January 23, 2020
Morgan Ricks, Vanderbilt Law School
“[T]he familiar controversy as to how and by whom bank-deposits are ‘created’ is a somewhat unreal one.” So wrote John Maynard Keynes near the start of his 1930 Treatise on Money.[i] Keynes asked whether deposit balances can be created “actively” by banks or only passively by depositors “on their own initiative.” He thought it was obvious that banks can create deposit balances actively, albeit only within practical limits. Keynes acknowledged that active deposit creation—i.e., crediting deposit accounts in the process of lending or investing—tends to “diminish the reserves” of the bank as newly created balances are “paid away to the customers of other banks.” He continued:
Practical bankers . . . have drawn from this the conclusion that for the banking system as a whole the initiative lies with the depositors, and that the banks can lend no more than their depositors have previously entrusted to them. But economists cannot accept this as being the common-sense which it pretends to be. I will, therefore, endeavor to make obvious a matter which need not, surely, be obscure.
Keynes went on to explain that, while a bank will experience a clearing drain when it creates deposits actively, by the same token the bank “finds itself strengthened whenever the other banks are actively creating deposits”—that is, it will receive clearing inflows. He concluded that banks can safely create deposits on their own initiative “provided that they move forward in step”:
Every movement forward by an individual bank weakens it, but every such movement by one of its neighbor banks strengthens it; so that if all move forward together, no one is weakened on balance. . . . Each Bank Chairman sitting in his parlour may regard himself as the passive instrument of outside forces over which he has no control; yet the “outside forces” may be nothing but himself and his fellow-chairmen, and certainly not his depositors.
Kenyes was not alone in conceiving of bank money creation in this way. Irving Fisher wrote in 1913 that “A bank depositor . . . has not ordinarily ‘deposited money.’”[ii] And Joseph Schumpeter wrote in 1954 that “It is much more realistic to say that banks … create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them.”[iii]
Others have seen these issues somewhat differently. In a classic 1963 article, James Tobin criticized as “superficial and irrelevant” the notion that “a bank can make a loan by ‘writing up’ its deposit liabilities.” After all, he wrote, the new deposit balance stays with the bank only for “a fleeting moment” because “the borrower pays out the money, and there is of course no guarantee that any of it stays in the lending bank.” Though a Keynesian himself, Tobin evidently didn’t see eye-to-eye with Keynes on this issue. The same goes for Paul Krugman, who wrote in 2012 that “any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand.”
This debate presents itself as a somewhat clinical, descriptivedebate over banks’ operational mechanics. But it has always been clear that more was at stake. Tobin in particular was primarily concerned with issues beyond the narrow question of bank money-creation mechanics. He sought to make a bigger, more conceptual point: that “[t]he distinction between commercial banks and other financial intermediaries has been too sharply drawn.” Tobin was promoting what he called a “new view” that would “blur the sharp traditional distinctions between money and other assets and between commercial banks and other financial intermediaries.” His paper’s title—Commercial Banks as Creators of “Money” (note the scare quotes around money)—says it all. Paul Krugman was coming from a similar place in writing a few years ago that “what banks do” is “not mostly about money creation!”
So what’s going on here is not so much a factual, empirically resolvable dispute over bank operating mechanics as a deeper clash between two paradigms. On one side there is an “intermediation paradigm” which sees banks as being primarily in the business of “taking funds” from depositors and then lending them out. The intermediation paradigm, which is where Tobin and Krugman are obviously coming from, tends to downplay the distinctions between banks and other financial institutions. (“‘Banking’ has become virtually synonymous with financial intermediation,”[iv] writes Richard Posner, in a typical example from this vein. “I … use the words ‘bank’ and ‘banking’ broadly, to encompass all financial intermediaries.”[v]) It also tends to downplay the significance of the monetary function of bank liabilities. Anat Admati and Martin Hellwig go so far as to say that the notion that banks “produce (or create) money … rests on an abuse of the word ‘money.’”
