Banks and macroeconomic models

There has been a recrudescence of blogospheric argument on the nature of commercial banks, whether they are best considered “financial intermediaries” not unlike mutual funds or insurance companies, or whether they are something different, in particular, whether their ability to issue liabilities that are near-perfect substitutes for base money renders them special in macroeconomically important ways. See e.g. Cullen Roche, Winterspeak, Ramanan, and Paul Krugman.

If banks are mere intermediaries between savers and borrowers, it may be reasonable to abstract them out of macroeconomic models and simply focus on the preferences of borrowers and savers and the price mechanism (interest rates) that ultimately reconcile those preferences, perhaps with “frictions”. If banks are special, if they have institutional characteristics that affect the macroeconomy in ways not captured by the stylized preferences of borrowers and savers, then it may be important to model the dynamics of the banking system explicitly.

Paul Krugman says banks are not special, most recently citing James Tobin’s famous paper on Commercial Banks As Creators of Money:

In particular, the discussion on pp. 412-413 of why the mechanics of lending don’t matter — yes, commercial banks, unlike other financial intermediaries, can make a loan simply by crediting the borrower with new deposits, but there’s no guarantee that the funds stay there — refutes, in one fell swoop, a lot of the nonsense one hears about how said mechanics of bank lending change everything about the role banks play in the economy.

I want to unpack this just a bit. First, please don’t misunderstand the argument. Tobin’s, and by extension Krugman’s, point is not the facile argument sometimes made, that loans don’t meaningfully create deposits because a bank needs to fund the loan when the deposit created by a loan is spent or transferred. That is true of an individual bank, but not of the banking system as a whole, the object to which Tobin correctly devotes his attention. It is an entirely uncontroversial fact that when the banking system net-increases its lending it creates new deposits, regardless of whether an individual lender’s balance sheet expands permanently or ephemerally.

Tobin’s argument was that this mechanical capacity of the banking system to “create new money” by net-lending ultimately doesn’t matter very much, because the non-bank private sector has a preferred portfolio of assets, of which bank deposits are a single component, and the net-lending of the banking system is constrained and ultimately determined by the non-bank sector’s desires. If the banking system somehow ramped up its lending in ways that create more bank deposits than the non-bank sector wished to hold, the nonbank sector would pay down bank loans until its preferred portfolio was restored. This is a perfectly coherent view, a view fully cognizant of the mechanics of bank lending and deposit creation, under which there is nothing fundamentally important about banks. Everything that matters is captured by the portfolio preference of nonbanks, so a macro modeler might reasonably ignore the details of the banking system and simply model the portfolio choice of the nonbank sector.

However, that a view is coherent doesn’t mean that it is accurate. The weakness of the Tobin/Krugman view is that common Achilles Heel of macroeconomic models, aggregation. In order for banks not to matter, it must be reasonable to model the nonbank private sector as if it were a unified actor with preferences independent of the behavior of the banking system. It’s easy to offer plausible accounts under which this would not be the case.

Suppose, for example, that banks lend primarily to cash-starved agents, and that cash-starved agents spend primarily to cash-rich agents. (I am including bank deposits as in my definition of “cash” here.) Should the banking system “exogenously” increase lending, the effect would be first a transfer of cash and an increase in debt to the cash-poor, and then a transfer of cash to the cash-rich as borrowers spent their loans. Suppose that the cash-rich then find themselves holding more bank deposits then they prefer to hold. Mechanically, they have absolutely no ability to redeem the deposits for other assets. The only way that deposits in aggregate are reduced is when loans are repaid to the banking system. But the cash-rich have very few loans to repay! Unless they pay off the loans of the cash-poor, taking losses to uphold the collective preferences of a putative nonbank private sector, bank deposits are as inescapable to cash-rich as base money is to the private sector as a whole.

If the real world looks anything like this, then commercial banks do indeed have something quite analogous to a central bank’s printing press. Net-expansions of the banking system’s balance sheet provoke an inescapable injection of deposits into the aggregate portfolio of the cash-rich. The price of bank deposits, like base money, is pegged to unity. If deposit balances come to exceed the desired allocation in portfolios of the cash-rich, the imbalance cannot be resolved by falling prices. Instead, a “hot potato” effect must take hold: prices of other assets might be bid higher until deposits are restored to their desired small share of the aggregate portfolio. Credit expansion would lead to asset price inflation (much more than to ordinary price inflation, as the consumption plans of the cash-rich need not change in real terms, so there is no impetus to bid up the prices of goods, services, or labor). As a stylized fact about the world, bank-credit-expansion-leads-to-asset-price inflation seems pretty solid. [1, 2]

This is just one account among a potentially infinite many under which the Tobin/Krugman “banks don’t matter” view would be insufficient, despite its theoretical coherence. It would be nice, from a tractability perspective, if the nonbank private sector could be modeled as a single agent with portfolio preferences independent of the behavior of the banking system. But I think the weight of the evidence suggests that the world is more complicated than that. I think we will need to account explicitly for the behavior of the banking system in order to capture important features of the macroeconomy.

[1] The account I’ve provided is a simplification. Implicitly, I’m presuming a banking system that holds no assets other than base money and loans to customers. In the real world, bank balance sheets may hold all sorts of assets. For the persnickety, lets generalize the tale. Deposits may be redeemed not just by repaying loans, but by purchasing any sort of asset off the consolidated banking system’s balance sheet. Repaying a loan is a special case of an asset purchase: a borrower buys up her own obligation to a bank. But deposit holders who are not borrowers can shed deposits in the real world by, for example, purchasing Treasury securities held by banks. Does this meaningfully change the story? Given a modest credit expansions, maybe. Given a large credit expansion, definitely not. Let’s go through it.

When we claim that “deposit balances come to exceed the desired allocation in portfolios of the cash-rich”, we are implicitly conjecturing some menu of other assets that become underrepresented. If all of those other assets are held on the banking system’s balance sheet and available for sale, then cash-rich agents can restore their preferred portfolio simply by redeeming excess deposits for the assets they desire until their desired allocation is restored.

However, unless the assets the cash-rich desire are illiquid loans to the cash-poor, there will exist a scale of credit expansion beyond which some or all of the desired assets become unavailable for purchase from bank balance sheets. A creative solution to this problem is for banks to try to transform illiquid loans to the cash poor into substitutes for the assets the cash-rich desire. That’s one explanation (in addition to regulatory arbitrage) for the securitization boom of the early 2000s. But as we’ve seen, the strategy has its limits. Unless we posit perfect alchemy, there will be some scale of credit expansion beyond which cash-rich agents cannot restore balance to their portfolios by purchasing assets from the banking system.

Realistically, the scale of credit expansion beyond which portfolio balance cannot be restored by direct redemption of deposits need not be very large at all. For example, cash-rich agents typically desire to hold much of their wealth in corporate equities, which commercial banks hold in small quantities if at all. Following an injection of deposits provoked by lending and spending, cash-rich agents will be unable to restore their desired allocation of stocks except by bidding up share prices.

A common, but foolish, dodge of these problems is to pretend that the only assets in the world (besides loans) are base money, bank deposits, and Treasury securities, and then to presume that the banking system will always carry a sufficient inventory of Treasury securities and base money to restore balance through deposit redemption. This is stupid for the obvious reason that private-sector portfolio allocations contain stuff other than Treasuries, base money, and bank deposits, and for the less obvious reason that accommodating unlimited redemption implies that the banking system may borrow in unlimited quantities from the state.

For the super-persnickety, bank deposits can also be redeemed by purchasing services, rather than assets, from the banking systems. That is, cash-rich agents could get rid of excess deposits by doing stuff that caused them to increase their bank-fee expenses. It is unlikely they’d find this a very appealing way to restore portfolio balance, however.

