Essays in Monetary Theory and Policy: On the Nature of Banking (2)

By  Darren Prince*

There are different views on the importance of banks in regards to what functions banks actually perform and how they interact with other aspects of an economy.  There are two main approaches to the banking industry and also within the two approaches there are different theories.  The orthodox and heterodox approaches to banking have very different views of the banking industry and the different approaches diverge at the very beginning of their theories.  To fully understand the beliefs that are the driving force behind the nature of banking in both approaches a brief description is needed to understand where the theories diverge.  The orthodox and heterodox theories diverge in their beliefs on the subject of “money” or more specifically what the origins of money are and what role does “money” play in a capitalist economy.  This brief description is needed to understand how each theory developed what they believe to be the nature of banking considering the fact that banks and financial institutions deal with money.  The overall purpose of the paper will be to describe the nature of banking within the different approaches and how these theories lead each approach to develop policies and procedures regarding the financial industry that are believed to best serve the efficiency of the United States economy.

The Orthodox Approach to Money:

Throughout the history of the United States the orthodox approach to economics has embedded its theories as the most prominent approaches to how the economy should be structured within the United States.  A description of the orthodox theory approach to the banking industry needs to start with the role of “money” within the economy.  A barter economy is the basis of orthodox theory and within a barter economy commodities are exchanged for money that is then exchanged for more commodities.  The value of money was determined by a commodity that had been designated as backing money and at different times during history different commodities determined the value of money, but over time gold was deemed to be the most efficient and gold enabled coins and notes issued by a government to hold value.  This was considered commodity money, as stated by Wray,

“The value of each marketed commodity is then denominated in the commodity chosen as the medium of exchange through the asocial forces of supply and demand,” (Wray, “Banking, Finance, and Money: A Socioeconomics Approach,” pg. 4).

Within this system money was simply a medium of exchange between different commodities that allowed an economy to function more efficiently and ruled out a “double coincidence” of wants.  This allows orthodox theorists to deem money to be neutral and to only serve as a lubricant between the exchanges of different commodities.  At the present time “fiat” money is used and is not backed by a commodity but it does not change orthodox economist’s view of money being neutral.  The different classifications of orthodox economists including Monetarists, Real-Business Cycle, and New Classical theorists all consider money to be neutral at varying degrees in the short run but in the long run money cannot be anything but neutral.

The next aspect of money within the orthodox approach that influences their perception of financial institutions is that money is created exogenously in the United States economy.  Exogenously is defined in this regard as referring to the creation of money outside the economic system by the authorities and money is not created by firms and households within the economy.  The orthodox economists believed that the Central Bank could directly control the money supply up until the “Volker Experiment” of the 1980’s and realized at this time that the central bank could not directly control the money supply.  Orthodox economists currently theorize that the Central Bank controls the money supply indirectly utilizing open market operations which target the federal funds rate and also can control the money supply indirectly with the “required reserve ratio” which affects the money multiplier but does not utilize this tool considering the effects that Orthodox economists believe it has on the money multiplier.  The money multiplier will be described in detail at a later time within this paper.   These two distinctions regarding money are needed to be valid for Orthodox theories regarding financial institutions to hold true.

Orthodox Theories pertaining to the nature of banks:

The description concerning the nature of banks along the lines of Orthodox theory within this paper will initially start with a simple description of what constitutes the financial system followed by a more complex description of how financial institutions operate and ending with the simple underlying theory regarding orthodox economics.  Orthodox economists believe that financial institutions play an important role within the economic system.  The role that financial institutions assume within an economic system is one of financial intermediation.  Financial institutions perform the function of channeling funds from individuals that have an excess amount of funds to individuals that have a shortage of funds or simply put they move funds from lenders to borrowers.  Financial institutions fall into different categories which are listed in Table 1.  The financial intermediary’s main functions are to lower transactions costs, reduce the exposure of investors to risk done by asset transformation and diversification and financial intermediaries are deemed to be the most efficient at collecting information that enables the financial institution to reduce adverse selection and the moral hazards that accompany the process between lending and borrowing.

