that dollars are more like demand deposits.

  6. Doc:

    By "dollars" I take it you mean dollar-denominated paper currency.

    However, with a gold standard, gold servces as the medium of account. It may or may not play an important role as medium of exchange.

    My view is that deposits are "real" money. And so is currency in a free banking system. But it is true, the issue of redeemable currency is constrained like deposits--no more than people want to hold.

    I think it is possible for something to be "real money" and have its quantity limited by redeemablity into something that doesn't serve as money. Black had a paper years ago about a gold standard with (near) zero reserves. Gold is only used for jewelry and the like. And paper money is tied to it by redeemabiliy.

  7. Thanks Bill, I'll have to look up that paper. Also if deposits are 'real' money then the fed in its currency creation power wouldn't then the central bank in its currency creation power be somewhat impotent?

  8. I mean impotent in shifting economic conditions by controlling MB.

  9. Under the current regime, reserve deposits at the Fed and currency are interconvertible. And all the monetary deposits are redeemable into Fed-issued currency or reserve balances at the Fed.

    I still think the deposits are reall money. It is just that their quantities are restrained by the redeemability.

    With a gold standard, the redeemable currency (and deposits) are all real money. The quantities are restrainted by the requirement that the be redeemed. I will look up the citation for the Black paper at the office today.

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