[2] Readers might complain that I am misrepresenting Tobin a bit here, in that I’ve attributed to him the view that an overabundance of deposits will be remedied via loan repayment or asset purchase, while Tobin explicitly allows for a price-adjustment mechanism as well:

Given the wealth and asset preferences of the community, demand for bank deposits can increase only if yields of other assets fall [and therefore prices of other assets rise]. The fall in these yields is bound to restrict profitable lending and investment opportunities available to the banks themselves. Eventually the marginal returns on lending and investing, account taken of the risks and administrative costs involved, will not exceed the marginal cost to the bank of attracting and holding additional deposits.

Tobin draws a sharp contradistinction between deposits and base money:

Once created, printing press money cannot be extinguished, except by reversal of the budget policies that led to its birth. The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies. For bank created money, however, there is a mechanism of extinction as well as creation, contraction as well as expansion. If bank deposits are excessive relative to public preferences, they will tend to decline; otherwise banks will lose income. The burden of adaptation is not placed entirely on the rest of the economy.

Tobin wants to conclude that bank deposits differ from the obligations of other private financial intermediaries in degree rather than in kind. But, on the facts he accurately and perspicaciously observes, he might as easily have argued that bank deposits differ from base money in degree rather than in kind. After all, the economy adjusts to the issuance of no other private-sector asset by shifting prices and yields of across the full spectrum of financial assets. That sort of adjustment implies a “hot potato” effect sometimes. It seems arbitrary for Tobin to claim that for the “‘hot potato’ analogy” to truly apply, bidding up of other assets must be the only conceivable means of private-sector adjustment to its issuance. Since bank deposits behave sometimes or partially like “hot potatoes”, since they uniquely share the quality of being pegged to a price of unity with a government guarantee, they arguably share as much resemblance to base money as they do to “ordinary” financial assets. Tobin makes much of the fact that there is a limit to profitable issuance of deposits, that eventually yields on lending and deposits must converge, but there are limits to profitable issuance of base money as well, the state’s capacity for seignorage is not inexhaustible. The state must contract the supply of its money and obligations when private sector demand for them falters, or risk hyperinflation and political collapse. Banks and states have surprisingly similar financial structures, and modern banking systems inevitably include states at their core.

I think a lot of assumptions that foreshadow current disagreements surrounding banking are embedded in Tobin’s phrasing: “Given the wealth and asset preferences of the community…[t]he fall in…yields is bound to restrict profitable lending and investment opportunities available to the banks themselves.” Tobin presumes a unified financial community and rational profit-seeking banks. People (like me) who think a detailed understanding of the institution of banking should be at the heart of macro modeling contest both of those assumptions. We think that there is no homogenous “community”, but segmented populations whose socially problematic interactions are often mediated via financial institutions. We think that banks do not always or even usually behave in ways that can be characterized by a well-behaved infinite-horizon profit maximization problem. Instead, for a variety of reasons ranging from agency problems, political influence, faddishness, and mere error, we view bank behavior as special and complex. So we find it convenient to model banks specially, or to examine expansions and contractions of credit as if they were exogenous, rather than presume that other aspects of our models neatly determine what banks will do.

Update History:

  • 7-Apr-2015, 10:25 p.m. PDT: “only of if yields of other assets fall”

54 Responses to “Banks and macroeconomic models”

  1. Steve Roth writes:

    we view bank behavior as special and complex. So we find it convenient to model banks specially

    I think this is the crux. Krugman et al, in assuming that banks are transparent intermediaries between lenders and borrowers, assume that there is a symmetry of incentives between lenders and borrowers based on their intertemporal consumption preferences.

    Or: they assume that even though banks as lenders have very different preferences, incentives, and reaction functions than real-sector lenders (orthogonal to those of real-sector borrowers), Tobin’s portfolio effect means we can model the economy as if lenders’ and borrowers prefs, incentives, and reaction functions were symmetrical.

    Or as you say so succinctly: “Everything that matters is captured by the portfolio preference of nonbanks”

    (I think I find Ramanan giving aid and comfort to this latter view, though I’m not sure I full understand him:

    Since “agency problems, political influence, faddishness, and mere error” do exist, however (among many other effects), it’s hard to give credence to the frictionless, agency- and incentive-free pipe dream of intermediation that is characterized in that view — whether that intermediation is seen as being direct between lenders and borrowers, or effected through the complex interactions of portfolio adjustments.

  2. Ramanan writes:

    I think Tobin’s idea that the Widow’s Cruse “runs dry” is based on his story that there is some mechanism which prevents the banking system as a whole from lending because at some point in time marginal returns on lending may not exceed marginal costs. But this is inaccurate – lending is limited by creditworthy demand.

    Also, although he rightly blurs the distinction between money and other assets – as the PKEists themselves emphasize, nonetheless the non-bank private sector has a high portfolio preference for bank money and hence it makes it easier for banks. As banks lend, income rises and so will people keep more of the newly created money with banks if the portfolio preference doesn’t change.

    So there are weaknesses as you say.

    Whatever said, Tobin’s insights are truly great.

    Also in such discussions Krugman should be separated from Tobin. PK is a thoroughly confused guy – trying to hide behind the authority of Tobin.

  3. Max writes:

    Deposits can be destroyed not just be selling the bank’s assets (which as you say, may be illiquid), but by selling other types of liquid bank liabilities, such as bonds or stocks. And of course, non-banks also issue bonds and stocks, so it’s not as if banks have a monopoly on the production of liquid financial assets.

  4. Ramanan writes:

    Steve Roth,

    “though I’m not sure I full understand him:”

    the discussion is actually centered around the Monetarist hot potato process. If you thin carefully, it needs an effort to dismiss the hot potato.

    To be cleare, assume no QE.

    If borrowers borrow a lot from banks, and spend it someone holds the money (to be more accurate the flow of money which is added to the stock of already existing money). But from the holder’s perspective he/she/it is holding it as per whatever its preference is – such as some proportion of its wealth. Without any mechanism, these two numbers may be different. So what brings them into equivalence?

    If you do not come up with any mechanism, you will be forced to agree to Monetarist hot potato that prices of goods and services rise so that supply and demand of money are equal.

    Of course you know there is the reflux mechanism but the reflux alone cannot be said to be sufficient to dismiss hot potato.

    So if you run out of ways of more thinking, you are then forced to believe that some non-bank out there is holding the money deposits non-volitionally. This is called convenience lending but it is too difficult to believe.

    However, fear not, there is a further mechanism which is the mediating role of banks and by changing their assets and liabilities in the reverse direction, money supply and demand can be brought into equivalence. This is a quantity adjustment as balance sheets are changing but there is also a price adjustment – which is changes in rates such as deposit rates, loan rates etc and also changes in prices of securities in general.

  5. Anon writes:

    Except for the part about the economy being made up of homogeneous agents with static, known preferences acting in an ergodic process, everything Paul Krugman says about banks is true.

  6. shah8 writes:

    Hey there, a big fan.

    Reading this post got me on my particular issue: The economic crisis is actually a political economy crisis. The cash poor people are cash poor because they have substantially reduced economic rights compared to the cash rich people, and this plays out in constant positive feedback cycling. At least until the breakdown that destroys the political system that fosters the pathology.

    Not only would pushing cash into the economy via banks work. *Direct* helicopter drops of money also would not work. Only reduced creditor friendliness, valuable services like health care, infrastructure improvement (not spending), etc, will work.

  7. Dan Kervick writes:

    … because at some point in time marginal returns on lending may not exceed marginal costs. But this is inaccurate – lending is limited by creditworthy demand.