According to orthodox theory the financial intermediaries discussed above are involved in the process of connecting savers and borrowers together to enable the markets to function with greater efficiency which in turn allows the markets to allocate scarce resources (finance).  The type of finance that is performed is not a concern within orthodox theory and it does not matter what financial instruments the market implements for example it could be income flow or the issuance of equity or simply to go into debt.  This orthodox belief is driven by the efficient market theory which states that fundamentals drive asset prices therefore financial intermediaries do not affect or influence real variables within the economy.

The money that resides within the system that lubricates the barter economy is exogenously created by the central bank in the United States economy and banks are considered to lend from reserves.  The central bank performs open market operations which is the purchase or sale of government bonds which essentially increases or decreases the amount of reserves (high-powered money) that is held by the financial intermediaries.  The purpose of open market operations is to target the short term interest rate to perform expansionary or contractionary monetary policy depending on the direction the authorities determine the economy should be moving.  Orthodox economists theorize that authorities control the money supply by open market operations and also sets the required reserve ratio which is the ratio between reserves (high-powered money) that banks have on hand and the amount of deposit liabilities (low-powered money) on their balance sheets and under orthodox theory this ratio allows banks to create deposits.  According to James Tobin,

“The substitution of inside money for outside money is the familiar story of deposit creation, in which the banking system turns a dollar or base or high-powered money into several dollars of deposits.  The extra dollars are inside or low-powered money.  The banks need to hold only a fraction k, set by law or convention or prudence, of their deposit liabilities as reserves in base money,” (James Tobin, “Financial Intermediaries,” New Palgrave: page 166).

The simple deposit multiplier is ΔD=1/ rr x ΔR, where ΔD equals the change in total checkable deposits in the banking systems, rr equals required reserve ratio, and ΔR equals the change in reserves for the banking system.  The key for the deposit multiplier to work is the ΔR needs to be turned into deposits and not currency.  If deposits are not created and the increase in reserves is held as currency the deposit creation does not occur.  Stated by Mishkin,

“The banking system as a whole can generate a multiple expansion of deposits, because when a bank loses its excess reserves, these reserves do not leave the banking system, even though they are lost to the individual bank.  So as each bank makes a loan and creates deposits, the reserves find their way to another bank, which uses them to make additional loans and create additional deposits,” (Mishkin, “The Economics of Money, Banking, and Financial Markets,” page 337).

An example of multiple deposit creation is detailed in Table 2.

There is one more aspect that needs to be discussed considering that the authorities control the money supply within orthodox theory.  The aspect that needs to be discussed is the effects that an increase or decrease in the money supply has upon the economy.  Orthodox economists utilize the quantity theory of money to display the effects that a change of money supply will have on an economic system.   The quantity theory of money can be defined as follows, MV=PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is real GDP.  MV combined is the money actually spent while PY combined is nominal GDP.  Orthodox theorists assume velocity (V) to be relatively stable, real GDP (Y) reaches its upper limit once full employment is reached and within the economy full employment is always maintained since the labor market is assumed to be in equilibrium at all times.  These assumptions allow the formula to be reduced to M=P where the causation is assumed to run from left to right.  This would imply that a change in the money supply causes a change in the nominal price level therefore a change in the money supply will only lead to inflation or deflation.

