Zoltan Jakab and Michael Kumhof (JK) have produced a working paper for the Bank of England on whether banks should be viewed as money creators or simple intermediaries. One of their main claims is that the mainstream modelling of banks is flawed because it views banks as the latter, when in reality they are the former.
I don't find their reasoning very convincing. They produce some detailed models in which they compare results where banks are intermediaries of loanable funds (ILF) with those where there is finance through money creation (FMC). By introducing various frictions into the ILF versions, they dampen the impact of shocks so that the FMC versions display greater volatility.
JK's argument is that most mainstream models with banks implicit assume that they those banks operate under the ILF model. Presumably this means that those models are somehow reflecting an unrealistic dampening of shocks due to implicit frictions. I find this line of argument odd. On the whole, mainstream models are constructed to exclude all frictions other than those under consideration. It is not clear to me what frictions JK would remove in those models to make them more realistic.
Part of the problem is that when JK compare the results of their different models, they are not comparing like with like. There are some important structural differences between their ILF models and their FMC models to do with which agents do what, and it is this that is giving their results rather than anything to do with bank operation.
Take for example their ILF Model 1 and FMC Model 1. In ILF Model 1, they have two types of household - borrowers and lenders. Borrowers have real capital assets which they use as collateral to get loans from banks. Lenders just hold bank deposits. Lenders are then assumed to face a transaction cost friction which depends on their holding of deposits. The greater the level of deposits the less this friction.
In FMC Model 1, these two types of household are folded into one. The representative household has loans, deposits and real capital. It still faces the same transaction costs, but is now in a position to mitigate this. It has no need to borrow to fund a holding of capital assets, but it can use the collateral to borrow to raise its holding of deposits and reduce the transaction cost friction. In the ILF Model 1, this cannot happen because lenders need the deposits but do not hold the collateral.
Now this may reflect a genuine friction that arises in the real world, but it seems to me to be all about heterogeneity and distribution and nothing to do with the operation of banks. Their entire result here depends on there being two classes of agent in one model, but only one in the other. JK seemed to have compared two different structural set-ups and concluded rather arbitrarily that the different results are all to do with loanable funds.
Even from the start, when they give a simple overview of what they see as the different models, they make this mistake of not comparing like with like (pp 11, 12 and figures 2 and 3). To make a proper comparison, we need to use the same assumptions about who is involved and what they are trying to achieve and then examine how the results might differ if we restrict what steps can be involved in getting to the result.
It's helpful to illustrate this by rejigging their examples slightly. So, we start with three non-bank entities (which I'll call A, B and C) and the Bank.
- A holds gravel (as per their example), which it does not wish to consume currently - it wishes to hold a bank deposit instead.
- B wants to invest in machinery, but has no current resources so needs to borrow.
- C has machinery to sell and would like to acquire gravel
- Each of A, B and C will take credit risk on the Bank, but only the Bank is willing to take credit risk on any of A,B or C.
We then have two different ways in which these objectives can be reconciled, the ILF route or the FMC route. These are illustrated in the diagrams below.
In the ILF model deposits and loans are contracted and settled in real goods rather than monetary payments (or ledger entries). (Odd as this sounds, it is a common assumption in mainstream models of banking. However, it is usually possible to reconstruct these into monetary models that are structurally equivalent - see here for example.) So, here, the steps are:
ILF1 - A deposits gravel with Bank
ILF2 - Bank lends gravel to B
ILF3 - B trades gravel with C in exchange for machinery
This scenario is the same as the ILF one that JK describe in the paper.
In the FMC scenario, we have monetary deposits so the steps are:
FMC1 - Bank lends to B (creating a deposit for B in doing so).
FMC2 - B buys machinery from C (by "transferring" the deposit).
FMC3 - C buys gravel from A (by "transferring" the deposit)
This is not equivalent to the FMC scenario in JK's paper, which lacks the final step here.
As I have set them out, we can see that in both scenarios we get the same end result. The issue then becomes whether the process allows these steps to take place as set out or not. In JK's alternative scenarios, they end up with completely different outcomes, so they don't even get near this issue.
I think there are some legitimate points to be made about how the operation of banks might impact on transaction frictions and what this means for volatility and response to shocks. Unfortunately, I do not think this paper has very much of interest to say on the topic.