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.

Money as a Good and Money as a Record

In a recent post, Nick Rowe has been playing around with how to think about money when measured money can be both posive and negative.

It is worth distinguishing two models of money, which on the face of it are very different.

In the first model, money is a type of good.  Monetary exchange means that every purchase involves the buyer delivering the agreed amount of money to the seller in return for goods and services.  It's useful to imagine this as a physical delivery - the buyer hands over some gold coins or paper notes to the seller.

In the second model, monetary exchange takes place through a series of accounts kept by a central registry (the Bank).  Each agent holds an account, which is nothing more than a record of a balance at the close of each day.  When a purchase takes place, the buyer requests the Bank to debit the purchase price from his own account and credit it to that of the seller.

In each case there is a limit on how much people can spend.  In the first model, this is a physical limit.  The buyer cannot hand over more paper notes than he actually has - you can't have negative notes.

In the second model, there is no physical limit.  If the buyer spends more than he holds, his balance simply becomes negative.  However, the Bank will want to impose some limits.  The more an account goes negative, the greater the risk to the Bank if the accountholder fails to get it positive again.  So the Bank will decline payment requests which will make accounts more negative than it wants.

So in the first model, the limit is necessarily zero.  In the second model, it may be any non-positive number and will depend on the Bank's view on credit risk.

This question of limits is the essential difference between the two models, rather than any question of whether money is in bearer or registered form.  Of course, the form money takes may dictate the limit - you can't have negative bearer notes.  But it's the limits that matter.

This allows us to see that the first model is simply a special case of the second model.  In the second model, the limit need only be non-positive.  In the first model, it must be zero.

Negative account balances in the second model are debts of the accountholder.  We can have debts in the first model as well, where the Bank (or any other agent) lends notes to someone.  However, there is a clear distinction here between debts and money.  Although the paper notes may constitute debts of the Bank, as far as the non-banking sector is concerned debts and money are quite different things.

This makes it easy to isolate a particular thing - in this case the collection of paper notes - and identify it as money or the medium of exchange.  Helpfully, such a thing can be captured in a single aggregate measure.  So, it's often easier to think through monetary mechanics using the first model, and often this is OK.

However, in the general case the distinction between medium of exchange and debt becomes more blurred.  We can no longer think of money as a simple aggregate; we need to start to think about the general liquidity position.  This manifests itself in the way counterparties to monetary contracts - both banks and non-banks - agree the terms under which those contracts may be settled on demand.

The second model is a closer reflection of the real world.  We can learn useful things from thinking about models where money is a good with a strictly positive value.  But we should not be misled into believing that everything we see in those models will translate neatly to the real world.

The "Moneyness" of Shadow Bank Liabilities

I was recently involved in an interesting discussion regarding the sense in which shadow bank liabilities might be considered money.  Along with many people, I feel that there is a qualitative difference between claims on banks and claims on non-banks, but I find it hard to put my finger on exactly what that difference is.

One possible approach is simply to say that claims on non-banks are not generally transferred to others as a means of payment for goods, services or other assets.  However, this answer overlooks the fact that bank deposits are not transferred as payment either.  Instead, what happens if I make a payment to you is that the balance of my account is reduced as consideration for my bank procuring that the balance of your account (potentially with another bank) is increased.  This may look very much like I have transferred a deposit to you, but the distinctuion is important.

Shadow bank liabilities are generally held by large institutional investors, so it's useful to look at how investors like this manage their funds.  Such investors will typically hold their liquid funds in a range of short term investments.  The most liquid of these, between one day and the next, will be overnight instruments.  These may be simple overnight bank deposits, but they may also be overnight repo (reverse repo from the cash investor's viewpoint) or other instruments, which may be with a bank or a non-bank.

To make and receive payments during the day, investors will have transaction accounts with banks.  These will typically pay little or no interest overnight.  They may also have provision to be overdrawn, either during the day - if payments are to be made from the account before receipts are confirmed - or overnight.  It is inefficient for institutions with large liquid asset pools to carry a significant positive or negative balance in their transaction account overnight.  Such institutions will therefore seek to place as much of their net cash inflow into overnight instruments during the course of the day.

At the start of each new business day, all of the overnight money placed the previous day has to be reinvested.  Likewise, all of the institutions that had borrowed through these overnight instruments need to refinance.  The money markets are therefore most liquid at the beginning of the day when there are lots of buyers and sellers.  As the day goes on and more and more positions are filled, the market becomes thinner and it can become harder for someone trying to match a position to get a good price.  Money managers will therefore try and estimate their daily cashflow and place it as early as possible, rather than wait till the end of the day.

When money is placed into an overnight instrument, the value is agreed at which it will be redeemed the next day.  However, there is no guarantee of the current day's value.  If an investor places $100 early in the day and then changes his mind later in the day, he cannot expect to get $100 back.  It will depend on what has happened in the money market during the day and may be less or more than the $100 placed.  The only certain value is the redemption value the next day.

In contrast, balances in transaction accounts retain their value during the day.  So $100 paid in early in the day may be paid out as $100 later in the day.  When we compare this with overnight instruments, it seems that that this is much more money-like, whereas overnight instruments, including deposits, are more like what we think of as bonds, albeit with a very short maturity.

I'm not sure that this enables us to answer the question of whether shadow bank liabilities are money.  However, I think there are some useful observations that can be made.

1.  Transaction accounts are qualitatively different to overnight instruments, and shadow banks are not on the whole in the business of operating such accounts.  We could think of transaction accounts alone as being money, as these are the only means with which general payments can be made, and everything else as bonds.  However, this approach makes it difficult to say anything meaningful about the quantity of money.  The balance of transaction accounts is managed down to minimal levels by the end of the day, which is the only point in time at which the balances can be meaningfully measured.  The picture given by the end of day balances bears little relationship to all the activity that takes place during the day.

2.  From point of view of the holder, the liquidity of an overnight instrument does not depend on whether it is issued by a bank or a non-bank.  When we come to think about implications for the financial markets generally and the real economy, we should not therefore expect investors to behave differently when they hold bank claims as opposed to non-bank claims.  In this sense, there is nothing special about banks.  

3.  When a payment is made between transaction accounts, one account is credited and one is debited.  If both accounts start at zero, this means one balance becomes positive and one becomes negative.  Negative balances can be avoided if the account from which the payment is made is positive in the first place.  Either way, each payment has balance sheet implications for the bank (or system of banks) providing the accounts.

We have looked at a situation where holders of liquid assets attempt to manage their transaction account balances to close to zero by the end of each day.  However, this process involves a mass of individual transactions with little coordination.  If a bank processes a payment from one account, it cannot be sure that this will be covered by subsequent receipts, so it faces a potential credit exposure.  In order for a bank to be able to do this, it therefore needs a balance sheet of some size.  Part of this will be constituted by the issue of overnight instruments.

So, whilst bank issued overnight instruments may be no more money-like that those issued by non-banks, in the hands of investors, they are important in creating the balance sheet depth necessary for banks to be able to process payments through transaction accounts.  It's not so much that overnight bank deposits are money, but rather that they facilitate monetary exchange.