    Ramanan, isn’t that more or less the same thing? Once the economy reaches a state where borrowers can no longer be expected to achieve an average return on investment sufficient to deliver interest returns to the borrower at the rate the borrower must charge to make a profit given the marginal cost of addition lending, then fewer and fewer loan applicants will appear creditworthy.

  8. Dan Kervick writes:

    I was a little bit puzzled in reading that Tobin article about how Tobin understands the institutional role of the central bank, and how he thinks the central bank conducts monetary policy. He seems to place all the emphasis on the ideas that (i) the central bank sets reserve requirements and (ii) the central bank issues physical currency, which play a special role because it is the only liability that can’t be extinguished except by being taxed out of circulation. The picture I came away with is that the central bank is (somehow) helicoptering currency into an economy, some members of which choose to act as financial intermediaries, attracting deposits and loaning them on. At that point, the central bank’s role is to dial reserve requirements up and down to modulate the pace of transmission from this acquiring and loaning on of deposits. If that’s the idea, you wouldn’t know from this picture that the Fed is actually a bank, and that it sits in the center of a centralized banking system.

    And I’m more puzzled than ever about how Krugman thinks QE works.

    As for the so-called “hot potato” effect, it seems extremely implausible to me that central bank asset purchases in the private sector, where these sales occur (i) through a voluntary process in the open market (ii) in precise aggregate quantities that are announced in advance by the central bank and so make the impact on prices very predictable, could leave the sellers of these assets in a state in which they then feel a significant need to “rebalance” their portfolio away from the dollars they just acquired. The portfolio impact of the asset sale is very much predictable. They already made their portfolio decision when they chose to sell the asset. If they weren’t happy about the impact it was going to have, then they wouldn’t sell the assets in the first place. The Fed is not going around stealing people’s securities in the middle of the night and stuffing dollars in their pockets while they sleep.

  9. JKH writes:


    Very deep post as usual.

    Your extreme point of a poor/rich asset liability structure for banking seems unstable and maybe contradictory in one way. If the extreme assumption is that the rich possess all the deposits that might eventually be needed to repay bank loans, but obviously won’t be used for that purpose, then the asset side of the balance sheet is in a state of expected comprehensive default. Credit assessment and capital allocation should prevent that extreme point from being reached. In other words, pricing will be a roadblock to that extreme point. And loans will be repaid by deposits held by the poor, away from the extreme asset-liability point.

    And the rich who have no loans to repay will bid up stocks and other things until they don’t want to get rid of their deposits.

    “Unless they pay off the loans of the cash-poor, taking losses to uphold the collective preferences of a putative nonbank private sector, bank deposits are as inescapable to cash-rich as base money is to the private sector as a whole.”

    But if the poor have the deposits sufficient to pay off their loans (as above, contrary to the extreme asset-liability point) then the debtless condition of the rich is not a factor in that regard. By spending to the point of asset pricing indifference, the rich may pass deposits indirectly to the poor. Why shouldn’t that happen? The indebted poor must already have access to some money in order to repay loans, by non-extreme assumption. Why won’t they get more?

    “Net-expansions of the banking system’s balance sheet provoke an inescapable injection of deposits into the aggregate portfolio of the cash-rich.”

    But again, it needs to be away from the extreme point. The banking system expands at a pace that is consistent with the borrowing needs of the cash poor, but also consistent with the credit analysis and capital allocation that allows the poor to borrow.

    In other words, I think the true poor/rich extreme point is only consistent with bank lending that becomes zero. Bank expansion can only occur away from that extreme point.

    Banks wouldn’t exist if they couldn’t balance credit assessment with capital allocation in the context of a viable income distribution in respect of borrowers. And given that they can and do exist on that basis, there’s no reason why they can’t grow on that basis.

    “If the real world looks anything like this, then commercial banks do indeed have something quite analogous to a central bank’s printing press.”

    But I think the criterion is growth under a viable income distribution for lending purposes, rather than growth under an extreme income distribution.

    The extreme point may also be where the poor have zero income, and can’t get a loan as a result – which contradicts the assumption that the rich build their deposit holdings.

    Credit assessment and capital allocation have to pick their spots along the income distribution continuum. That allows lending, deposit creation, and growth.

    And if growth equates to a printing press, then that is the situation. In other words, all it requires is growth, according to your criterion for “uniqueness”.

    Which is another way of saying that the uniqueness comes from “loans create deposits” on a sustainable basis.

  10. Diego Espinosa writes:

    Dan Kervick makes a point I’ve wondered about. If someone sells Treasuries to the Fed, they are by definition indifferent between holding cash and Treasuries at that sale price. Why, then, is cash a “hot potato”?

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  12. Luis Enrique writes:

    “the mechanics of lending don’t matter” for what?

    I am convinced by your cash poor / cash rich story in which an exogenous increase in bank lending has an effect. But if I was trying to write down a macroeconomic model to study monetary policy rules, or whatever, would I need to include that mechanism?

    On the face of it, Krugman’s assertion is plainly false. We can think of all sorts of ways in which the mechanics of lending matter, for some definition of “matter”. But all models necessarily exclude all manner of things that might matter in other contexts.

    One candidate for a macro model in which the mechanics of lending might matter could be a model that tries to explain the origins of financial crises within the banking sector. Traditional-modern (!) macro has never tried to model where shocks come from, and has just footled about arguing over optimal monetary policy etc. supposing shocks exist. Now there are a bunch of papers that try to model credit booms and crises. I expect Krugman wouldn’t assert the mechanics of lending don’t matter there. I am not absolutely sure I understand where he thinks those mechanics doesn’t matter, but he might have in mind models about fiscal policy, unemployment etc. at the ZLB in the wake of a large negative shock. I’m not sure he’s right, but I do think his claims need to be evaluated in the context of a particularly problem and not by thinking about whether lending mechanics matter per se.

  13. Luis Enrique writes:


    yes, the hot potato story makes me imagine somebody shoving a steaming Jacky P into my hand against my wishes. You’re right assets sales are voluntary, however selling assets in return for cash is obligatory. Whilst some people might look at their portfolio and decide to increase their cash holdings, I think for most sellers of assets, cash is just an unwanted but unavoidable intermediate step in-between selling what I don’t want and buying what I do. So it’s a hot potato that you voluntarily accept but don’t want to hold onto.

  14. FRauncher writes:

    I cannot understand how Krugman could be so WRONG in his take on this! Among economists he is my idol. I read all his blogs and columns every day. But he is really, really wrong. How could he fall into this simple fallacy of composition?

    Here i write not as some kind of a theorist but as the most micro of microeconomists – an ex banker of 50 years ago, about the same time that Tobin was theorizing. In those days, each branch of BofA California (which was almost a macro economy in itself) wired the essentials of its balance sheet every day to the cashiers dept. Often what we loaned in one branch, was deposited in another, but in case there was imbalance, the cashier’s NY office could easily buy or sell fed funds to even out reserves in the system.

    Even small banks which were not members of the Fed system had their money center correspondents which essentially served the same purpose.

    Thus it is obvious that every individual or business that earns a living wage or income, be she a salaried clerk or a hedge fund has a bank account (yes even a shadow bank) and that everything bought or sold is eventually reflected in a bank account. thus banks do create money through loans, and that money (or very little of it) does not just disappear down some rat hole, unless loans are repaid or written off. What is loaned in one bank may be paid to an account in another bank, but essentally it stays in the banking system. There have been many changes in the last 50 years, but that is still the same.

    In those days, most of us did not understand that we were encouraging the fallacy of composition. We used to require our middle sized borrowers to keep “compensating balances” with us, 10% or 20% of a line of credit, which we said was to assure us of a supply of loanable funds, but which in fact was just a means of inflating our balance sheets. Thus we reinforced the conventional wisdom that many still believe today.

