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Banks are special because the medium of exchange is special, says Nick Rowe

Posted in Opinion

By Nick Rowe*

If we used cows as media of exchange (if we bought and sold everything else in exchange for cows), would you say that dairy farming is a special industry that is macroeconomically important?

I would.

Because if we used cows as media of exchange, then what happened on dairy farms would affect the supply of media of exchange, and I think the supply of media of exchange is macroeconomically important in explaining short-run recessions.

And if you wouldn't say that, why would you say that banks are special and macroeconomically important in the real world?

Banks can create the medium of exchange "at the stroke of a pen", and lend it out for a monthly fee.

But a talented artist can create valuable drawings at the stroke of a pen, and lend those drawings out for a monthly fee to those who want to hang them on their walls.

If the medium of exchange is not special, or macroeconomically important, then banks are no more special or macroeconomically important than that talented artist.

Ask yourself these two questions:

1. Is the medium of exchange a special good, that is unlike all other goods, in a way that is macroeconomically important?

2. Are commercial banks special firms, that are unlike other firms, and unlike other financial intermediaries, in a way that is macroeconomically important?

I think those two questions are very closely related.

It would be hard to answer "no" to the first and "yes" to the second. That's because:

Banks are financial intermediaries whose liabilities are used as media of exchange. If the medium of exchange is not a special good, and not a macroeconomically important good, then banks cannot be special or macroeconomically important either. Banks would be no more special or macroeconomically important than mutual funds.

My own view:

In long run equilibrium, banks are no different from other financial intermediaries. They borrow and lend.

They make life easier for ultimate borrowers and ultimate lenders to get together, just like shopkeepers.

And the main task of monetary policy is to keep the economy in that long run equilibrium by preventing monetary instability by preventing banks lending either more or less money for some people to invest or consume than other people want to save.

But in the short run disequilibrium, the quantity of medium of exchange matters a lot:

1. Every market in a monetary exchange economy is a market for the medium of exchange. This means that the medium of exchange is special because there are two ways an individual can get more medium of exchange: he can buy more medium of exchange (by selling more of other goods); or he can sell less medium of exchange (by buying less of other goods).

2. An excess demand for the medium of exchange prevents people making the mutually advantageous exchanges that would be possible if barter were easy so we did not need monetary exchange. That's what we call a "recession". If I could sell my goods, I would want to buy your goods; and if you could sell your goods, you would want to buy my goods; but neither of us will part with our money because we don't know whether that money will return to us, and it's too difficult to organise a  swap.

3. Unlike other goods, people will accept more medium of exchange even if they do not plan to hold more medium of exchange and even if they think nobody else plans to hold more medium of exchange. We accept money in exchange for other goods only because we know that others in turn will accept it from us. The quantity of medium of exchange is supply-determined in a way that is not true of other goods. The talented artist can create drawings at the stroke of a pen, but cannot rent them out unless he can find someone who wants to hang that drawing on his wall. An excess supply of drawings immediately refluxes to the artist. The talented artist cannot create an excess supply of his product; banks (in aggregate) can. I borrow the drawings because I want to hold the drawings; I borrow the money because I want to buy something else.

So I think that commercial banks are macroeconomically important because, and only because, they influence the supply of media of exchange.

Otherwise, if that were not important, they would be just like any other financial intermediary.

But tell me: is the medium of exchange a special good, and a macroeconomically important good, and a good whose supply matters, in yourmacroeconomic view of the world?

If not, what's the big deal about banks?

And if we did use cows as money, would you forget about financial intermediaries, and start writing about dairy farms instead? Or if we used the drawings of talented artists as money, would you forget about financial intermediaries and start writing about artists instead?

-----------------------------------------------------------------------------------

Nick Rowe is an Associate Professor in the Department of Economics at Carleton University, in Ottawa, Canada. This article was first published in his blog Worthwhile Canadian Iniative here ». It is republished here with permission.

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16 Comments

So my redcows are macro

So my redcows are macro important, more so than the special banks? Ok I buy that, maybe.

They certainly are special

They certainly are special alright.
They pay me 3.85% for twelve months and then when i need to borrow they charge a minimum of 15.95% plus afee of $165 to apply.
Where else can you get away with this.

http://www.rabodirect.co.nz/c

http://www.rabodirect.co.nz/customer.aspx
Currently 4.20% on call. Ok you have to add $50 a month. I like the fact that it is on call, as it puts pressure on the bank to pay more for it's deposits. It also gives the option of joining in a bank run should that become unexpectedly necessary. The other big advantage of cash is it allows you to take advantage of bargains should they appear and you are able to recognise them.

