Banks, Non-Banks and the Medium of Exchange

Paul Krugman's comments on Tobin and banking sparked an extensive discussion on the blogosphere. Much of this discussion has related to the different status of banks and other financial institutions (NBFIs).  Throughout this discussion, the following argument keeps cropping up:

Because loans create deposits and bank deposits can be used as money, bank lending increases the total purchasing power in the economy and is therefore expansionary.  Non-bank lending merely redistributes existing purchasing power and is therefore not expansionary.

It seems to me that there are one or two ideas here that are getting muddled.  In particular, I think there is some confusion about the implications of the following two semi-facts:

- The amount of bank deposits outstanding is determined primarily by the amount of bank loans outstanding.

- Bank deposits can be used as the medium of exchange, whereas claims on NBFIs cannot.

I call them semi-facts, because I think there are grounds for questioning both, but I do think they are reasonable assertions and I'm going to assume for the rest of this post that they hold.

To examine this, I want to imagine the simple economy illustrated by the following balance sheet:

	Households	Firms	Banks	NBFIs	Net
Money	Mh		-M	Mf	0
Time deposits	D		-D		0
Savings accounts	S			-S	0
Loans		-L	Lb	Lf	0
Total	V	-L	0	0	0

Here the financial sector is represented by two types of lender: banks and NBFIs.  Both entities make loans to firms (households are assumed not to borrow).  What exactly constitutes the medium of account is, I think, a difficult question in real economies.  Here, I'm going to make it simple by assuming that payments may only be made using the balance of checking accounts at banks - what I have called money.  In addition, households also hold time deposits with banks.  NBFIs offer savings accounts to households and these represent their only liability.  NBFIs have to attract funds into their savings accounts before they can make loans.  As the timing of new loans does not necessarily coincide with the timing of new savings, they also hold some money balances as a float.

To give a special status to the medium of account, we are going to assume that household demand for money balances is in a fixed ratio to nominal income (Y). 

Mh = k.Y

This means that time deposits and savings accounts are not in any way substitutes for money.  However, we will assume that time deposits and savings accounts are substitutes for each other.  How much of each households wish to hold depends on the rates offered, but we will assume that a small change in rates is enough to cause significant switches from one to the other.  We are also going to assume that firms are indifferent between borrowing from banks and NBFIs.

The first thing to notice is that the immediate impact on the non-financial sector is the same for an increase in NBFI lending as it is for an increase in bank lending.  Loans (L) increase and money holdings (Mh) increase (we are assuming firms do not retain any money, so all money holdings end up with households).  An increase in bank lending would be offset by an increase in overall money (M goes up and Lb goes up).  An increase in NBFI lending involves a transfer of money (Mf goes down and Lf goes up).  But in both cases, household money (and therefore overall household wealth goes up).

If NBFIs wish to expand their business, they will need to do two things.  They will need to start lending more.  They will also need to get in more deposits.  They can do the latter by increasing their savings rates slightly, to attract money from banks.  However, it turns out that households do not need to reduce their holdings of bank debt at all.  The extra deposits required by NBFIs is exactly matched by the extra money holdings realised by households from the very loans made by the NBFIs.  All they need to do is ensure that all of the new household wealth is channelled into new savings accounts rather than new bank deposits.  But the actions of the banks are likely to help this process.  Unless the banks also wish to increase lending, they will not want an increase in interest-bearing time deposits.  If households are trying to place too much into time deposits, they will cut their deposit rates.

So loans create deposits for NBFIs as well as banks, albeit in a rather different way.  Debt levels and overall household wealth levels can rise purely off the back of a decision by NBFIs to expand their business.

But what about money, the medium of exchange?  NBFI lending does not create any new money, so unless the banks are lending, how can actual purchasing power increase?

Now we should be able to see where the confusion lies.  The quantity that is determined by bank lending is not money, but total bank debt.  Money, our purchasing power, is just a subset of that and is not fixed by the amount of lending.  If more money is needed, households can be achieve this without any new bank lending by simply reducing their holding of time deposits (obviously, there may be a slight lag here as time deposits are allowed to mature, but typically this will be small as maturity dates will be staggered).  So, we might see a growth in NBFI loans and NBFI savings accounts, a growth in the stock of money and a reduction in bank time deposits.  There is no reason why this should not be as expansionary as bank lending.

It is worth noting there is still an asymmetry here. This process cannot go on forever, because ultimately the amount of money is limited by the amount of bank debt.  Bank debt, on the other hand, can expand indefinitely (at least within the framework of this model).  However, the point here is not that bank lending and NBFI lending are identical.  The point is that it is quite wrong to say that NBFI lending doesn't add to the medium of exchange and therefore cannot be expansionary.