Monday, August 19, 2013

Scott Sumner ignores banks, so what?

In response to a recent comment by Cullen Roche, Scott Sumner wrote that "I have no interest in banking or bookkeeping. My interest is monetary policy."

Now this is a point that Sumner has made before. For instance, he wrote an old post back in January entitled Keeping Banks out of Macro, in which he claimed that bank lending "is not a causal factor—it mostly reflects the growth rate of NGDP."

To Minskyites and Post Keynesians like Cullen, who put a lot of importance on the banking system and the financial instability that results from bank failures, this claim is blasphemous. But given the side of the field from which Sumner comes from, I think he makes a lot of sense. As Sumner points out in his comment, his main interest is monetary policy, and Sumnerian monetary policy boils down to exercising control over NGDP. Sumner usually explains this by reference to the medium of account role of money, and though I think his terminology is a bit buggy, I agree with him.* By wielding its control over base money, or what Sumner calls the medium of account, the Fed can push up the price level, and therefore NGDP, to whatever heights it wants to.

This relates back to my previous post in which I made the analogy of a central bank's power to Archimedes's boast that he could move the world. Give a central banker a long enough lever and a fulcrum on which to place it, and he'll move prices and therefore NGDP as high as he wishes.

Whether there is a banking system or not in the picture will interfere in no way with a central banker's Archimedean lever. Here's a very short explanation for why banks don't change anything. Think of a private bank deposit as a call option on central bank base money. Any bank that holds another bank's deposits can "put them back" to the issuer whenever they wish in return for an equivalent amount of central bank deposits or notes. Similarly, a consumer or business holding a bank deposit can always convert them into an identical quantity of central bank cash. This one-to-one correspondence between underlying central bank money and bank deposits, enforced by the option to convert, means that if the purchasing power of base money declines, then so must the purchasing power of a bank deposit.

The correspondence between option and underlying is fairly non-controversial. If Apple's stock price falls, then options to buy Apple will fall too. If the options fail to fall in sync with the underlying stock, arbitrageurs will sell options and buy Apple until the gap has disappeared. Just so, if a central bank drives down the purchasing power of base money, a failure of bank deposits to corroborate the fall of the underlying will be exploited by arbitrageurs until that failure has disappeared. Of course in practice we almost never see a difference between the price of central bank money and bank deposits. The process is so automatic that we never think about it.

I'm not being original here. For instance, in an article on calling for the death of the money multiplier, David Glasner described the equality of inside and outside money, noting that
it is convenient to view the value of money as being determined by the supply of and the demand for base money, which then determines the value of inside money via the arbitrage opportunities created by the convertibility of inside into outside money.
In David's quote, inside money is bank deposits, and outside money is central bank notes and deposits.

So to sum up, since a central banker has precise control of the purchasing power of the liabilities that it issues (explained in my previous post), it will automatically exercise that same control over the purchasing power of the liabilities of the entire banking system, insofar as private banking deposits function as call options on underlying central bank liabilities. Should Ben Bernanke desire to push up NGDP by 10%, he need only hurt the purchasing power of his own liabilities, and this will be immediately reflected in a fall in the purchasing power of all derivative US dollar bank deposits. In a world without banks, Bernanke would exercise just as much control over the price level. Given the observational equivalence of a world with banking and one without, I don't think Sumner, who is primarily interested in manipulating NGDP, is off base in his lack of interest in banking.

Of course, Sumner may have an entirely different reason for ignoring banking than the explanation I've put forward. As for banking in general, I do I think it is important to understand it since there is more to understanding economies than the range of issues that interest Sumner.

*I think the unit of account role is a more accurate word to use than medium of account. Shops post prices in terms of the unit of account, not the medium of account.

Update: Cullen Roche adds a response.


  1. I'm a bit confused. If the lever is Woodfordian rate guidance, what does the size of the base matter?

    In time t+1 when the Fed violates the Taylor rule, banks can borrow all the reserves they want at the too-low fed funds rate. You don't need a single dollar of pre-existing reserves to make that happen.