The intermediation paradigm is grounded, perhaps unconsciously, in concepts from modern finance, which posits that a firm’s financing structure is irrelevant to its value, provided that certain conditions are met. Tobin himself came to academic fame in part by applying new financial concepts from portfolio theory to the analysis of money demand.[vi] And when Krugman wrote that banking is “not mostly about money creation” he referred to the seminal bank-run model of Diamond and Dybvig, which is a corporate-finance model in which there is something called banking but nothing called money. Krugman has criticized the money paradigm as “banking mysticism,” opining that banks are really just “a clever but somewhat dangerous form of financial intermediary.”
On the other side there is a “money paradigm” which tends to see banks not as takers of funds that are then lent out but rather as issuers of “funds.” Needless to say, taking and issuing are opposites. The money paradigm sees banks as an integral part of the overall monetary framework, a status that justifies a unique relationship with the state. Within the bank regulatory literature, the clash between the intermediation paradigm and the money paradigm shows up in disputes over the “specialness” (or lack thereof) of banks.[vii]
Here is my modest contribution to this perennial debate: Just as the dispute over banks’ operational mechanics isn’t really an empirical issue, the clash between the intermediation and money paradigms isn’t really a conceptual issue. It’s primarily a normative one. What I mean is that the specialness of banks—or of bank-issued money-claims—is a policy choice.
To see this, just consider a different institutional set-up from what we have today. Consider the nineteenth century, when banks’ liabilities consisted mostly of physical notes (redeemable for specie, i.e. gold or silver coin) rather than deposit balances. It would be odd to describe such banks as being in the business of “taking funds” that are then lent out. Surely holders of bank notes did not typically think of themselves as having delivered “funds” to the bank in any meaningful sense. They seldom deposited specie and accepted bank notes in return; rather, they accepted bank notes as loans or (more likely) in commerce. Bank notes were obviously issued by banks quite “actively” (to use Keynes’s word) in the process of lending or investing. And these claims circulated as money in a quite literal and conspicuous way. The intermediation paradigm just isn’t a good conceptual fit here. And the banking system’s shift from bank note liabilities to deposit liabilities arguably did not involve any relevant change in economic substance.[viii]
Or consider a fiat-money-issuing central bank like the Federal Reserve. Does it “take funds” that are then invested? Obviously not. Like other modern central banks, the Fed buys financial assets in exchange for newly created money in the form of reserve balances which are convertible by their holders (banks) into physical currency. The Fed obviously doesn’t need to “get” the “funds” first. Reserve balances are created at a keystroke in exchange for financial assets. “Funds” or “money” or “cash” never appears on the asset side of the Fed’s balance sheet. Its liabilities are funds. The intermediation paradigm doesn’t work here either, but the money paradigm obviously does, and this would still be true even if everyone held their bank account at the Fed.[ix]
So the institutional setup dictates the paradigm fit. And the institutional setup isn’t a fact of nature; it presents choices. I agree with Keynes that there’s something “unreal” about debates over bank money-creation mechanics. Everyone agrees that banks lend in the first instance by writing up their liabilities, and everyone agrees that there are practical limits to this due to clearing drains. But approach it now from a policy angle. Should we allow free entry into this business model—the practice of issuing large quantities of short-term or demandable IOUs, continuously rolled over, to fund portfolios of financial assets? Historically, Anglo-American law has recognized this as a sensitive activity and has sought to legally confine this distinctive funding model to one or more specially chartered banks, which have then been required to inhabit a special institutional environment, operating essentially as franchisees of the state.[x] This system was understood to be a way of outsourcing money augmentation, an activity that was thought to raise sensitive issues of instability, monetary control, and rent capture. And this always has required entry restriction: specifying the funding model that is permissible for banks but off-limits for everyone else.
