Commercial Banks as Creators of "Money" James Tobin

Commercial Banks as Creators of "Money" 

James Tobin

 I. 

THE OLD VIEW 

Perhaps the greatest moment of triumph for the elementary economics teacher is his exposition of the multiple creation of bank credit and bank deposits Before the admiring eyes of freshmen he puts to rout the practical banker who is so sure that he "lends only the money depositors entrust to him.' The banker is shown to have a worm's eye's view, and his error stands as an introductory object lesson in the fallacy of composition. From the 0lympian vantage of the teacher and the textbook it appears that the banker's dictum must be reversed: depositors entrust to bankers what- ever amounts the bankers lend. To be sure, this is not true of a single bank one bank's loan may wind up as another bank's depoait. But it is, the arithmetic of successive rounds of deposit creation makes clear, true Whatever their other errors of the banking system as a whole. a long line of financial heretics have been right in speaking of "fountain pen money, money created by the stroke of the bank president's pen when he approves a loan and credits the proceeds to the borrower's checking account. In this time-honored exposition two characteristics of commercial banksboth of which are alleged to differentiate them sharply from other financial intermediaries--are intertwined. One is that their liabilities, well at least their demand deposit liabilities--serve as widely acceptable means of payment. Thus they count, along with coin and currency in public "money. The other is that the preferences of the public circulation, normally play no role in determining the total volume of deposits or the total quantity of money. For it is the beginning of wisdom in monetary economics to observe that money is like the "hot potato" of a children's game one individual may pass it to another, but the group as a whole cannot If the economy and the supply of money are out of adjustment, get rid of it. This is as true, evidently of it is the economy that must do the adjusting. money created by bankers' fountain pens as of money created by public print- On the other hand, financial intermediaries other than banks ing presses. do not create money, and the scale of their assets is limited by their liabilities, i.e., by the savings the public entrusts to them. They cannot 11 count on receiving "deposits" to match every extension of their lending. The commercial banks and only the conmercial banks, in other words, And because they possess this key to unlimited possess the widow's cruse. Once this is expansion, they have to be restrained by reserve requirements. done, determination of the aggregate volume of bank deposits is just a matter of accounting and arithmetic: simply divide the available supply of bank reserves by the required reserve ratio. The foregoing is admittedly a caricature, but I believe it is not a great exaggeration of the impressions conveyed by economics teaching con- cerning the roles of commercial banks and other financial institutions in the monetary system. In conveying this melange of propositions, economics has replaced the naive fallacy of composition of the banker with other half- truths perhaps equally misleading. These have their root in the mystique of "money"--the tradition of distinguishing sharply between those assets which are and those which are not "money, " and accordingly between those institu- tions which emit "money" and those whose liabilities are not "money. The persistent strength of this tradition is remarkable given the uncertainty and controversy over where to draw the dividing line between money and other Time was when only currency was regarded assets as money, and the use of bank deposits was regarded as a way of economizing currency and increasing the velocity of money. Today scholars and statisticians wonder and argue whether to count commercial bank time and savings deposits in the money supplya And if so, why not similar accounts in other institutions? Never- theless, once the arbitrary line is drawn, assets on the money side of the line are assumed to possess to the full properties which assets on the other side completely lack For example, an eminent monetary economist, more candid than many of his colleagues, admits that we don't really know what money is, but proceeds to argue that, whatever it is, its supply should grow regularly at a rate of the order of 3 to 4 per cent per year. *E. S. Shaw, "Money Supply and Stable Economic Growth," in United States Monetary Policy, American Assembly, New York, 1958, pp. 49-71. 

 
II THE "NEW VIEW" 