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  16. PeterN writes:

    If you’re going to model an economy, I’ve always felt it was important to have a clear definition of money and to use it without equivocation. It doesn’t appear this feeling is very widely shared.
    It has been fashionable to invoke arbitrage mechanisms to support concepts like the efficient market hypothesis, but to ignore them when discussing money. I’m not going to argue terminology here, so it you want to call some credit media of exchange money and others something else, fine. I choose not to do so. It makes no difference to the underlying argument. Instead I think it’s more useful to talk about moneyness. Some media of exchange command premiums over others due to greater liquidity, superior safety or wider acceptability. Currency issued by central banks which have some reserve currency status has usually been the most monetary form of money, since it commands the highest premium (measured by the opportunity cost of holding it). This is particularly true in its effective currency area. The currencies of the US, Japan, China, Great Britain and the Eurozone are generally considered to be first tier currencies. These would be followed by currencies like the Swiss Franc, which though safe and liquid, trade in smaller volumes and are backed by smaller economies.

    Lower power money would be the various instruments tracked as part of the M4 aggregates of the major currencies, and there are undoubtably other instruments that qualify as money that command lesser premiums or have restricted circulation. Thus the Linden dollar used in the online community Second Life is money. It’s exchangeable with other forms of money through brokers at posted discounts. Then there are Bitcoins and the like. Equivalently backed credit instruments that pay interest are considered more or less moneylike inversely according to the interest rate payed, since this directly reduces the opportunity cost of holding them.

    The point of this preamble is that there are always arbitrage opportunities between forms of money. It requires considerable justification to ignore this and treat a monetary subset as a closed system, when it is possible to create credit anywhere in the larger system of which it is part.
    A second point of equivocation is the use of the term “intermediate”. After all a thief is an intermediate between me and his fence. To call an institution an intermediate says nothing about, agency, fiduciary responsibility, practical accountability, incentives, information assymetries, risk or fraud. Financial intermediaries have demonstrated notable failings in all these areas recently and done so on a large scale.

    This matters because of the distortions both the actuality and the threat of these “frictions” and biases create in the functioning of the intermediation process. A great deal of the system is an attempt to control these factors – with indifferent success.

    Then there is risk. Intermediaries don’t just recycle funds, they speculate on duration and redistribute risk. You can’t give any reasonable account of the events of this financial century (like the Euro crisis) without including risk. For example banks are critically influenced by funds at risk and measures of risk weighted assets, and when banks transfer risk to their depositors (as in Spain), the results matter.

    Another term of equivocation is “bank”. The bank of Krugmanland and banks like Morgan Stanley, and Goldman Sachs exist in two different universes. It’s not clear that in a world of rational expectations, the latter two could even exist.

  17. A H writes:

    JKH makes some good criticism of the model in this post, but I think it can be made to work a bit better if you look at it froma Minskian perspective.

    You have an economy with banks, a financial assets, ponzi households and hedge households.

    Ponzi households need to borrow in order to consume, their income and assets are not enough to cover their needs. They hold a small amount of financial assets

    Hedge household’s income is enough to cover all there consumption needs so they don’t need to borrow. They next period they go back to the bank and get a new loan.

    So banks lend to the ponzi households, who use all of the loan in consumption. This means that the deposits created by these loans get transfered to the hedge households. Since hedge households have no debt and no need to go further into debt, they use them to buy financial assets, causeing the price of finanicial assets to increase.

    This inflation in financial assets also causes the balance sheet of the ponzi household improve, meaning they can keep rolling over debt for an even longer period of time.

  18. JP Koning writes:

    “…bank deposits are as inescapable to cash-rich as base money is to the private sector as a whole.”

    Interesting, this is the exact same point made back in the early 1800s by the currency school in the big currency school vs banking school dust up. Plus ca change. Currency school advocates accused the Bank of England and the country banks of overexpanding their note issues, whereas the banking school maintained that overexpansion could never occur thanks the “specie convertibility” release valve.

    The banking school take on your story would probably go something like this. Assume an “exogenous” increase in bank lending, and the created deposits end up in the hands of the cash-rich. When the cash-rich spend these deposits, say by writing cheques, the cheques they write will end up being held by private banks who in turn will require settlement of competitor’s cheques in base money. The settlement process destroys bank deposits, allowing the initial injection of deposits to “escape”.

    Banks responsible for the exogenous increase will have to scramble to get enough settlement media once their cheques reflux back to them. Presumably they’ll sell assets, or pay another bank to sell assets on there behalf and borrow the freed-up reserves, thereby canceling out any brief inflationary effects created by the original purchases of assets by the cash-rich.

  19. Peter K. writes:


    “And I’m more puzzled than ever about how Krugman thinks QE works.”

    My guess is that he sees it as primarily a signaling/communication device. The history has been that over the past few years when inflation expectations began dropping (disinflation) the Fed performed a QE and inflation expectations went back up.

    In June when Bernanke signaled a tapering of QE, interest rates rose one percent and it became that much more expensive to buy a house. Demand was sucked out of the economy over Bernanke’s communication. (Did it also become more expensive for state and local government to borrow? I think it did. Their budget pictures worsened over Bernanke’s signal and hence fiscal policy was tightened.)

    Krugman would prefer that the Fed perform irresponsibly and show some Rooseveltian resolve, have a regime-change as Christina Romer put it. Promise larger and larger QEs until they hit 4 percent inflation and continue until output gap is closed and economy is at full employment. Then switch to a NGDP target. See Abenomics for an example. Instead the Fed promises more of the same.

  20. Tom writes:

    This is actually the crucially flawed thought in Tobin’s argument: “If the banking system somehow ramped up its lending in ways that create more bank deposits than the non-bank sector wished to hold, the nonbank sector would pay down bank loans until its preferred portfolio was restored.”

    Individuals and organizations each determine their own preferred holdings of bank deposits, but in the aggregate, deposit-holders do not control the total supply of deposits. Individuals who have more band deposit cash than they want to hold can rid themselves of it various ways besides paying down bank loans. The demand for deposits turns out to be very flexible.

    As an example, deposits have grown very rapidly in recent years because central banks also create deposits when they lend to the real economy (eg by buying Treasurys and MBS). The deposit supply has grown far faster than the economy. Are we supposed to believe that’s because people and companies have become so much more desirous of cash? Do we know they were more desirous of cash because they failed to keep the deposit supply stable by paying down bank loans in the same quantities as the Fed was buying Treasurys and MBS? When you scratch the surface, the Tobin-Krugman argument gets very absurd very quickly.

    As a rule, bank loans are only paid down in aggregate during a down cycle. It’s traumatic for the economy when more loans are being repaid than are being issued. The result, or cause (it’s a bit of a chicken or egg debate) is generally recession, and likely debt deflation, especially if other kinds of credit such as deficit spending are not countering the bank credit contraction.

  21. JKH writes:

    “Suppose that the cash-rich then find themselves holding more bank deposits then they prefer to hold. Mechanically, they have absolutely no ability to redeem the deposits for other assets. The only way that deposits in aggregate are reduced is when loans are repaid to the banking system. But the cash-rich have very few loans to repay! Unless they pay off the loans of the cash-poor, taking losses to uphold the collective preferences of a putative nonbank private sector, bank deposits are as inescapable to cash-rich as base money is to the private sector as a whole.”

    If that poses a sufficiently large asset inflation threat, the government could issue bonds and hold the money passively with the banks – transferring the rich depositors’ deposit glut to the government. The government would pay the cost of the yield curve for doing so. And that would add incrementally to the deficit as a result of the interest rate differential. But this would shrink the private sector money supply, which is essentially the problem that needs to be addressed. The rich would extend term.