Orthodox economists’ belief that money is neutral, exogenous, and simply a medium of exchange combined with the theory that financial institutions simply bring together lenders and borrowers which in turn allows the market to allocate resources in a more efficient manner is consistent with the main underlying belief that an unregulated market is the most conducive market in regards to a capitalist economy.  The conviction to a laissez-faire market system is the prominent factor in determining what policies should be implemented in regards to the financial sector of a capitalist economy and this strong conviction to a laissez-faire approach courses through all of mainstream economics including classical, monetarist, new classical, and real business cycle.  This laissez-faire approach was developed by Adam Smith,

“As every individual, therefore endeavors as much as he can both to employ his capital in the support of domestic industry, as so to direct that industry that its produce may be of the greatest value; every individual necessarily labors to render the annual revenue of society as great as he can.  He generally, indeed, neither intends to promote the public interest, nor know how much he is promoting it…and by directing that industry in such a manner as its produce may be of the greatest value, he is intending only his own gain, and he is in this, as in so many other cases, led as if by an invisible hand to promote an end which was not part of his intention,” (Minsky, “The Economic Problem at the end of the second millennium,” Page 10).

The policy suggested by orthodox economists regarding the financial sector is one that does not include any type of regulation accept the self-supervision of the invisible hand that will guide the market to its utmost efficiency.  As stated by Minsky,

“The heart of the neoclassical system is that relative prices and outputs are determined by preferences over real goods and services, the technology and maximization behavior.  The perfect foresight assumption of neo-classical theory means that investment is just an allocation over time, where time adds no special difficulty.  (One implication of the neo-classical theory is that for any capital asset at every moment of time the depreciated value of the original cost equals the present value of future profits.)  In as much as all relevant variables are determined by “real relations” nothing of significance is affected by the financial structure.” (Minsky, “The Capital Development of the Economy and the Structure of Financial Institutions,” page 18).

Heterodox Approach to the nature of banking:

There is another approach to the nature of banking in regards to how financial institutions operate as well as to what policies and procedures should be implemented to guide financial institutions to promote the stability and well-being of a capitalist economy.  The heterodox approach analyzes financial institutions and the effects that they have on the rest of the economy in a manner which is in direct opposition to the orthodox approach regarding the financial sector.  A brief description on the origins and functions of money within the heterodox approach will be needed to fully understand their analysis of the nature of banking.

Heterodox Approach to the origins of money:

Heterodox economists do not believe that monies value is determined by a commodity and that throughout history if a commodity was declared to back the value of a coin it was simply to enable the coin or note to be accepted by society.  Mitchell Innes stated,

“The misunderstanding that has arisen on this subject is due to the difficulty of realizing that the use of money does not necessarily imply the physical presence of a metallic currency, nor even the existence of a metallic standard of value.  We are so accustomed to a system in which the dollar or the sovereign of a definite weight of gold corresponds to a dollar or a pound of money that we cannot easily believe that there could exist a pound without a sovereign or dollar without a gold or silver dollar of a definite known weight.  But throughout the whole range of history, not only is there not evidence of the existence of a metallic standard of value to which the commercial monetary denomination, the “money of account” as it is usually called, corresponds, but there is overwhelming evidence that there never was, a monetary unit which depended on the value of a coin or on a weight of metal; that there never was until quite modern days, and fixed relationship between the monetary unit and any metal; that, in fact, there never was such a thing as a metallic standard of value,” (Mitchell Innes, page 379).

Heterodox economists believe that money is backed up by the authorities’ power to impose a tax on the citizens of the country.  Randall Wray stated,

“Why would anyone accept government’s “fiat” currency?   Because the government currency is the main (and usually the only) thing accepted by government in payment of taxes and other money due to government.  To avoid the penalties imposed for nonpayment of taxes (including prison), the taxpayer needs to obtain the government’s currency,” (Randall Wray, “Modern Money Theory,” Page 48).

The authorities by establishing a sovereign currency backed by taxes have created a demand for the currency and the firms, financial institutions and citizens of the nation will utilize this unit of account to create credits and clear debts.  This creation of credit and clearing of debt denominated in the unit of account is a social process that has developed throughout history and is the true origin of money.  The creation of money is simply the creation of a loan (credit) denominated in a certain currency in which the lender requires and guarantees the debt can be paid back in the same currency by the borrower of said loan.  It is within this theory that heterodox economists have come to recognize the modern economies as monetary capitalist economies and not commodity based economies.  The creation of money through a loan enables the borrower to purchase input commodities and through the production process produces another commodity that in turn is sold for money prime, (M-C-C-M’).  The production process in a monetary capitalist economy starts with money and ends with money prime therefore money is not simply a medium of exchange and is not neutral in the short run or the long run.