Totally agree, personally I

Totally agree, personally I think its very important to have money on call or short term in the situation we are in now.  The other maybe cash like thing is Govn bonds due to expire in say <6 months....Personally I wouldnt invest in anything right now I cant liquidate fast and move, fast.
regards

Anyone have any tips for

Anyone have any tips for things the banks don't like?
 
My own suggestion above is to only lend on call if you can possibly manage it. It forces them to pay more for their longer term deposits. After all there is no collateral from their side and the guys at Northern Rock, RBS, Lehman all thought they were the bees knees until suddenly they weren't.
 
There must be a whole string of things we can do to help level the playing field.

The quantity of medium of

The quantity of medium of exchange is supply-determined in a way that is not true of other goods. 
I thought it was demand driven ..  ie. endogenous money supply growth 
 
But tell me: is the medium of exchange a special good, and a macroeconomically important good, and a good whose supply matters, in yourmacroeconomic view of the world?
Is viewing money as a "good" the best way to percieve its' importance..???  Money is simply something that is legalized by the State and simply has the qualities of ....medium of exchange, unit of account and store of value.....   ( these are qualities ..rather than a "good" )
It isn't Banks that give money its "power "... its' the State.
The only "Big Deal" about Banks is that because we accept their liabilities as "money".... their "IOUs'"  far exceed their ability to pay out in "real money".. ie.. they are very highly leveraged.
If they were simply financial intermediaries....  then Banks would be just another boring business...
BUT....  because they can create "credit"... that spends like Money....   the Banking System requires a "Central Bank".. to provide life support in the form of Liquidity... (GFC showed us just how naked they are when the tide goes out.)
In that regard .... Banks and the Banking system is a "very big Deal"....    and Governments should deal to them when they abuse their privilege...
Do you agree..??
 

Yes, is it a good or a

Yes, is it a good or a service , and if so why does it not attract GST like bread and milk do? Answer, they are more special, preferred, closer to power, better connected,  than any other sector of society. They are The Privileged Ones Who Must Not Be Named.

I think you’re confusing the

I think you’re confusing the money and currency Nick.
 
 
Money is an abstract unit of measure, which the community has decided to generally accepted to serve various economic functions. Unit of Account, Store of Value, Medium of Exchange, and Standard of Deferred Payment.
 
Currency is a good which the community generally accepts as a form of payment.
 
We actually live in a very singular age where the nature of currency actually fully adheres to the official definition. In prior periods (before around 1815), the government mint lacked a sufficient supply of gold or silver to serve the needs of the average person who would deal primarily in small change. The majority of gold and silver was locked up in bank vaults serving as a store of value for the wealthy and the public finances. The common folks had to make do with private token currencies, personal credit, and the trucking work system where they accepted rejects and materials from their employers as payment for their labours. Also the lines between money and currency have become so blurred that even Central Bank governors aren’t able to categorically define what is money and what is not. If they can’t who can? And how are they supposed to manage the money supply? They can’t and Alan Greenspan concurs with me.
 
Mr. GREENSPAN. Let me suggest to you that the monetary aggregates as we measure them are getting increasingly complex and difficult to integrate into a set of forecasts.
The problem we have is not that money is unimportant, but how we define it. By definition, all prices are indeed the ratio of exchange of a good for money. And what we seek is what that is. Our problem is, we used M1 at one point as the proxy for money, and it turned out to be very difficult as an indicator of any financial state... We have never done it with M3 per se, because it largely reflects the extent of the expansion of the banking industry, and when, in effect, banks expand, in and of itself it doesn’t tell you terribly much about what the real money is…The difficulty is in defining what part of our liquidity structure is truly money. We have had trouble ferreting out proxies for that for a number of years. And the standard we employ is whether it gives us a good forward indicator of the direction of finance and the economy. Regrettably none of those that we have been able to develop, including MZM, have done that. That does not mean that we think that money is irrelevant; it means that we think that our measures of money have been inadequate and as a consequence of that we, as I have mentioned previously, have downgraded the use of the monetary aggregates for monetary policy purposes until we are able to find a more stable proxy for what we believe is the underlying money in the economy.
Dr. PAUL. So it is hard to manage something you can’t define.
Mr. GREENSPAN. It is not possible to manage something you cannot define.
 
http://www.lewrockwell.com/2005/07/ron-paul/questioning-greenspan/
 
Furthermore you didn’t mention that 97% of our money supply is credit money created ex nihilo by private banks. A good part as to why people so generally accept bank money is because the government has conferred de jure legitimacy upon bank money and treat it interchangeably with government issued legal tender as if it were one in the same. They endow bank money with the singular privilege of allowing bank money to be used to pay their tax liabilities, a status that no other currency will ever likely share.
 