    More importantly and realistically, this is a normal occurrence within banking itself. Banks regularly convert demand deposits into term deposits by offering appealing terms for doing so. It is a part of regular asset liability management procedure. And it has the same sort of liquidity related hedging effect as the government action above.

    This highlights one of the weaknesses inherent in the “loans create deposits” tic of the blogosphere. It entirely overlooks the capacity of banks to adjust the terms of demand deposits in this way. It’s another way in which banks are special. They can very easily reshape the money liabilities they issue into other liabilities by offering the right terms. It happens all the time.

  22. Peter N writes:

    You can demonstrate the role of credit without banks, if you assume it is exogenous. Assume it is magically injected into the economy. Then

    1) Some of it will fund production. This increases the supply of goods, so it is (in simplified theory) not inflationary and adds to real GDP

    2) Some of it will increase CPI inflation, affecting the other part of NGDP

    3) Some of it will fuel asset inflation which isn’t tracked by NGDP

    4) Some of it may be canceled by deflationary forces (like the effect of cheap imports on CPI inflation).

    If the net credit goes negative, these trends reverse, but this also has a negative effect on expectations and creates problems with liquidity and Fisher debt deflation. This seems to me a reasonably coherent story.

    One point of including financial institutions in models is to remove the exogenous credit magic and be able to make predictions about financial cycles, ordinary or otherwise.

    The other point is to model any pathological behavior, rents, risk shifting, perverse incentives, agency problems, information asymmetry problems and the like.

    Not everybody is interested in modeling (or believes in the importance or even the existence of) all of these problems, which can get people at cross purposes fairly quickly.

  23. […] in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can […]

  24. […] in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can […]

  25. […] in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can ignore […]

  26. […] in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can […]

  27. Dan Kervick writes:

    That Tobin article really helps me understand where Krugman has been coming from, and not in a good way. Correct me if I’m wrong, but these seem to be key points of the Tobin framework:

    1. Banks are credit intermediaries. They are different from other intermediaries only with respect to expertise resulting from specialization and the economies of scale they can achieve, but not in fundamental kind.

    2. Like other credit intermediaries, banks conduct business by attracting deposits of money and then lending those deposits on.

    3. The Fed (somehow) determines the supply of money in the economy, independently of the operations of credit intermediaries.

    4. Currency is an especially important form of liability, because it is only extinguished by being taxed out of the economy.

    5. The most important tool of monetary policy, besides regulation of the money supply, is the adjustment of reserve requirements.

    6. The role of reserve requirement adjustments is to modulate the pace of lending by expanding or tightening the bottleneck between attracting deposits lending them on.

    All of this seems quite off the mark to me.

    A lot of economists seem to have missed the part of US history where we created a highly centralized, state-governed banking system. The Fed is a bank, governed primarily by government appointees, and the Fed member banks are indeed special in that (i) they are permitted to hold deposits at the central bank, (ii) have access to the central bank’s credit window and (iii) have access to the government’s deposit guarantee program. In addition they are governed and regulated in ways too numerous to mention by the central bank.

    The fact that the deposit account form of money is created and extinguished through the processes of lending and loan repayment doesn’t make it different in kind from currency. The currency is just a physical form of the liabilities of the central bank and the government, convertible on demand to deposit balances at the central bank, and extinguished via payment obligations – which include both taxes and loan repayment.

    Also, the Fed doesn’t operate a money helicopter that sprinkles money into the economy independently of the credit operations of the supposed “intermediaries” in the commercial banking system. It closely partners with its member banks in the process of money creation and destruction, accommodating expansions and contractions of commercial bank balance sheets with expansions and contractions of the central bank balance sheet, meeting the demand for credit and bank liquidity in the interbank payment system which is itself a reaction to changes in the demand for credit and liquidity in the world of households and non-banking firms. Those banks are the chief mechanism through which the Fed’s monetary policies are executed. I don’t see how Krugman can hold that in order to understand how and whether various actual or proposed monetary policies will work, it doesn’t matter how these institutions are structured!

    The Fed and the Fed’s member banks are a single organic system for the social management of the credit and monetary system. The member banks aren’t just so many independent goldsmith bankers operating independently by trading in the money that the Fed emits through some other mysterious channel. Because of the growth of shadow banking, the architecture of the system is more ragged now, and the degree of Fed control has been lessened. But it’s still nothing like the Tobin picture!

  28. stone writes:

    Perhaps the key consequence of increased bank lending is to increase the size of the banking sector of the economy. In the UK and USA, >80% of bank lending is for home mortgages and in the UK that is overwhelmingly for pre-existing housing stock. So more lending simply means that we each get saddled with a bigger mortgage since houses sell for as much as banks will lend to bid up house prices. So instead of each person ending up spending say £50k on mortagage interest we instead get to spend £100k and as a consequence get to provide for some extra bankers (or provide more for the bankers).
    Perhaps one way to incorporate the banking sector into macro models would be as an overhead that saps surplus production of the host economy and that can cause the economy to implode if it grabs too big a share.

  29. Matthew writes:

    I’m not sure I see any policy relevance here. Basically, you’ve pointed out that if preferences are heterogeneous in a certain way, we can end up with “sunspot equilibria” in which totally extrinsic factors shift bank lending away from reflecting preferences of the cash-rich towards the preferences of the cash-poor. That particular shift involves a brief period of asset price inflation, and a shift back could cause a period relative asset price deflation. That looks superficially like a bubble, except that both equilibria are actually stable.

    Maybe you could argue that staying with one equilibrium is better than volatility, but there appears to me no inherent reason to want to influence which equilibrium we stay at.

    Then again, without seeing some math, Im not totally sure I understand the model.

  30. Unanimous writes:

    Max and JKH have both made the point that demand deposits are often converted into term deposits, bank bonds, and, less often, bank shares. Normally, competition between banks to keep their individual reserve balances slightly in excess of requirements compels them to offer interest rates for term deposit accounts and bonds, and to a lesser extent to sell shares. The amount of demand deposits therefore normally tends towards the non-bank preference for them over term deposits and bank bonds. You can see the variety of bank liabilities by looking at bank balance sheets.

    This is not exactly the way that Krugman/Tobin explain things, but it is very similar to the points they make and lends support to it – non-bank preferences determine the amount of demand deposits, and non-bank preferences are the main determiner of the macroeconomy.

    But, the tendency is only a tendency, and it is a non-QE tendency assuming competition by each bank trying to keep a particular reserve balance. In the real world, under changing investment and borrowing fashions and with unadjustable fixed interest rates over certain terms, things can get out of wack, and the situations of banks and the amount of cash affects the macroeconomy.

    A second point to make is that historically there have been situations in which banks were not present, but promissory notes of convenient denominations were issued by prominent companies and individuals which circulated as cash. The banking function and cash creation therefore does not depend on banks. When banks don’t exist, the banking function is carried out nevertheless, and cash is still endogenously created.

    But banks being unessential to the functioning of markets does not mean that the amounts of cash, term deposits, bonds, shares, and prices of other asset don’t interact in strange ways, or cause markets to not clear for prolonged periods of time. Also, marketing influences the formation of preferences, and banks carry out marketing and influence the formation of preferences. They do so from the point of view of the banking sector, and so are not “transparent” intermediaries but active participants in the economy.

  31. JKH writes:

    Tobin’s paper is fine.

    Banks are intermediaries.

    So are insurance companies.

    Banks are special.

    So are insurance companies.

    It’s only logical that different elements in a classified group have things in common and things that are unique.