The other aspect where heterodox economists diverge is that the creation of money is not exogenous but in reality is endogenous and the creation of money occurs from within the economy by individuals and firms through the creation of loans originated through the financial institutions.  The authorities in the United States economy do not have the power to force individuals and firms to take out loans from the financial institutions.  The exogenous variable that effects the money supply is the short term interest rate which the central bank targets but the monetary base itself is an endogenous variable.  The concepts of a tax driven monetary system where the money supply is created endogenously from within an economy greatly influences heterodox economists approach to the nature of banking and one that counters mainstream economic theory.

The Heterodox Approach to the nature of banking:

Financial Institutions play a vital role in a monetary economic system and the nature of their actions effect households, firms, and governments.  The financial institutions are connected to the real economy through the liabilities that they issue which are recorded in their balance sheets.  Financial institutions are in business to make a profit and within a simple economy they make profits by extending loans to entrepreneurs or firms on which they charge an interest rate which they determine and the loans are contractual agreements between the lender (bank) and the borrower.  The loan is credit issued by the lender and is debt held by the borrower of the loan therefore the bank will extend loans when they deem that the borrower is credit worthy and is capable of repaying the principal and interest within an established amount of time.  For example a firm will finance the production of an output and upon sale of the output is able to repay the loan extended to the firm from the bank.  This process is rather simple and would not seem to have any negative consequences on the parties involved but would seem to benefit all parties.  Unfortunately this simple example is not the whole story.  The financial structure of the current economic system is vast and extremely complicated.

The first issue at hand regarding the structure of the financial system is to determine how they are capable of issuing a larger denomination of loans than the amount of deposits that they have on their balance sheets.  Where does the money come from?  A bank has more than one option regarding how it can raise the amount of funds it needs.  A bank has the option of utilizing the overnight lending market which is simply lending of reserves between banks so essentially one bank extends credit and the borrowing bank holds the debt.  Another path that the bank could take to accumulate funds is to sell assets that it owns but this is highly unlikely unless the bank is going to profit from the sale of the asset.  The last course of action that a bank would take to acquire funds is through the discount window which is simply the “lender of last resort” and that is the policy established by the government that the treasury is required by law to accommodate the bank if necessary.  It was stated earlier in this essay that orthodox economists’ theory states that the required reserve ratio constrains the amount of loans that can be issued.  This belief is invalidated by the “lender of last resort” policy of the United States therefore banks are not constrained by the ratio of reserves to deposits.  John Smithin quotes Moore, Kaldor, Dow and Saville,

“The argument is that in practice central banks cannot refuse to accommodate demands for borrowed reserves at the “discount window” ,as this would mean abandoning their responsibility for the liquidity of the system and the “lender of last resort” function,” (Smithin, Page 56).

Financial institutions are able to borrow funds through the interbank lending market as well as the discount window and both rates charged to the bank will be below the rate that a bank imposes upon a customer therefore the bank is not constrained by the amount of reserves entered in their accounting ledgers.  The most important aspect regarding the methods that banks employ to accumulate funds to maintain solvency is that connections are established between households, firms, banks and the government.  Financial institutions therefore do not lend from reserves but create money by issuing liabilities, within this system the bank is only monetarily constrained by the amount of credit worthy borrowers wherein the solvency of the loans made rely on the ability of the initial debtor to make good on the loan.

