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.

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[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".

The Irrelevance of Private Money Creation to Loanable Funds Critiques

A frequently repeated claim deployed in critiques of loanable funds theory is that private bank money creation removes the constraint on investment being limited by "prior" savings.  In a generally good article on loanable funds here, Servaas Storm spends a lot of time discussing the ex nihilo creation of private money.

I think this is highly misleading.  Whilst not denying that understanding bank behaviour is important,  the savings constraint issue is simply a result of having a monetary exchange economy and has nothing to do with where the money comes from.    

First some clarification.  It is sometimes suggested that the constraint in question is that saving must take place before investment.  To the extent this really does refer to the order of events in time, it is clearly wrong.  Saving and investment must always take place simultaneously, by their very definition, regardless of whether we are talking about a barter or monetary economy.  

What does matter is the relationship between plans and outcomes, specifically when agents have plans that are inconsistent.[1]  In a normal market for some commodity, if planned demand is different from planned supply, the amount actually traded will be the lower of the two.  Neither buyer or seller will trade more than they want. 

Translated into a loanable funds market, this means that the amount of actual saving would be the lower of planned saving and planned investment.  Savers cannot end up saving more than they planned.  And this is indeed what we find in a barter economy, where all saving is in the form of commodities.

The difference with a monetary economy is that actual saving is not constrained by planned saving.  This is because actual saving must be equal to actual investment and actual investment is not constrained by planned saving. 

The easiest way to see this is to think about bank lending and recognise that banks can provide finance to enable new investment without first needing to check the plans of their depositors.  Although this is a useful picture, it can lead to the mistaken view that it is private bank money creation that removes the planned saving constraint.  This is not correct.  What removes that constraint is monetary exchange and that holds even with a fixed, exogenous money supply.

Consider an economy where there is a fixed money supply of $100, all held by households.  Households also hold $100 in loans to firms, so $200 in total financial assets.  Firms would like to borrow more and invest more, but households do not wish to take on more credit risk.

Now assume that households become less risk averse and wish to change their portfolio to $50 money and $150 loans.  Note the important distinction here between saving and lending.  Households are planning additional lending, but they are not planning any increase in holding of financial assets (which we can equate to saving here, as we will assume households do not undertake investment expenditure).  Although we talk about loanable funds, we don't mean what is actually loaned but what is saved.  Here, the planned saving is zero.

However, if the $50 of additional loans to firms is spend on investment then it ends up back in the hands of households again.  Household income has risen and they end up still holding $100 of money, even though they planned to only hold $50.  Total financial assets has risen to $250.  There has been actual saving of $50, unconstrained by planned saving of zero, without any new money being created.

The point here is that what facilitates the change in investment and therefore actual saving, is not a savings decision, but a portfolio decision.  The reason bank lending matters is because it is a form of portfolio decision and, indeed, banks play a large part in the overall portfolio decisions.  Money creation matters because it changes the portfolio options for households and may therefore influence their portfolio decisions.  It is not the magic ingredient that undoes the loanable funds model.

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[1] Part of the reason this whole issue doesn't figure much in more mainstream economics is that there is a tendency to focus on analysing outcomes that are consistent with plans, and less attention is given to the question of what happens when they are not.

Banks and Liquidity Preference

Consider a simple economy with three sectors: households, firms and government.  There are two assets: government bills and loans to firms.  Firms can hold bills, but we'll assume their holdings are generally zero.  All loans to firms are made by households.  The national balance sheet looks like this.

	Households	Firms	Government
Loans	L	- L
Bills	B		- B

(To avoid needing to include money as a separate asset class, we'll assume here that the bills are used as the medium of exchange.  This could be through direct physical exchange.  Alternatively, all bills could be held in individual accounts in a central registry with households and firms making payments by instructing the registry to transfer ownership interests.)

For simplicity, we will assume that firms wish to invest as much as they can and are limited only by the amount that households are prepared to lend.  Household behaviour can then be split into two decisions that are strictly independent. 

First, they make a decision that determines the total addition to their holdings of financial assets.  It is usual to think of this as being a decision about how much they spend on consumption, given their income expectation and other factors.  The accumulation of financial assets - saving - is the residual.

Secondly, they make a decision which determines the split between making additional loans and acquiring additional bills.  It will be useful to think of this as being a decision about the amount of additional loans they want to make.  We can imagine that bills are riskless and households have no limits on how many they hold, but that loans to firms carry default risk and households wish to manage their exposure.

It is crucial to recognise that these are two separate decisions.  Households can decide to spend less on consumption, without changing their decision about how much to lend to firms.  Likewise, they can decide to lend more to firms, without changing their decision about how much to consume.  Putting this latter point another way, a household decision to save more is not a pre-condition of an increase in loans to firms.

Each decision affects expenditure independently.  We have assumed that firms will spend all they can borrow, so the decision to lend affects expenditure directly.  As we have noted, this is not dependent on a decision by households to consume less.  So although, for the economy as a whole, investment must equal income less consumption, both investment and consumption are separately determined, making income the thing that needs to adjust.

If we were instead to assume that there was just one decision and the amount to be loaned to firms had to be exactly equal to the amount saved, then we would have the sort of situation conjured up by loanable funds imagery.  We could imagine that the amount to be loaned was determined by the amount households decided to save.  This might be the case in a simple barter model where saving could only be undertaken by retaining real goods

How do banks fit into this picture?  The answer is all to do with the lending decision and not the saving decision.  If the amount to be loaned to firms is still decided entirely by households, then banks are mere conduits - what people often mean when they question whether banks are just intermediaries.  On the other hand, if part or all of that decision falls to banks, then they immediately become an active part of the process.

We can illustrate this by adding banks into our balance sheet in two different ways.  In the first (shown below), banks hold the loans and households hold deposits at the bank instead. 

	Households	Firms	Banks	Government
Deposits	D		- D
Loans		- L	L
Bills	B			-  B

We need to make two further assumptions here.

a) that households decide between bills and deposits in the same way that they did between bills and loans; and

b) that banks accept any amounts deposited, which they then automatically lend out.

In this case, we can see that the lending decision still rests entirely with households, notwithstanding that banks are making the actual loans.  This is a true banks-as-simple-intermediaries model.

Alternatively, we might add in banks as shown below:

	Households	Firms	Banks	Government
Deposits	D		- D
Loans		- L	L
Bills			B	- B

In this scenario, a decision by households to increase holdings of deposits is the same as a decision to save.  There is no way for households to do one and not the other.  Rather than making two separate decisions, households now only get to make one.  The split between loans and bills - essentially the decision to lend - is in the hands of banks.  So, now, bank behaviour is crucial.

In reality, we are somewhere between these  two situations.  Bank decisions on lending are important, but household decisions matter too.  A major factor in the financial crisis was non-banks (households, here) trying to switch from bank debt (deposits) to government securities (bills).

Once we start to consider separate objectives for households and banks, we need to start bringing interest rates into the picture (or rather interest rate differentials).

We can see here the critical importance of portfolio decisions and how they are made.  This basic idea is really what liquidity preference is about in Keynesian and post-Keynesian economics.  Liquidity preference is perhaps an unfortunate term because, although liquidity is an important element, we need to look at aspects of portfolio preference that go beyond that.

Jakab and Kumhof on Banks and Loanable Funds

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.