    The primary role of banks is not necessarily payment settlement. You might think that way if you thought loans creates deposits describes banking. But banks have assets and liabilities with a non-trivial duration and risk mix. There is an intermediation effect. Banks manage that effect through centralized function such as asset-liability management, risk management, and capital management. And if people don’t know how those functions work, they should check their bearings before being too aggressive about calling mainstream economists ignorant about banking. There’s some truth to that, but there’s also a question of degree. And in that context, Tobin’s paper is fine.

    Yes, return on capital is a priority.

    But you can’t get there without providing a service to borrowers and depositors, obviously.

    Everything gets priced.

    Return on capital is a constraint on asset-liability pricing, but in a sensible way market competition is a constraint on return on capital expectations. You can’t make 20 per cent ROE on a business where the market is at 15 per cent ROE. Otherwise, you end up with no banking business if you think that way about everything.

    “…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.”

    Nothing wrong with that.

    Tobin is basically describing asset-liability management, which is an internal function performed by banks in fact.

    Nothing there implies loanable funds.

    Tobin fully understands loans create deposits and that the money multiplier is wrong. It’s right there in the paper.

    The reason Tobin appears to refer to bank depositors as lenders is because they are lenders in the counterfactual without banks. They become depositors instead with banks. This is what he means and it is a non-issue.

    Total confusion on the internet about this idea of intermediary. Like it’s some virus to be avoided.

    Incredibly silly.

    Its just more of moving definitions and vocabulary around from one corner of the room to another.

    Ramanan is right that Tobin is not responsible for Krugman’s confusion. Nothing wrong with Tobin (or very little). Krugman is responsible for his own confusion.

  32. Dan Kervick writes:

    Tobin is out to critique what he calls “The Old View”, while preserving aspects of that view that he thinks are important. One of these aspects, on his account, is that reserve requirements and interest rate caps are to some degree effective in controlling the creation of deposit accounts.

    One of the strongest points he makes is that bank demand deposits are genuine liabilities of the bank, and that banks therefore don’t simply create both the liability and the means to pay it “from thin air.” To the extent that the “fountain pen money” picture conveys that erroneous impression, it is misleading.

    When we use these bank deposits as payment assets, we are employing the well-understood technique of using the negotiable liability of a third party to settle a debt. And while I am not happy with the particular account he gives of the matter, I think his claim that these liabilities are different in kind from the money issued by the central bank is important. Central bank money is also classified as a liability of the central bank for many accounting purposes, and in official government communications about the balance sheet of the central bank, are liabilities in a much more peculiar sense than the liabilities of private sector entities, since the central bank’s issuance of money is not constrained by anything other than its policy purposes. Positive financial “equity” on the central bank balance sheet is just a policy choice governed by price stabilization aims.

    Where I think Tobin goes off a bit is in his overly strong insistence that there is no difference between money and other types of assets significant enough to require a special type of economic asset analysis, and that similarly there is no difference between commercial banks and other financial intermediaries that is significant enough to require a special type of economic institutional analysis. He seems to be of the opinion that if there were very significant difference s of this kind, then that would lead to the conclusion that the bank’s possessed a widow’s cruse, resulting in an unrestrained continuing gusher of money. Nobody doubts that banks create deposit account liabilities as part of their participation in a market in which they are trading those liabilities for other assets: promissory notes, and that their behavior in that market is thus constrained by the supply and demand for the types of assets on the two sides of the exchange. But I don’t see why recognizing this depends on denying that money is a special form of asset, that bank deposit account liabilities function in our society in that special role, and that banks are special types of economic agents deserving of a specialized form of economic analysis because of their ability to generate this particular form of liability.

    The fact is, that in the vast majority of exchange transaction that occur in our society, there are a few particular forms of negotiable liability that, as a class, are involved in the exchange on at least one side of that exchange: the physical currency liabilities issued by the central bank, the deposit account liabilities issued to commercial banks by the central bank, and the deposit account liabilities issued by commercial banks to everyone else. This is an empirical fact that demands explanation, not an inconvenient fact to be explained away.

    It is also important to recognize that what the liability is traded for when a bank issues a deposit liability in the process of making a loan – a promissory note – is itself an instrument that creates an obligation for payment with the very same types of assets described in the previous paragraph.

    It should also be noted that the whole conceptualization of market exchange in terms of “supply” and “demand” is based on a distinction between the broad class of commodities, services and assets for sale, on the one hand, and a particular subclass of assets – payment assets – on the other. If you were modeling exchange in a barter economy, you would just have two different intersecting curves, nether one of which would be privileged by the label “demand curve” while the other was the “supply curve”. Both parties would be at the same time suppliers and demanders. The classification into supply and demand is based on the implicit recognition that at one side of the transaction (the demander)is a party with a schedule of willingness to part with a payment asset in exchange for something else, while the other side (the supplier) has a schedule of willingness to part with that something else in exchange for the payment asset.

  33. Nick Edmonds writes:

    It’s hard to understand the importance of banks to macro-economic outcomes without recognising that the people that borrow money are not generally the same people that hold bank deposits. This is essentially the cash-rich / cash-starved distinction you make.

    That is not to say that you need to have a model with banks in order to get the same mechanics. A model with distinct borrowers and lenders and, crucially, some portfolio choice is enough to get the same result. So you could argue that modelling banks doesn’t matter because you can get the same results by attributing suitable behavioural assumptions to your non-bank agents.

    But will that help understand what happens in the real world? The massive expansion of credit prior to the crisis and the subsequent entrenchment mattered. It mattered whether you’re a monetarist who sees it as the creation of hot potato money or whether you’re a PKE who sees it as facilitating debt funded expenditure – you can take your pick as to which story you prefer. But trying to understand why credit did indeed expand so much, without understanding what was happening in banking is crazy.

  34. errorr writes:

    Is there an explanation in the portfolio preferences of the cash rich for everything?

    Looking for clarity here…

    If pre 2007 the “giant pool of money” had a high demand for cash like assests and the securitization of mortgages convinced the cash rich that gse and mbs bonds were safe enough to be cash like then the moment when everyone realized the emperor wor no clothes the protfolio preferences shifted suddenly and drastically enough that there was not enough money and the fed was too slow to fix things. When the market saw Lehman go down everyone realised that the Fed wouldn’t provide liquidity at “any” cost and nobody wanted to hold anything but treasuries or cash, the FED reacted very slowly in lowering interest rates which didn’t allow the cash to endogenously grow to fill demand causing a recession.

    At this point even lowering to 0 was not enough to fufill preferences so the need for more money has been unmet. The only way to meet the demanded portfolio needs of the cash rich are to print money by expanding lending. This can be done either by lending directly to government (simplified) or improving the balance sheets f the cash poor through something like a massive payroll tax cut. Alternately the FED tries QE which if buying treasuries is useless because treasuries are cash equivalent (inverse to their length of maturity) or by buying mbs which could possibly convince people once again that they are suitable to meet the portfolio requirements of money demand.

    After this it seems like Krugman is using a post hoc rationalization of his preferred solution of government borrowing where the functioning of the banks don’t matter to his percieved best solution and so he uses an antuquated explanation of bank operations.

    The monetarists do something similar with different strong priors.

    Lastly that leaves the PKE types where they argue that addressing the balance sheets of the cash poor (Cullen Roche’s view) will allow the renewed lending to endogenously expand the money supply to meet the portfolio preferences of the cash rich.

    In the end the argument seems more about efficacy than anything where examination of the technical aspects of banking is vital to the argument of the PKE types but not necessarily to others which is why they ignore it.