Financial institutions are not unlike firms and households in respect to the desire to accrue profits from the daily operations of their activities.  Financial institutions have a motive to innovate in the same fashion as entrepreneurs and firms but the success or failure of financial innovations transform the whole economy opposed to that of firms and entrepreneurs wherein success is circulated through the economy by way of the products that are invented but failure is more isolated to the firm or entrepreneur.  Minsky stated,

“Profits are available in financial structures and institutions as well as to innovators in products, production techniques, and marketing.  Many of the great fortunes accrued to financial innovators, either as borrowers or lenders.  Banks, other financial institutions, businesses, and households are always seeking new ways to finance activities.  Successful financial innovators are rewarded by fortunes and flattered by imitators.  Once an innovation proves successful, it can spread rapidly because financial innovation are almost always the application of some idea, and there is no patent constraint upon imitators,” (Minksy, “Commitments and Liabilities” Page 220).

The restrictions placed upon financial institutions are the source of the initiative to innovate in an attempt to circumvent the restrictions that the financial institutions view as an obstacle to greater profit opportunities.  Financial institutions in stages throughout history have created financial products in an attempt to move away from the simple model economy discussed above in which they simply financed the production of firms wherein this type of financial structure two types of prices emerge.  Two sets of prices were established by the fact that the entire wage bill was not paid to the workers but a portion was also distributed to individuals that produced investment goods.  The two different price levels are determined in different ways.  One price level is for capital assets, which is determined by the present value of expected profits and profits were determined by investments.  The second price level is that of the current output and labor which is determined by ordinary price theory.  As capital assets became increasingly expensive entrepreneurs could no longer afford to establish ownership over the capital asset and financing was required which traditional commercial banks could not handle.  Wray stated,

“External finance in the form of shares and bonds financed the ownership of capital assets.  This leads to the second type of bank, the investment bank.  The function of the investment bank is to provide the external finance to put the produced capital goods into the hands of the entrepreneur,”  this type of financial institution could take on two different forms according to Wray, “one form in which the investment bank holds the equities and bonds issued by the corporation that requires financing by issuing debt and shares held by households within this type of financing the success is determined by the borrower’s ability to pay but the another form emerged where investment bankers placed the debt and equities of corporations into the portfolios of households.   This form was successful if the banker could sell the debt or equity and did not require the borrower to be successful,” (Wray, “What Do Banks Do” Page 7).

The financial institutions moved into a stage of capitalism where the borrower no longer needed to be successful for the bank to make a profit therefore the banks were no longer restricted by the amount of credit worthy individuals seeking loans.  The scheme that came into play was known as “pump and dump” wherein a large amount of money flowed into the financial sector which in turn elevated (pump) the value of the  equity well above the actual value of the output produced by the capital asset in turn the financial institution would eventual sell (dump) the equity to households.   This type of banking spread rapidly throughout the United States but came to an end with the emergence of the Great Depression which influenced political leaders to restructure the financial industry in a manner to create stability and restore solvency upon the institutions.  The period following this reconstruction was one of stability in which the economy was stable but as the government became complacent financial institutions were once again beginning to develop innovations in which to increase profits.  The financial innovations once again allowed the circumvention of regulations and moved capitalism into a stage referred to as money manager capitalism by Minsky.  The new model of capitalism that emerged was one similar to the “pump and dump” schemes prior to the Great Depression.  The model that emerged is referred to as “originate and distribute” which has been greatly enhanced by the emergence of the securities market which allows financial institutions to originate loans and to bundle a large amount of the loans and then securitize the bundle of loans and distribute the securities among mutual funds, trust funds, IRA accounts and insurance companies.  The originators of the securities once again do not have an incentive to provide sound underwriting of the loans residing within the securities.  The incentive rather is to originate the loans increasing profits through processing fees and then securitize the loans allowing for the distribution of the securities throughout the financial structure and moving the loans off the balance sheets of the originating banks which allowed the originating banks to start the process again not considering the credibility of liabilities issued.  This has been referred to as the layering of debt on top of debt but the ability of the initial borrower will still determine whether each loan is repaid and if a large percentage of loans within the security default the final holder of the security will be affected.  This originate and distribute model enhanced by financial innovations, lack of regulations and a return to laissez-faire economics has led to the financialization of the economy and  once again created instability within the United States economy leading to a recession that has impacted the global economy.  The impact of the financial institutions upon the global economy is a direct consequence of the way in which the balance sheets of households, firms, financial institutions and government are all interconnected therefore financial institutions which allocate financial resources are not simply financial intermediaries but are integrated throughout the economy and whose actions have an effect on the real variables.

