Endogenous Money vs. the Money Multiplier (guest post by Justin Merrill)
(This is a guest post by Justin Merrill, an investment advisor in Fairfax, Virginia, who independently studies banking, free banking and monetary theory. He is also a media editor at freebanking.org and you can find some of its work here and here)
The proponents of the “New View”, especially Tobin and Gurley and Shaw, have been a large influence on me, but so has Leland Yeager. This discussion prompted me to reread Yeager’s work, “What are Banks?” and see if their views could be reconciled.
I believe the following to be true:
- Outside money is exogenous with a couple (Post-Keynesian) qualifications and also a “hot potato”.
- Inside money is endogenously created and subject to market forces.
- The reserve multiplier explanation should die a quick, painful death.
- Monetary policy does influence inside money creation through controlling expectations and liquidity, which affects banks’ cost of funds.
- Attempts to regulate inside money creation for “macro-prudential” purposes are folly because the problem is monetary policy. The only way to keep both money and credit harmonized is by allowing a natural rate of interest.
Framing the Discussion:
To be clear, what is being debated is the usefulness of the money multiplier model (MMM) and the endogeneity of money and how these are related. Someone (I think it was Julien) recently blogged that the pro-endo critics of the MMM are contradicting themselves because the model explicitly states that commercial banks create the majority of money. But this is not what the debate is. The debate is what limits the creation of money (reserve requirements or market forces) and if the textbook MMM is remotely accurate or even useful.
James Tobin and the “New View”:
I mostly agree with the new view. I believe that inside money is determined mostly by market forces and that banks compete with other financial intermediaries. They provide liquidity by optimally allocating society’s wealth between deposits and risk assets.
Where I disagree with the New View is when they go so far as to say that banks are pure intermediaries and not in anyway special. This overlooks the other functions of banks and also leads one to ask why banks exist at all when we could all just hold diversified financial assets with lower fees/higher yields? While these financial assets compete with bank deposits, they are not perfect substitutes. Banks’ liabilities are special and so are some other functions they provide.
Leland Yeager’s Monetarist view:
In Yeager’s essay, “What are Banks?”, he explicitly says that the broad money supply is exogenously controlled by the monetary authority. He argues that fluctuations in money demand don’t impact money supply, only the price level and nominal income.
Yeager thinks the old view, that reserves multiplied by reserve ratios determine the broad money supply, is correct. His most convincing argument is that banks will invest any excess reserves in marketable securities. One flaw in this particular argument is that the return on excess reserves isn’t just the opportunity cost of marketable securities, but also of lending to other banks, which is a usually higher rate than T-bills. One notable difference is that lending Federal Funds is an unsecured market while T-bills are “riskless” and this risk difference might explain some of the spread. The more recent innovation of interest on reserves also complicates the MMM explanation and has partially caused the Fed Funds market to dry up since implementation. If interbank lending rates or IOR are higher than the return of near perfect substitutes (marketable securities such as T-bills), the reserves will stay in the system.
Some Problems with the Money Multiplier Model:
The reason I want to see the MMM die a fast, painful death is because it abstracts away from real decisions of individuals involved in the market process and turns the entire banking system into a policy lever for bureaucrats to adjust.
One way we could attempt to settle the validity of the MMM is empirically. We could survey bank treasurers and ask them what their bottlenecks are, such as: costs of funding, lending opportunities, or reserve maintenance. In the US, banks report their regulatory reserve status every two weeks and have to maintain reserve requirements over the average of the period. This means that if a firm sees an outflow of reserves in week one, in week two they must retain a surplus to offset last week’s deficit.
We could also use macro data to try to verify if reserve requirements determine the money supply and if the banking system remains fully loaned up. I would rather challenge it with the following proposition: imagine a truly free banking system with no central bank and no special regulations. The outside money could be a commodity but that is irrelevant to my point. The point is that with no regulator to enforce reserve requirements, what determines the inside money supply? Some might answer that individual banks would determine their own reserve ratio and that would in aggregate set the money supply, but this begs the question because it doesn’t explain what the prudent bank treasurer is thinking when deciding on a ratio or even if they are thinking in terms of reserve ratios at all!
I suspect that the prudent bank treasurer is only tangentially thinking about reserve ratios in regards to net redemptions and that what they are really thinking about is maximizing profits. If they can make a loan at a risk adjusted rate that is higher than what they can borrow on the wholesale market, why wouldn’t they make a loan and borrow reserves? This kind of interbank lending usually has higher costs than interest paid on deposits so it is not the ideal source of funding, but if the marginal investment return is high enough, the treasurer will authorize the loan and borrow reserves until they can secure more “sticky” and affordable funding. One thing I noticed is that both sides of the debate, Tobin and Yeager, accuse the other side of assuming that banks are not profit maximizers. I suspect it is Yeager who is guilty because the New View actually incorporates marginal profit/loss into its analysis.
Checking accounts aren’t that interesting, or interest bearing. The textbook version explains that reserves create bank deposits without any specification between demand and time deposits. When Tobin was writing, both were subject to reserve requirements, if I’m not mistaken. Interest on checking accounts was also forbidden. My interpretation of Tobin’s point is that bank deposits compete with other financial assets, and should they be allowed to pay interest, will do so. Time deposits are a better characterization of Tobin’s point because they are held for their certainty and return, whereas demand deposits are for transactions.The MMM is still taught like it is the 1960’s even though we have financial liberalization and innovation. No longer do time deposits have interest ceilings, MMMFs are checkable, NOW accounts enable demand deposits to pay interest (and I think Dodd-Frank scrapped all prohibitions of interest on demand deposits), and maybe most importantly, time deposits are not subject to reserve requirements. So how do MMM proponents explain the supply and yield of time deposits, especially if savings accounts are still counted as money? This leads into a paradox that can only be countered with either a concession that the Fed doesn’t control M2, or only M1 is money, or maybe that the MMM should be abandoned.
A Final Note on Institutional Analysis:
Regulatory reserve requirements are an intervention, to be specific, a quota. Interventions only take effect if they are binding. The reason the MMM is insufficient is because it is a specific theory of money creation, not a general theory. Relying on the MMM is as naive as relying on minimum wage laws to explain labor market wages for unskilled labor. Some might argue that binding reserve requirements are required to create artificial scarcity and give a fiat currency a positive value, but I’m sufficiently convinced by Eugene Fama’s “Banking in the Theory of Finance” that the services rendered from money are sufficient to give it positive value so long as the issuer constrains the supply. I also believe that monetary policy can be effective (or destructive) absent reserve requirements. One final argument for reserve requirements is that someone needs to make the banks stay liquid enough to pay off depositors. This justification was codified at the national level under the National Banking Act of 1863 and was made obsolete with the creation of the Federal Reserve System. The central bank can offset a reserve drain and be the lender of last resort. Empirically, reserve requirements were an ineffective tool for regulating liquidity and theoretically may even contribute to panics, but that’s worthy of a different post altogether. I also plan on writing a more detailed post explaining the mechanics behind the reasoning that inside money is not a “hot potato”.