Thursday, 26 June 2014

Money with Passive Banks



It is sometimes said that banks are more than just financial intermediaries, because they can sort of create their own funds to lend.  In this analysis, a simple financial intermediary would be one that takes in funds that the public place with it and then allocates these between different assets.  Banks, in contrast, don't need to wait for funds to come in, because the very act of their lending creates the deposits that fund them.  It might therefore be concluded that bank decisions matter, whereas those of other financial institutions do not (or at least they matter less).

Whatever the merits of this analysis, I always find it useful to look at things from different angles, so I thought I'd describe a slightly different approach.  What I want to do is start from the concept of a completely passive bank, which makes no decisions of any importance, and then see what we need to change to get a more realistic picture.

So, this starts with a bank that does no more than record transactions.  Everyone has an account with the bank and each account carries a balance measured in units of the currency.  Whenever any one person wants to make a payment to another, they inform the bank of the payment and the bank debits one account and credits the other.  The bank only acts on instructions; it makes no decisions for itself.

Account balances can be negative.  If a person makes a payment in excess of the positive balance in their account, then the bank simply records that excess as a negative balance.  The total balance of all accounts in the black is equal to the total negative balance on all accounts in the red.  So whilst individual balances will change from time to time, the total net balance is always zero.

In this model, the balances in these accounts form the medium of account.  We could measure the aggregate positive balance of accounts and call this the quantity of the medium of exchange, but this might be misleading as the negative balances are also a part of that medium.

This concept of money might be said to fit with the basic New Keynesian model.  Agents can transact and make payments to one another, but the aggregate balance is zero.  The total amount of positive balances (which we might want to call the money supply) doesn't really matter.  It would be easy to add an interest rate to this picture - with interest charged on negative balances and credited to positive balances.  However, there are no credit constraints.  Everyone spends purely based on how they wish to spread their expenditure.

So the natural extension is to include credit limits.  With what we have here, individuals hold claims on the bank; the exposure to those with negative balances is pooled.  So it may be impractical for the individuals to decide on how credit is allocated.  This creates a natural role for the bank.  For an individual to make any payment which would result in its balance going negative, it has to be first approved by the bank.  Furthermore, the bank will then also require that the account is made positive again within a specified length of time.

What we have now is more like our normal simple model of a bank.  We have positive balances which we call deposits and negative balances which we call loans.  The bank takes an active role in deciding how much is lent, to whom and for how long.  Individual depositors have no role in this decision.  We could say that loans create deposits, although an alternative would be to say that the two are actually created in parallel by spending decisions.

So we have arrived at the same concept of what a bank does, but via a different route.  I think the alternative perspective is useful for a couple of reasons.  First, it highlights that the credit rationing aspect of bank activity is critical to why they matter.  This helps us frame questions about how credit decisions outside banking might matter as well.   Secondly, it gives a different and, I would say, more realistic concept of how the medium of exchange operates in modern economy.  Rather than the MOE being a quantifiable thing which is created by lending and then circulated until it is extinguished, it is just a system of payments and balances, both positive and negative.

22 comments:

  1. It sounds to me like your "passive bank" is better described as a "credit card bank".

    If we think of your "passive bank" as the local bank on the corner, then it seems to me that we are mixing property (money) with promises of property (negative money). The result is (to me) an unrealistic model only extends into a misleading model.

    We begin with "Account balances can be negative. If a person makes a payment in excess of the positive balance in their account, then the bank simply records that excess as a negative balance." I believe that money is always property. If money is property, then the bank should not allow negative transfers because there is no such thing as negative property.

    We could certainly allow a two medium of exchange system where one medium is money and the other is promise of money, but the two mediums are absolutely not the same. The promise of money will always carry much more risk than money when both are used as a medium of exchange.

    You go on to assume that in the passive bank, both money and negative money are in equal amounts. This carries the implication that money begets negative money as if the two were equal. If money and promise of money are both mediums of account and mediums of exchange, there should be no reason that both are in equal amounts.