You question whether farmers should be able to issue money in New Zealand. I would answer who better to than farmers by proxy of the Fonterra Cooperative? After all at least farmers have something valuable like land, milk, equity, and livestock to underpin the money they would issue unlike banks who have what, faith and promises with the implicit State guarantee (again backed up by nothing more than faith and promises, well apart from the ability to steal from you and even following generations to pay for someone else’s financial liabilities). At least they no longer would be faced with the threat of having surrender their land in case they run into financial difficulties. I think many farmers would greet that prospect pretty positively. 

I think the Greenspan - Paul

I think the Greenspan - Paul conversation was about the money multiplier. Both Paul and Greenspan follow schools of thought which say that the Fed controls the amount of money in circulation, by controling the base (where Greenspan refers to the underlying money in the economy). Of course no such thing exists and the Fed must supply whatever base the banking industry needs to settle, and credit creation expands the money aggregates in most cases and leads the expansion (in reality). By undefined, Greenspan is really just saying that they don't know what controls the price level, e.g from the Fischer equation MV=PY (though he still implies there is such a thing in the money aggregates somewhere).
I don't think it says the Fed is having trouble understanding what is a medium of exchange in the economy at all however, though Paul scored a lot of political points for rhetoric from this implication here.
 

You are correct in the sense

You are correct in the sense Alan Greenspan was force to argue with Ron Paul on the terms of the monetarist economy theory which held sway at the time, which was propounded by Milton Friedman who was thorough ignorant about the true workings of the modern banking system. It wasn't the money multiplier which was the subject of the fundamental nature of money which lies at the centre of the monetarists confusion about how the economy works.
This article in the Socialist Standard of 1983 throws that in stark relief.
 
And Friedman’s Monetarism is not a new name for Marx’s money theory, or for the quantity theory, but a new name for a quite different theory, the “Bank-deposit Theory of Prices”, which holds that the price level is determined by the rise and fall of bank deposits. Both Marx and the quantity theorists were completely opposed to it. The principal thing that Marx and the quantity theorists had i” they meant only the notes and coins in circulation, the currency.
For Friedman and other Monetarists, as for the bank-deposit theorists, “money” includes, along with the relatively small amount of currency, the much larger amount of bank deposits. Professor Edwin Cannan, in his book Modern Currency and the Regulation of its Value, published in 1931, had a chapter entitled “The Bank-deposit Theory of Prices”. Cannan’s description of that theory showed it to be exactly the same as the theory now advanced by Friedman under the name Monetarism. Cannan was of course opposed to it.
Marx and the quantity theorists made it quite clear that by “money”, in connection with prices, they meant only the currency. In Capital vol. 1 (Kerr edition, p.143), Marx dealt with inflation in terms of the “bits of paper”, put into circulation by the state, “on which their various denominations, say £1, £2, £5 etc. are printed”. Nothing about bank deposits being the factor determining the price level.
http://www.marxists.org/archive/hardcastle/marxmonetarist.htm

Marx understanding, and

Marx understanding, and Friedmans understanding are certainly not my understanding of how the price level works. 
Actually the Fischer equation is rather mistated as well. Fischer said, MV=PT, (its true by accounting identity) meaning the price level is the aggregate of the medium spent, the number or transactions with that medium, divided by the number of transactions. Later economists changed the T for Y, under the assumption that people could only spend out of their income, at least in aggregate.
http://en.wikipedia.org/wiki/Irving_Fisher
If Marx makes the assumption that spending power is related to income in this way, then Friedman is correct to draw the conclusion that monetarism and Marx theory are the same. Friedman also makes the incorrect assumption that banks lend out prior deposits and so there will be a stable relationship between the quantity of base money and the level of bank deposits, which is the main component of spending in the price equation.
I think its correct to say that bank deposits are the main medium spent in the economy, and so they will bear the closest relation to the price level as above. On the other hand, the mechanism must run from spending to bank deposits (because of the accounting banks use to lend) so basically you will end up with the credit created to support the amount of spending done at the same time.
If Marx concluded there was a stable relationship between currency and the price level, he was incorrect, that's the relationship Greenspan was looking for but was never found.
That Marxist article is awful unfortunately, it doesn't understand what is being discussed, for example
"In view of the belief of the Keynesians and the Monetarists that they are in opposite camps it is relevant to recall that Keynes also was a “mystic”. Like the Monetarists he urged abandonment of the policy of directly controlling the amount of money, and was responsible for drafting the statement in the 1931 Report of the Committee on Finance and Industry that “the bulk of deposits arise out of the action of the banks themselves.”
The Monetarists were in favour of controling the quantity of money, this they thought could be achieved by controling the amount of base money (which as Friedman says is under control by the government). But this means abandoning interest rate targeting, and the Monetarists lost all control of the own rate of money, when their policy was tried. Keynes correctly says (the level of bank deposits is not related to the base (its related to the quantity of lending) and this arises out of the actions of the banks. Plainly Keynes was in the opposite camp to Friedman, and many Keynesians argued against the implementation of Monetary targeting at the time. As J.K Galbraith said, the problem for Monetarism is that its been tried.