    Also, I'd point out that high inflation almost always starts out with credit creation. That is, agents perceive that the fiscal authority is producing unpayable claims. They foresee that these claims can only be serviced through reserve issuance. They rush to borrow to spend their future deposits (income) now rather than wait for them to appear.

    Inflation is hedging behavior, and credit both enables and produces it.

    1. Can you clarify? What phrase in the post is confusing?

    2. "By wielding its control over base money, or what Sumner calls the medium of account, the Fed can push up the price level"

      I thought the lever you suggested is that the Fed pushes up the price level by promising to hold rates low when inflation does rise. Today's base level is irrelevant to that dynamic, as banks can borrow as many reserves as they want in that future point in time.

      If the medium of account is paramount, then QE should work by itself, no? My other question is, why don't we have $3tr+ in "account medium"? Sumner blames the 25bp IOR.

    3. In writing "wielding its control over base money", I was deliberately vague about what sort of control over the base it exercises ... control over the quantity of reserves? ... over interest on reserves? ...over future interest on reserves? In different situations ie. pre-2008 vs post-2008, the Fed must wield its power over the base in different ways. As long as laws don't cut off the appropriate route, the Fed will always will have full control over the medium of account's purchasing power. So I could have just as easily have written that phrase "by wielding its control over the current and or future rate of interest paid on base money, or what Sumner calls the medium of account, the Fed can push up the price level."

      I think that you're right that the quantity of base money currently does not matter.

      "If the medium of account is paramount, then QE should work by itself, no?"

      Not if it simply buys up liquid assets at market rates. But as I've said before the Fed has other theoretical ways to control the return on the medium of account. It can reduce IOR below 0 and adopt Miles Kimball's plan. Or it can promise to be silly in the future in order to reduce the return on the medium of account today. Or it can buy assets now at wrong prices in order to hurt the safety of the medium of account.

    4. Your last paragraph implies there is not a one-to-one relationship between the base and the medium of account. That relationship depends on signalling regarding the future value of Fed deposits. I don't disagree, I just don't know where that leaves "the base" as a useful concept.

  2. Sorry, I don't understand if banks are unimportant for the result od MP. i susppect that yes, I don't agree with SS.
    Take for example the Euro. The bad situation of banks in piigs has has an huge influence in the nule effcts of ECB MP.
    The banks is a micro theory topic, but with huge consequences at macro level.

    1. All I'm saying is that if it needs to hit a certain price level, a central bank can't be inhibited by the banking system. The pass-through to central bank price changes to the banking sector occurs immediately due to the option clause that deposits carry.

    2. "The pass-through to central bank price changes..."

      The pass-through of central bank price changes...

  3. I think it's more accurate to describe a bank deposit as a debt rather than a call option. If you have a $100 bank deposit that simply means that your bank owes you $100.

    1. Actually many banks are very clear that this is exactly what a deposit is. For example:

      Citibank: Client Manual, Consumer Accounts

      “Unless otherwise expressly agreed in writing, our relationship with you will be that of debtor and creditor. That is, we owe you the amount of your deposit.” (p.5)

      Bank Of America: Deposit Agreement and Disclosures

      “Our deposit relationship with you is that of debtor and creditor.” (p.2)

      Wells Fargo: Consumer Account Agreement

      “The Bank’s relationship with you concerning your account is that of debtor and creditor.” (p.39)

    2. Yes, it's debt with a call option attached to it. Much like a retractable bond.

    3. Isn't the whole point of a call option that the price of the underlying asset can differ from the agreed strike price? But with a bank deposit there is no such difference. You just buy a $100 deposit with $100 cash, or vice versa. If you have a $100 deposit the bank simply owes you $100. What am I missing?

    4. If you really want you can call a deposit an instantly convertible debt instrument, or a sight bill, rather than debt with a call option. It really doesn't matter what you want to call it.

      The point is that the perpetual promise of instant convertibility of deposits into base money anchors the former's purchasing power to the latter.

  4. Would you be willing to look over my Hyperinflation FAQ and comment on it?