    I think your passive bank model would work if the bank rejected negative transfers for the initial condition. Then, when we relaxed the negative transfer condition to allow credit, the bank could assign who got the credit and who took the risk of loss of property. This seems to me to be an accurate model of banks today.

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    1. It's important to what I'm saying here that we imagine a position where the total positive balance is equal to the total negative balance. So, to make this clearer let's assume we start from a position where everyone's balance is zero. Now, if the first payment is $10 from A to B, A's balance will go to -$10 and B's will go to +$10. So the total is still zero. Subsequent payemts will change individual balances, but the total will still be zero.

      There is no reason why the bank should not allow this (apart from the possible credit issues). It may seem odd if you want to think of money as property with an enduring existence, but part of the reason for this post was to illustrate what I think is actually a better description of how money really works.

      Of course, we can take the same payments and balances and legal relationships and give them different names. So we could say that what has happened above is that the bank has loaned $10 to A (creating a $10 deposit in the process) and A has paid that $10 to B. That's a more conventional description, but in economic terms, it's identical to what I've described.

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  2. Nick, O/T: Now that David Andolfatto has updated his latest post (in response to your comment):

    1. Are you satisfied with the consistency of his model?

    2. Do you share his conclusions?

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    1. I saw that he'd done that, but I haven't had a chance to go through it yet. I'm sure he's fixed the problem, though.

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  3. Elegant.

    I would add that what distinguishes banks from other institutions is that its liabilities can be used to settle debts.

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    1. Or is that implied in the fact that banks record transactions?

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    2. Thanks. It is certainly an important distinction generally that bank liabilities are used to settle debts to banks and non-banks, but non-bank liabilities are used to settle neither. Here, settlement of debt, whether to the bank itself or a non-bank is simply part of the payment process. Settlement of a debt to a non-bank would be by a payment from the debtor's account to the creditor's account. Repayment of debt to the bank happens by the debtor receiving sufficient payments into its account to eliminate the negative balance.

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  4. Good article. The credit rationing role is the key feature for banks from an economic perspective, although the payment system needs to function from a legal/logistics perspective. But one could imagine the payments system being taken over by the government, and the economic role of the banks would not change much.

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    1. Thanks. I think from a economics perspective, it is important that a payment infrastructure exists and that it functions, but otherwise that's it. There isn't any quantity there that we need to be concerned with. The quantities are things like balances and credit limits.

      I agree that you could imagine a payments system detached from other banking activity and it might have some merit. The issue is how to manage the limit on payments, whether that's through credit limits or liquid asset holdings. With conventional banking, that's done by having payment accounts and sight deposits as the same thing, but there are potentially other ways of doing it.

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  5. If Nick Rowe wasn't on vacation, he'd probably say something like: "everybody accepts money". In some sense, by definition if all credits (money) are the same, then there is an asymmetry between the debtors and creditors, because not all debits are the same (idiosynchratic risk). Even in the aggregrate the risk cannot be zero (e.g. there's always a possibility all the debtors can die), so in some sense the monetarists' asymmetry remains, although they assume it is high (the 'magic of money') vs. others who would assume it is low ('backed'; very nearly zero risk).

    I tend to be sympathetic to the view that the credit rationing function of the bank is a form of backing, which has both good and bad sides, namely to stabilize the value of money by ensuring good debits, but they can overshoot on both the reckless and cautious sides. But, maybe this is the wrong view.

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    1. Yes. I'm certainly not trying to play down the role of differentiated credit risk, becasue I think it plays a very important role in much of what happens in advanced economies. But I am trying to present an alternative to the idea that the medium of exchange should be seen as a quantifiable thing. I think it makes much more sense to understand it as being the set of accounts and the payments system.