Fischer's equation is only

Fischer's equation is only correct if you assume that money circulates through the economy. It doesn't. Instead money operates in an accounting cycle, where banks create credit to facilitate economic activity, is disbursed as income, and is returned to the banking system to repay debt. 
 
“The fallacy in the theory lies in the incorrect assumption that money "circulates", whereas it is issued against production, and withdrawn as purchasing power as the goods are bought for consumption. “ ( “The Alberta Post-War Reconstruction Committee Report of the Subcommittee on Finance")

The truth is that money does not “circulate” but instead operates in an accounting cycle, and B payments are monies on their way back to the bank, thus completing the cycle. Therefore, B payments do not exist as income to anyone. Income, by contrast, is flowing from the bank, and reaches individuals through the media of wages, salaries, and dividends. The argument that B payments are income is a complete fallacy based on the erroneous assumption that the circulation of money increases its purchasing power.
 
http://social-credit.blogspot.co.nz/2007_10_01_archive.html
 
Its unfortunate that the article unjustly attacked Major Douglas' monetary theories, because his still are some of the most nuanced, complete description of how the monetary system works. They failed to note the distinction Social Creditors made between A income and B payments which were central to his A+B Theorem. 
 
The cyclic rate of purchasing power of money can be calculated by calculating the average amount of deposits held by depositors in banks relative to the amount of clearings through the banks, minus the amount of "Butcher-Baker" transactions. Douglas referred to any transaction that broke a chain of repayments as a "Butcher-Baker" transaction...and therefore, these transactions leave a trail of debt, and must be deducted when calculating the cyclic rate of purchasing power, because the monetary cycle has not been completed. Douglas calculated the average cyclic rate of purchasing power to be approximately two and a half weeks in Britain ("The Old and the New Economics”). Therefore; any cost anterior to three weeks, must form a part of the gap between income and prices. Douglas spoke of this fact when questioned before the Alberta Agricultural Commission.
 
http://social-credit.blogspot.co.nz/2007_10_01_archive.html
 
 

No, this A+B theorem is

No, this A+B theorem is incorrect.
First of all, the MV=PT version of the price equation is true by accounting, whatever circulates as money M, times the number of times each bit of it is spent V, must equal the price level P, times the number of transactions T. That's true by definition, and over any accounting period, though it doesn't tell much about the behaviour of this system.
The social credit page states that the first criticism is incorrect, however it is not. The correct criticism of this is that all payments in the economy are somebodies income. Say that you manufacture some furniture, using wood in the process, you don't pay the tree money for its use, you pay the harvester & seller of the tree for it. That payment is his income. There is one exception to this, payments above interest of debt (e.g those which actually extinguish a debt obligation). All other payments in the economy are somebodies income. This is the correct criticism of the A+B theorem.
The social credit site dismisses this with the paragraph,
The truth is that money does not "circulate" but instead operates in an accounting cycle, and B payments are monies on their way back to the bank, thus completing the cycle. Therefore, B payments do not exist as income to anyone.
but the dismissal is completely un-justified. It is unjustified because the volume of B payments does not add up to the rate at which bank debt is repaid. There are far too many B payments in the economy, compared to the re-payment rate and thats true even today while there is widespread debt repayment going on. Its clear when a firm gets income the first thing they do is not pay down any debt, also payment periods for debts differ widely. At least while debt is outstanding it circulates.
There is also a problem in Douglas statement, 
but since all payments go into prices, the rate of generation or prices cannot be less than A plus B.
A firm might for example borrow money to spend (which is how Douglas even says it works) so their expenditure is not limited by their income. Of course this means that if they can and subsequently do repay their debt then this depends on the borrowers repayment plan, and that depends on the uncertain process of forecasting the future, somewhat accurately. There is no particular reason to think that bank debt is going to be repaid at all with any certainty.
 

Anark - good post. I've

Anark - good post. I've hammered on about undrwrite here, for yonks.
 
We just differ about where we are on the curve. My take is that if banks continue, their 'profit' has to be at the expense of someone/thing else.

I might just give you 10 out

I might just give you 10 out of 10 for the bleeding obvious...
;]
As BH said elsewhere in relation to the provinces and frost bite, the edge will be left to fend for itself as the declining empire retreats to its core.  Same for banks or anyone else that has a monopoly, they will continue and continue to try to grow no matter what damage they do to small businesses or anyone else if we dont curb them.
regards
 
 

These guys are trying to do

These guys are trying to do something:
 
http://www.positivemoney.org.nz/
 
Take the money creation and its rent out of the hands of the banks. Then maybe we have a chance at creating real shared wealth, high employment, a future for our kids in NZ.