Heterodox economists have observed financial institutions throughout history and established that stability over a period of time will eventually lead to an instable financial structure therefore a government is responsible for establishing regulations that supervise the structure of the financial institutions and the regulations enforced need to evolve alongside financial innovations to preserve a stable economy.  Orthodox economists’ belief that financial institutions do not have an effect upon real variables in essence detaches them from any debate regarding the implementation of policy and procedures regarding the financial structure of the United States economy.  Minksy stated,

“In particular as neo-classical economic theory divorces the financial structure from the investment.  It has no room for speculation as plays on the difference between the market evaluation of the uncertain expected profits and the cost of producing capital assets.  It does not allow for market power to determine the value of firms.  Given these attributes the neo classical theory cannot be a guide to the appropriate structure of banking and financial institutions:  A neo classical theorists should stand mute when policy matters that deal with finance are on the “table,” (Minksy, “The Capital Development of the Economy and the Structure of Financial Institutions,” pg. 18).

According to heterodox economists policies and procedures should be implemented that establish a structure that promotes the capital development of the economy opposed to a structure that promotes the financialization of the economy where financial institutions are not held accountable for the loans that they originate.   Traditional commercial banks should be required to hold loans to maturity while mutual funds, trust funds and insurance companies which manage household portfolios should be restricted from investing in certain markets such as the commodity index future markets wherein they channel large amount of funds into the market which creates bubbles in said markets and cause spot market prices to adjust to future prices.  True speculative investment should be left to hedge fund managers therefore leaving these casino type investments to individuals that are qualified and wealthy enough to incur losses.  Minsky referred to this as the compartmentalization of financial institutions and restricts each type of institution to the activities that they are qualified to undertake and will also reduce the interconnection of the balance sheets therefore negative consequences induced by speculative and Ponzi finance will be secluded to certain financial institutions.  The large banks that have been created through money manager capitalism would be dismantled and policies would be implemented that do not allow the central bank to prop us these institutions if they become insolvent.  A crisis would allow the government to evaluate the financial structure’s weaknesses allowing the authorities to re-establish regulations that removed weaknesses and restored a stable financial structure.

 

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*A Note:

For the next few weeks we will be running a series of articles on monetary theory and policy. These are final essays written by MA students in my class this past Fall semester. I was very happy with the results—students indicated that they had a firm grasp of both the orthodox approach as well as the heterodox approach to the subject. Most of them also included some Modern Money Theory in their answers. I asked about half of the students in the class if they would like to contribute their essay to this series. Sometimes students are the best teachers because they see things with a fresh eye and cut to what is important. They are usually less concerned with esoteric academic debates than are their professors. Note that these contributions are voluntary and are written by Masters students. I told students they could choose to use their own names, or they could choose an alias. Comments are welcome, but please be nice—remember these are students.

For your reference, here were the topics for the paper. The paper had a maximum  limit of 6000 words.

Choose one of the following. You must consider and address both the orthodox approach and the heterodox approach in your essay. Where relevant, include various strands of each.

A) What is the nature of money? Given the nature of money, what approach should be taken to policy-making?

B) What is the nature of banking? Given the nature of banking, what approach should be taken to policy-making?

C) According to John Smithin there are several main themes throughout controversies of monetary economics, each typically addressed by each of the various approaches to monetary theory and policy. In your essay, discuss how each of the approaches we covered this semester tackles these themes enumerated by Smithin. 

L. Randall Wray