This post was inspired by an excellent recent post by Nick Rowe. Unfortunately he won’t entirely agree with this one.
Is it more useful to define money as the monetary base, or as M1 (cash plus checking account balances?) Nick would say M1. I prefer the base. So let’s think about what makes the base different from checking account balances. The basic difference this: changes in the base are neutral, in the long run they affect all nominal variables proportionately. If the Fed wants to increase all nominal variables by 100 fold, it simply increases the base 100 fold. Because banks are profit-maximizing institutions, the DD/MB ratio is not affected (in the long run) by changes in the monetary base. It’s a real variable. In nominal terms the Fed is the dog and banks are the tail.
Banks can increase M1 by making it more attractive to hold demand deposits. They can pay interest on checking accounts, for example, or offer free services. That changes a real variable; DD/MB. But they cannot make the Fed print more money. That’s the key difference. The Fed can get the banks to create more deposits, but the banks can’t get the Fed to print more. The banks maximize profits while the Fed maximizes social welfare.
What about the fact that bank money is also a media of exchange? Doesn’t that make banks special? Not really. Monetary theory is symmetrical. There is essentially no difference between an increase in the supply of money and a decrease in the demand for money. Any sector of the economy that has a major impact on the supply or the demand for money can influence nominal spending as long as there is no monetary offset. If drugs were legalized and less currency was used for drug smuggling then there would be a drop in the demand for base money. Typically we don’t worry about this problem because of monetary offset. But that’s equally true of a change in the supply of media of exchange originating in the banking system. Banks don’t matter because the Fed won’t let them matter.
There are situations where a change in the private demand for base money does matter. The bank failures of the 1930s were important because we were on the gold standard and that limited the ability of the Fed to do monetary offset. If prohibition had increased the demand for currency during the early 1930s that would have also been deflationary. So banks did matter under the gold standard because of the difficulties in doing monetary offset. So did prohibition. Today, however, banks are not particularly special or important.
There is one possible exception to this claim. If the inflation rate is already relatively low, or more precisely if the nominal GDP growth rate is relatively low, then a major banking crisis could drive the nominal interest rate to zero. At that point monetary offset requires unconventional policies that central banks seem reluctant to engage in.
To summarize, Nick thinks banks are special because they create a significant fraction of transactions balances, a.k.a. M1. I don’t think banks are very important because of monetary offset. The Fed drives the nominal economy, because it’s not a profit-maximizing institution. That gives it the ability to target nominal aggregates such as inflation or nominal GDP growth.
PS. This is my first post done with “Dragon dictate for Mac.” I find it difficult to get used to “writing” this way. Hopefully I will get used to it over time.
PPS. At least Nick and I agree that loans don’t matter.