      The relationship between the quality of bank assets and the value of money is an odd one. If there is a sudden shock to the economy, you'd expect credit defaults and so losses to bank assets. But this doesn't lead to a fall in the value of money. In fact if anything, you might expect such a shock to lead to deflation, which increases the value of money. This all depends of course on the relationship between commercial bank money and central bank money and what the central bank is doing, but it's actually not that straightforward in my view.

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  9. Interesting thoughts!

    

But I don't see much difference between this hypothetical kind of banks and the banks we have now. You seem to propose a system of inelastic money supply but as long as you can have negative accounts you come back to the currently prevailing system of money creation by the banks. This seems to be the same as when I take a EUR 100 loan from a bank: the bank thus puts a EUR 100 loan in its asset side of the balance sheet and EUR 100 deposit on the liability side. Now in this example formally there is no "negative" account but it's the same thing, isn't it?

    

I have recently come across this article that suggest a very rigid monetary system where banks do not create money at all:

http://www.pieria.co.uk/articles/martin_wolf_proposes_the_death_of_banking




    By the way, I am also starting a blog about money:

http://mihaililiev.wordpress.com

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    1. Yes, but in a sense that is what I'm saying. I'm just trying to suggest a different way of looking at it, but it is really the same thing and it certainly is a reasonable description of what we have now. The problem is that many economists when they talk about money think of it in physical terms. So even though they know that most money is electronic, they still imagine it operating within the same constraints that would apply if it were gold coins. Such as, that its quantity must be strictly positive and that payments must happen in an order, e.g.. A cannot pay B until A has received payment from C.

      I posted something myself in connection to that Martin Wolf article. http://monetaryreflections.blogspot.co.uk/2014/04/cohrane-and-wolf-on-full-reserve-banking.html

      Good luck with your blog!

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    2. Nick, thanks for replying.

      You are right that people often think about money as if it were a thing while in fact most money signifies credit/debt. I think some economist, especially monetary economists, do understand that all these debts cable each other out. This was particularly highlighted during the gold standard where not all 'money' was gold but there was again a huge edifice of credit money (in the form of deposits) that could never have been concerted all at once into gold. It was understood by the most shrewd economists (i.e. Allyn Young in the US) that this 'credit money' was necessary to allow the economy to function properly and that normally it posed no problems.

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  11. Do banks simply perform an accounting function by recording transactions and allowing/rejecting credit applications, or, do banks perform a property management role? The comments seem to divide into these two maps of perspective.

    The first perspective (recording transactions and allowing/rejecting credit) certainly describes credit card issuing banks. It seems to me that banks do much more than effectively provide unlimited credit cards (to favored borrowers).

    The second perspective (performing a property management role) is a view that money is like real property but, unlike real property, money can be increased in quantity without limit. Banks have a role in this money increase process, a role that must be considered in any model of the banking system.

    If banks are acting in a property manage role, then banks must have property to manage. Now we can ask if banks manage property created by others, or, if banks can create property out of thin air? This is quite a different question from whether banks can create DEPOSITS out of thin air, which, of course, is much easier than creating property.

    When the IRS recently declared BITCOIN "property" for tax purposes, it caught my attention. Isn't all money "property"? Banks manage money so, to me, banks ARE managing property.

    Finally, if money is property, then how is new money created with value immediately inherent? Perhaps the subject of future posts.

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    1. Roger,

      Don't get distracted by the way the IRS use the term "property". It has no relevance for economics, only for those sections of the tax code that refer to "property". (It has not always been clear that money is property for the purposes of the code and it has been the subject of a number of US court cases.)

      What we think of as a money asset is not like a tangible asset, but just the valuation of a collection of rights under a contractual relationship. I'm not sure what you mean by a property management function. When we hold bank money, what we really have is just a contractual relationship with the bank. To the extent that represents our property, it is not being managed by the bank.

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    2. I would say that 'money' is more than a contractual relation with the bank. But it is definitely not property. It could be better described as promise or credit. And promises, of course, can be created out of the thin air.

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  12. Interesting and well explained, thanks.

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