    PK and SS are ignoring the real problem with their position which is that if banks matter as outlined above then their solutions dictated by their strong ideological priors are not as effective as they like to portray. SS seems the weakest especially since the new paper out of Jackson Hole suggest that QE buying of treasuries is barely effective. PK doesn’t take the time to explain how straight deficit spending addresses the need for money creation without directly benefiting the balance sheets of the cash poor even though he has in the past mentioned the importance of that fact.

    In the end everyone agrees what the end result should be but the strongest argument seems to be to make sure that the money ends up in the right place would be to directly give it to those with the worst balance sheets through some form of direct transfer.

    Is this about right or am I missing something?

  35. errorr writes:

    Sorry if the previous paragraph is difficult to read but I am using a buggy phone to post.

    If I have this right this post finally let me connect all the necessary dots and fit together all the seemingly rational arguments of the three major types of thoughts.

    Once again another fantastic post by SRW.

    Of course the Austerians are still nuts and don’t seem to say how anything but time can make things better which in light of what I read seems nutso.

  36. errorr writes:

    After reading through some more comments I saw JKH challenge the cash rich/poor dichotomy. However, if you take the mass of underwater homeowners and defaulters you DO have a situation where money is slowly moving as the cash richer buy up foreclosures. However there is a major time lag here and adjustment has been slow.

    Bankruptcy is a subject on which I am more than a dilettante and I assure you the process is slow and painful way to rectify the possible imbalance between the cash rich portfolio preferences and having the necessary group of consumers available to make money creation viable to the extent necessary to meet demand.

  37. Ramanan writes:


    “Where I think Tobin goes off a bit is in his overly strong insistence that there is no difference between money and other types of assets significant enough to require a special type of economic asset analysis, and that similarly there is no difference between commercial banks and other financial intermediaries that is significant enough to require a special type of economic institutional analysis”

    That is incorrect. If you read up his asset allocation theory, households and institutions have portfolio allocation decisions and parameters so the distinction is the difference in these parameters. You can see this clearly in Wynne Godley and Marc Lavoie’s book.

  38. Detroit Dan writes:

    There are lots of different opinions here, but everyone seems to agree that Krugman and, especially, Sumner are wrong. So we have consensus on that at least…

  39. Dan Kervick writes:


    I’m basing my reading on the text of the paper SRW and Krugman cited. See pp. 414-15 of the paper. It’s a pretty old paper, so did Tobin reconsider?

    In any case I’m not getting the argument that somehow Tobin is fine, and that if Krugman is mistaken the mistakes are of Krugman’s own manufacture. It seems to me that Krugman is justified in claiming to find support for his model of the monetary system in that Tobin article. The fundamental issue in contention, it seems to me, is how much one need to know about the institutional structure of the banking system and Fed-Bank operational mechanics to properly judge the potential impact of monetary policies such as QE, or even more conventional policies. Krugman’s apparent answer is something like “Hardly at all; banks are just financial intermediaries who can be rolled into the rest of the economy for the purposes of analysis. They can issue liabilities of various rates and maturities (including the zero rate, non-maturing ones)and try to trade them for assets of various kinds, but so can anyone else. The results depend on the supply and demand for different types of assets in the economy as economic agents attempt to achieve their preferred portfolio balance.”

    But obviously, if a bank issues a non-maturing, non-interest-bearing liability in the form of a deposit account balance, it is going to have a lot more success in trading it for an interest bearing promissory note than I would. Why is that? I understand Tobin’s answer to be basically that (a) banks are specialists in a particular type of trade, and so know how to do it better; (b) Kervick is a small and unpracticed financial intermediary, with fewer payment services to offer, no economies of scale to pass on to the borrower, and less reliable in his contingency plans for dealing with unforeseen losses.

    It seems to me that Tobin nowhere acknowledges that Federal Reserve member banks are part of an organized and centralized public-private banking and credit system; that the Fed isn’t just the issuer of currency and regulations, but is a state-run bank; that the member banks are virtually unique in having deposits at that bank and access to the bank’s credit facilities; that member banks are unique in having access to the Fed’s rapid and streamlined interbank payment system and the netting systems that access it, and and that commercial banks are also unique in having access to the government’s deposit guarantee system (unlike the intermediary Kervick.) Those facts seem absolutely crucial to me in explaining why almost everyone accepts a bank’s risk-free “fountain pen money” as payment for virtually everything, and why banks can therefore find a huge market for that kind of liability that Kervick and other intermediaries cannot find.

  40. Ramanan writes:


    Too many accusations but … one example … Tobin mentions importance of government guarantees, banks being able to borrow reserves from the central bank and so on.

    It is better to keep Krugman and Tobin separate – there is a gigantic difference between the two personalities. Do not blur the two to show Tobin wrong. He had his errors but not the ones you point out.

  41. Dan Kervick writes:


    In section IV, and then reiterated again at the beginning of section VI, Tobin discusses the ways in which banks differ from other intermediaries. And then he includes a summary of his main points at the end of the paper, where he repeats the point about the differences between banks and other intermediaries as point 3. In all three places, he says the difference have to do with reserve requirements and regulatory ceilings on interest rates banks can charge for loans. So while he mentions government deposit guarantees and the discount window in passing, he doesn’t seem to think these institutions are important in explaining the (minor) differences between banks and other credit intermediaries.

  42. Ramanan writes:

    “In all three places, he says the difference have to do with reserve requirements and regulatory ceilings on interest rates banks can charge for loans.”

    Which is true as it had an effect.

  43. Ramanan writes:

    In case you do not know how it works, see my post

  44. Ramanan writes:

    The point he is making is not the there is no difference at all. The point he is making is that the Widow’s cruse runs dry. Banks still have to induce the public to bank with them. People overemphasizing the point that loans create deposits and that banks create deposits simply by crediting bank accounts unlike a non-bank financial doesn’t mean too much.

    My observation is that Krugman has his own confusion interpreting Tobin and this is the source of confusion in the part of others. It is funny actually how Krugman’s confusion has confused others.

  45. JKH writes:

    I think there’s a complicated multi-lateral discussion going on here. I think MMTers and likeminded are contemptuous of what they perceive to be Krugman’s lack of comprehension of “loans create deposits” and some of the accounting realities of banking. At the same time, Krugman embraces Tobin as the standard bearer for how banks are just another intermediary. At the same time, Tobin understood “loans create deposits” and the bogusness of the money multiplier 30 years before Mosler wrote about it – that’s absolutely clear from his essay. At the same time, those who embrace “loans create deposits” are delusional if they think that’s all there is to banking, or if they think it somehow negates Tobin’s essay, or if they think banks aren’t financial intermediaries in the sense that Tobin described (all of those being false claims, in my view). At the same time, some believe that Godley and Lavoie reject the Tobin thesis, which is also a false claim (in my view, but I stand to be corrected by the one person who might confirm that one way or the other). I think Godley and Lavoie in saying “we’re doing something different” were focusing on the aspect of the role of banks in facilitating firm production and that that really wasn’t inconsistent with what Tobin had to say at all. Tobin just didn’t focus on that piece, although once again he absolutely does reference it in his essay.

    So it’s complicated.

    (transcribed from )

  46. Dan Kervick writes:

    Yes, Tobin was seeking to explain why, in periods like the thirties, increases in bank reserves can result in a large part of those reserves remaining as “free reserves” – what we usually now call “excess reserves” – rather than becoming required reserves as the banks fill up their loan books with new loans. And obviously, the answer is that the generation of lending does not depend on the current state of bank reserves alone, but on conditions in the market for loans. The latter include such things the demand for loans; bank perceptions of the solvency and credit-worthiness of loan candidates; the costs for banks of acquiring additional reserves if they should needed, and without regard to their current reserve position; the banks capital positions, etc.