In recent decades, entry restriction has fallen into disrepair in U.S. law. True, legally you still need a bank charter to maintain deposit liabilities. But Congress has not provided a functional definition of “deposit” for this purpose and nonbanks issue all sorts of functional substitutes for deposits on an enormous scale. This is the core of the so-called “shadow banking” problem. Experts define shadow banking in different ways, but pretty much everyone agrees that heavy reliance on short-term debt is a big part of it. And this problem arose in conjunction with the paradigm shift that Tobin helped spearhead. In an influential 1976 article, The Soundness of Financial Intermediaries, Robert Clark expressed deep skepticism that banks’ monetary function had much if anything to do with their regulation. The article’s title leaves no doubt as to which paradigm it adopts. Regulators followed suit. In 1980 the primary federal bank regulator, the Office of the Comptroller of the Currency (O.C.C.), relaxed its longstanding policy of granting new charters based on public convenience and necessity, a franchising approach.[xi] It concluded instead that “[t]he marketplace normally is the best regulator of economic activity; and competition allows the marketplace to function.”[xii] In 1987, as part of a general deregulatory trend, the O.C.C. declared that it was moving beyond the “textbook sense” of banking—i.e. the money paradigm—and toward a “modern concept of banking as funds intermediation.”[xiii]
The view Tobin had espoused in his 1967 article—his “new view” that sought to “blur the sharp traditional distinctions … between commercial banks and other financial intermediaries”—won the day. Conceptual blurring has led to actual, institutional blurring. The banking system no longer has a monopoly on money augmentation—this line has not been policed at all—but nonbank money-augmentation firms turn out to raise all the same policy problems that banks have always raised. Money creation has seeped out of the banking system proper, on a vast scale. In response, our financial regulatory apparatus has expanded enormously. So has the reach of public support facilities for the financial sector. As we speak, the Federal Reserve is supplying below-market funding to Wall Street dealer firms and hedge funds that rely heavily on overnight repo funding (a deposit substitute). This is the inevitable result of failing to police the traditional, structural institutional boundary that confined money augmentation to banks.
This, to me, is what is really at stake in debates over bank money-creation mechanics. It’s not really about the mechanics themselves; it’s about policy choices. We’re living with the consequences of a policy choice made circa 1980, one that was the product of an intellectual revolution. It will take another intellectual revolution to undo the damage.
[i] John Maynard Keynes, A Treatise on Money (New York: Harcourt, Brace, 1930), 1:23–30.
[ii] Irving Fisher, The Purchasing Power of Money 37–39 (rev. ed. 1913).
[iii] Joseph A. Schumpeter, History of Economic Analysis 1114 (1954).
[iv] Richard A. Posner, A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression 46 (2009).
[v] Id. at xvi
[vi] See James Tobin, Liquidity Preference as Behavior Towards Risk, 25 Rev. Econ. Stud. 65 (1958).
[vii] See E. Gerald Corrigan, Are Banks Special?, Annual Report: Federal Reserve Bank of Minneapolis (Jan. 1982), https://www.minneapolisfed.org/article/2000/are-banks-special; Richard C. Aspinwall, On the “Specialness” of Banking, 7 Issues in Bank Reg. 16 (1983).
[viii] Ludwig von Mises, The Theory of Money and Credit 53 (H. E. Batson trans., Yale Univ. Press 1953) (1912) (“[B]anknotes, say, and cash deposits differ only in mere externals, important perhaps from the business and legal points of view, but quite insignificant from the point of view of economics.”); A. Mitchell Innes, What is Money?, 30 Banking L. J. 377, 407 (1913) (“A bank note differs in no essential way from an entry in the deposit register of a bank.”); Schumpeter, supra, at 1115 (“[T]he obvious truth [is] that deposits and banknotes are fundamentally the same thing.”).
[ix] See Morgan Ricks, John Crawford, and Lev Menand, A Public Option for Bank Accounts (or Central Banking for All), https://ssrn.com/abstract=3192162.
[x] The franchising metaphor comes from Robert Hockett & Saule Omarova, The Finance Franchise, 102 Cornell L. Rev. 1143 (2017), https://scholarship.law.cornell.edu/cgi/viewcontent.cgi?article=2660&context=facpub.
[xi] See infra text accompanying notes 177–84.
[xii] Clarification and Revision of Charter Policy, 45 Fed. Reg. 68603, 68604 (Oct. 15, 1980).
[xiii] Office of the Comptroller of the Currency No Objection Letter 87-5 (July 20, 1987).