Friday, 9 February 2018

What is the Benefit to Banks from Money Creation?



In a response to a recent post by Brian Romanchuk, somebody made the following comment:

"If private banks are ..... allowed to create and lend out their own money, they can undercut the ..... free market rate of interest, and for the simple reason that printing money is cheaper than having to borrow it or earn it."

This seems to suggest a kind of model in which banks choose whether to finance themselves with someone else's money that they have to pay to borrow, or money they create for themselves for free.  I think the problem is that this confuses two distinct ideas: that there is a benefit from having monetary liabilities and that bank lending increases deposits.

The potential benefit that accrues to banks by virtue of their status as money issuers arises through a reduced rate of interest on monetary liabilities.  If a particular type of bank deposit, such as a positive current account balance, is readily available for making payments, then it typically carries a lower rate of interest than other deposits. 

Sometimes the rate of interest on such balances is zero, but it need not be.  The important point is that there is a benefit to the bank through a reduced funding cost.  Set against this is the cost to the bank of providing current account services in the form of the costs of premises, staff and equipment.

At this point it is worth noting that these costs and benefits are based on the level of the bank's outstanding monetary liabilities.  It is nothing to do with which bank makes the loan that creates the deposit.  It is quite possible to have banks making lots of loans, but having minimal liabilities in the form of immediately available deposits, because that bank relies on different funding techniques.  These banks would be creating new money, but not getting any of the potential benefit that arises from having monetary liabilities.

On the other hand, it would be possible to have a bank with very large current account liabilities but which never engaged in deposit creation.  This would happen if the bank was simply taking deposits through payments received in from other sources and making all of its loans in cash[1].  The potential benefit of operating current accounts would be very important to such a bank.  

The point here is that it makes no sense to say that it is cheaper for a bank to print money than borrow it.  What the bank does at the point of making a loan is irrelevant.  What matters is how it chooses to manage its liabilities going forward and in particular the extent to which it chooses to compete for current account deposits.

The extent of the benefit depends then on how competitive that market is.  Under perfect competition, banks would have to offer interest rates on current accounts that would simply leave them with normal profits.  However, it is likely that there is a degree of monopolistic competition in the provision of banking services, particularly at the retail level, and this means that there is some supernormal profit that accrues to banks as providers of monetary liabilities.

It is difficult to assess how profitable it is for banks to have monetary liabilities, largely because many of the costs are shared with other activities.  Even for the banks themselves, it is somewhat arbitrary how costs get allocated.  However, the point here is that any such profit is just regular monopolistic profit in the market for current account services and not something to do with money being created out of thin air.


[1] Making loans in cash does in fact "create money" in the sense of increasing the broad money supply, but it is not what people usually have in mind when they talk of banks "printing money".

Saturday, 27 January 2018

Automation and Real Wages



Economists generally work on the basis that improvements in technology lead to higher real wages.  Conventional production functions (when combined with other assumptions) invariably produce this result.  Looking at the Cobb-Douglas production function, as the most common example, an increase in total factor productivity raises labour's marginal product.  With the normal assumptions about competition, this leads to higher real wages.

Although I have no problem with using such things at times, I am wary of simple aggregate production functions.  It seems clear to me that technological developments can lead to reduced real wage levels, even without considering how such developments might impact on monopoly power.

Although I'm sure others have produced models that illustrate this, I'm not aware of any and, in any event, I like to experiment with things myself, so I have constructed a little model of production in which technological innovation leads to a fall in real wages.

There is a single good produced by a combination of labour and capital.  There are two possible production techniques, each of which requires a fixed quantity of labour and a fixed quantity of capital to produce a fixed quantity of the good.  These quantities are set out in the table below:


Output
Labour Input
Capital Input
Technique A
12
1
1
Technique B
24
1
4


Total labour and total capital are fixed.  There is perfect competition and no demand deficiency.  This has two implications:

1. The use of each techniques will normally be such that will ensure full employment of both labour and capital.  However, if the ratio of available labour to available capital is too extreme, then all production will use a single technique (whichever maximises use of the abundant factor) and some of that abundant factor will be unutilised.  This possibility is ignored here - it is assumed that available labour and capital always lead to some combination of possible techniques.

2. The real wage will be at a level that ensures the return on capital is the same for each technique.  If it were not, suppliers of capital would switch technique which would lead to shortages or surpluses in the labour market.  With the numbers here, the real wage works out as 8 units of output per unit of labour.

Marginal productivity is not well defined for each individual technique.  However, given the above conclusion about how the techniques are combined, there is a marginal productivity of labour at an aggregate level.  It is relatively easy to show that this is equal to the real wage.

If we take factor supplies of 12 units of labour and 24 units of capital, we get the following output matrix:


Labour Used
Capital Used
Production
Technique A
8
8
96
Technique B
4
16
96
Total
12
24
192


We now want to consider the innovation of a new technique involving a more intensive ratio of capital to labour.  For this to be beneficial overall, it must yield a higher return on capital given the prevailing real wage.  The details of this new technique are:


Output
Labour Input
Capital Input
Technique C
30
1
5


Technique C dominates technique B at all levels of the real wage, so the latter is completely abandoned.  Since the relative factor input ratios have changed, there is also a change in the amount of resources devoted to technique A.  The new levels of production are shown below:


Labour Used
Capital Used
Production
Technique A
9
9
108
Technique C
3
15
90
Total
12
24
198

The change in techniques also impacts on the real wage, which must settle at a new level to continue to equate return on capital across techniques.  In fact this involves a fall in the real wage to 7.5.   

The interesting thing here is that although labour productivity (labour's average product) has increased, its marginal product has decreased.  Real wages have therefore fallen, even though output per head has risen.  The corresponding change is that the return on capital has increased.

My belief is that, on the whole, technological progress results in higher overall real wages.  However, I do not think we can assume that all new innovations will do this.