    But understanding these facts do not at all depend on (i) denying that there are very important differences between money and other goods, (ii) denying that there are very important differences between banks and other private sector credit intermediaries, or (iii) denying that the important difference between banks and other credit intermediaries consists in part in the fact that the deposit account liabilities of commercial banks function as money. It only requires recognizing that deposit-money is a genuine liability of the bank that issues it, and so the fact that banks can issue these liabilities at will and trade them for promissory notes, does not entail that it will always be in the economic interest of banks to do so, or that they will always find a large market for those trades.

    In my June essay, “Do Banks Create Money from Thin Air?” I also warned against over-emphasizing the “loans create deposits” slogan. I began the essay like this:

    It is sometimes said that commercial banks in our modern monetary system create money “from thin air”. While there is truth in this metaphorical claim, the metaphor can also be seriously misleading, and leads some to attribute powers to commercial banks that are actually retained by the government alone under our system. It is worth trying to get clear about all this.

  47. JKH writes:

    More shameless transciption for the hopper:

    Krugman argued that banks are not special in the same way Tobin did.

    Neither Krugman nor Tobin argue that financial intermediaries are not special relative to a counterfactual economy. Quite the contrary.

    Godley uses Tobin to build the case for how banks work.

    I don’t think that conflicts with what Tobin says about banks not being special.

    A point of logic:

    X = A + B
    Y = B + C

    X is special relative to Y in respect of A (e.g. banks creating money from lending)
    Y is special relative to X in respect of C (e.g. issuing insurance policies)
    But neither X nor Y is special relative to B (active asset liability management and pricing)

    It is quite possible for the same entity to be both special and not special

    It’s a matter of the classification paradigm

    (from )

  48. Ramanan writes:

    Dan Kervick,

    Don’t really know what you are trying to say here and in your post.

    Your post attempts to say that banks individually do not have a Widow’s Cruse but doesn’t show it for banks collectively which is what Tobin shows.

    Sorry what about the thirties?

  49. Dan Kervick writes:

    Ramanan, my comments in this thread discuss why the banks don’t have a widow’s cruse either individually or collectively, and argue that understanding why that don’t does not require Tobin’s own explanation of those facts, which I believe is inadequate and excessive since it is based on minimizing the differences between banks and other intermediaries, between money and other goods, and between bank deposits and other money-like payment assets. One doesn’t need to accept Tobin’s analysis to understand why there is no widow’s cruse. One can endorse the super-specialness of money, banks, and the monetary status of commercial bank deposit liabilities without attributing to them a widow’s cruse, as Tobin understands it.

    The reference to the thirties is from Tobin’s paper. See page 416.

  50. Ramanan writes:


    Yeah saw that reference to thirties but about it?

    If you actually read him carefully – you won’t find what you think. In a crisis situation, a single bank and the banking system as a whole worries about its liquidity position. There is zilch bit of any notion of exogenous money and standard causality in the paper.

    The point about deposit ceiling is mentioned because when they were lifted banks were able to attract deposits from customers holding accounts with non-banks.

    I should have worded differently – I actually don’t see the point of your post except some payment system mechanics. You certainly say a bank’s deposits can fly out but there still exists a question: the banking system as a whole has deposits and if a deposit flies out from one it goes into another so collectively it seems to have a Widow’s cruse without further argument. To disprove this you have to use Tobin’s argument.

    So I don’t see why you have TTL accounts and so on – it is important but not relevant at all.

    You definitely need ideas of asset allocation theory about arguing these points. I don’t see you using it in your post.

  51. Dan Kervick writes:

    I should have worded differently – I actually don’t see the point of your post except some payment system mechanics. You certainly say a bank’s deposits can fly out but there still exists a question: the banking system as a whole has deposits and if a deposit flies out from one it goes into another so collectively it seems to have a Widow’s cruse without further argument. To disprove this you have to use Tobin’s argument.

    I have little understanding of what you are saying here, Ram. I don’t know what “fly out” means. The term doesn’t even have an impressionistic relationship to any process I described in either my comments here or the essay I linked to. I Also I don’t know why you would say that the fact that deposits move from bank to implies the banks collectively have a widow’s cruse. When Tobin introduces that term on pages 408-09, he seems very clearly to be using the term to mean that (i) the preferences of the public normally play no role in determining either the total volume of deposits or the total quantity of money, (ii) the total volume of deposits will automatically adjust via a hot potato mechanism to the quantity of money, which includes “fountain pen money”, i.e. the creation of a marked-up deposit balances by commercial banks and (iii) in a system with reserve requirements, the quantity of deposits will automatically expand following the expansion of reserves to equal the quantity of reserves divided by the required reserve ratio. Tobin quite rightly rejects this myth of the widow’s cruse.

    Tobin also believes that reserve requirements and interest rate ceilings are effective in creating a situation in which additions to bank reserves normally permit new loans which generate their own deposits. (I’m not saying anything about the extent to which this is true, only that Tobin believes it is a fact that needs to be explained.) Tobin claims that this phenomenon lends some superficial credibility to the widow’s cruse view, and so that if one is to refute the myth of the widow’s cruse, an alternative explanation of the fact must be offered. Tobin’s explanation is that reserve requirements and interest rate ceilings artificially prevent banks and their potential customers from reaching competitive equilibrium, and so when the reserves are expanded, it becomes profitable for banks to acquire additional assets.

    What I have argued against is the explanatory framework Tobin develops to reject the widow’s cruse, a framework that is a version of what he calls the “New View”. That framework is based on denying, for the purposes of economic analysis sufficient to understand the phenomena in question (i) that there are very important differences between money and other goods, (ii) that there are very important differences between banks and other private sector credit intermediaries, or (iii) that the important difference between banks and other credit intermediaries consists in part in the fact that the deposit account liabilities of commercial banks function as money. These points are all summarized at the end of the paper.

    My contrary argument is that (i) we can understand why the widow’s cruse myth is false without accepting those key points of Tobin’s framework; and (ii) the framework is a flawed and inadequate one for understanding money and banking, at least as they exist in our contemporary world. I have claimed contra Tobin that Federal Reserve member banks are not just financial intermediaries that happen to be subject to certain reserve requirements and interest rate ceilings, but that they are unique in having deposits at that bank and access to the bank’s credit facilities; that member banks are unique in having access to the Fed’s rapid and streamlined interbank payment system and the netting systems that access it, and and that commercial banks are also unique in having access to the government’s deposit guarantee system. As a result, I have argued, the Fed’s member banks are together with the Fed’s regional banks part of a single, integrated and centralized national monetary and credit system, a public-private partnership that contains both profit-making and non-profit components, and so it simply won’t do to view them as only one kind of financial intermediary among others that happens to be subject to a few additional regulations, or to view the deposit liabilities they issue as merely one kind of financial liability that is in no way special.

    And I have argued that accepting my alternative framework in no way implies that banks possess a widow’s cruse, i.e. that the volume of money and deposits created is unconstrained by public preferences. And it certainly doesn’t entail the hot potato view or the money multiplier view.

    On a smaller point, I don’t “need” TTL accounts for anything. You are referring to one small piece of my discussion in the essay I linked to in which my target was other people who claim that the existence of TTL accounts shows that the government must acquire its spending power by taxing commercial bank money into its Treasury. My claim was that that picture is wrong, and that TTL accounts are irrelevant to the issue. That has almost nothing to do with the discussion here, or even with the main arguments of that other essay, so I don’t know why that is something that drew your attention.

  52. […] that Tobin-Brainard depends fundamentally on not modelling the details of bank lending. [Note that Steve Waldman gives a more general explanation of the problem with Tobin-Brainard: "it must be reasonable to […]

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  54. The greatest discovery of any generation is that a human being can alter his life by altering his attitude.