A more recent development in monetary economics tends to blur the sharp traditional distinctions between money and other assets and between commercial banks and other financial intermediaries; to focus on demands for and supplies of the whole spectrum of assets rather than on the quantity and velocity of "money"; and to regard the structure of interest rates, asset yields, and credit availabilities rather than the quantity of money as the linkage between monetary and financial institutions and policies on the one hand and the real economy on the other.* In this essay I propose to look *For a review of this development and for references to its pro- see Harry Johnson's survey article, "Monetary Theory and Policy,' I will confine myself 20 tagonists, American Economic Review, LII, June 1962, pp. 335-384. to mentioning the importance, in originating and contributing to the "new view," of John Gurley and E. S. Shaw (yes, the very same Shaw cited in the previous footnote, but presumably in a different incarnation). Their view- point is summarized in Money in a Institution, 1960. Theory of Finance, Washington, Brookings briefly at 'new view" for the theory of deposit implications of this creation, of which I have above described or caricatured the traditional version One of the incidental advantages of this theoretical development is to effect something of a reconciliation between the economics teacher and the practical banker. According to the 'new view," the essential function of financial inter- mediaries, including commercial banks, is to satisfy simultaneously the port- folio preferences of two types of individuals or firms.** On one side are **This paragraph and the three following are adapted with minor changes from the author's paper with William Brainard, "Financial Intermedi- aries and the Effectiveneas of Monetary Controls," American Economic Review LII, May 1963, pp. 384-386. borrowers, who wish to expand their holdings of real assets--inventories, residential real estate, productive plant and equipment, etc.--beyond the limits of their own net worth. On the other side are lenders, who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default. The assets of financial intermediaries are obligations of the borrowers--promissory notes, bonds, mortgages. The liabilities of financial intermediaries are the assets of the lenders--bank deposits, insurance policies, pension rights. Financial intermediaries typically assume liabilities of smaller de- fault risk and greater predictability of value than their assets. The principal kinds of institutions take on liabilities of greater liquidity too; thus bank depositors can require payment on demand, while bank loans become due only on specified dates. The reasons that the intermediation of financial institutions can accomplish these transformations between the nature of the obligation of the borrower and the ature of the asset of the ultimate lender are these: (1) administrative economy and expertise in negotiating, accounting, appraising, and collecting; (2) reduction of risk per dollar of lending by the pooling of independent risks, with respect both to loan default and to deposit withdrawal; (3) governmental guarantees of the liabilities of the institutions and other provisions (bank examination, investment regulations, supervision of insurance companies, last-resort lending) designed to assure the solvency and liquidity of the inst:itutions. For these reasons, intermediation permits borrowers who wish to ex- pand their investments in real assets to be accommodated at lower rates and easier terms than if they had to borrow directly from the lenders. If the creditors of financial intermediaries had to hold instead the kinds of obligations that private borrowers are capable of providing, they would cer- tainly insist on higher rates and stricter terms. Therefore, any autonomous increase--for example, improvements in the efficiency of financial institu- tions or the creation of new types of intermediaries--in the amount of financial intermediation in the economy can be expected to be, ceteris paribus This is true whether the growth occurs an expansionary influence. in intermediaries with monetary liabilities--i.e., commercial banks--or in other intermediaries. Financial institutions fall fairly easily into distinct categories, 'intermediary" offering each industry or a differentiated product to its customers, both lenders and borrowers. From the point of view of lenders, the obligations of the various intermediaries are more or less close, but not perfect, substitutes. For example, savings deposits share most of the attributes of demand deposits; but they are not means of payment, and the institution has the right, seldom exercised, to require notice of withdrawal. Similarly there is differentiation in the kinds of credit offered borrowers. Each intermediary has its specialty--e.g., the commercial loan for banks, the But the borrowers' real estage mortgage for the savings-and-loan association. market is not completely compartmentalized. The same credit instruments are handled by more than one intermediary, and many borrowers have flexibility Thus there is some substitutability, in the in the type of debt they incur. demand for credit by borrowers, between the assets of the various inter- mediaries.* *These features of the market structure of intermediaries, and their implications for the supposed uniqueness of banks, have been emphasized by on the deposit side is analyzed by David and Charlotte Alhadeff, "The Struggle for Commer- cial Bank Savings," Quarterly Journal of Economics, LXXII, February 1958, 1-22. An example of substitutability Gurley and Shaw, loc. cit. The special attention given commercial banks in economic analysis is usually justified by the observation that, alone among intermediaries, banks create" means of payment. This rationale is on its face far from convincing. The meansof-payment characteristic of demand deposits is indeed a feature differentiating bank liabilities from those of other intermediaries. Insurance against death is equally a feature differentiating 1ife insurance policies from the obligations of other intermediaries, including banks. It is not obvious that one kind of differentiation should be singled out for Like other different:ia, the means-of-payment special analytical treatment. attribute has its price. Savings deposits, for example, are perfect sub- stitutes for demand deposits in every respect except as a medium of exchange This advantage of checking accounts does not give banks absolute immunity from the competition of savings banks; it is a limited advantage that can be, at least in some part for many depositors, overcome by differences in yield It follows that the community's demand for bank deposits is not indefinite, even though demand deposits do serve as means of payment. III THE WIDOW'S CRUSE Neither individually nor collectively do commercial banks possess a "widows cruse. Quite apart from legal reserve requirements, commercial banks are limited in scale by the same kinds of economic processes that de- termine the aggregate size of other intermediaries. One often cited difference between commercial banks and other inter- mediaries must be quickly dismissed as superficial and irrelevant. This is the fact that a bank can make a loan by "writing up" its deposit liabilities, while a savings and loan association, for example, cannot satisfy a mortgage borrower by crediting him with a share account. The association must transfer means of payment to the borrower; its total liabilities do not rise along with its assets. True enough, but neither do the bank's for more than a fleeting moment Borrowers do not incur debt in order to hold idle deposits, any more than savings and loan shares. The borrower pays out the money, and there is of course no guarantee that any of it stays in the lending bank Whether or not it stays in the banking system as a whole is another question, about to be discussed. But the answer clearly does not depend on the way the loan was It depends initially made. on whether somewhere in the chain of transactions initiated by the borrower's outlays are found depositors who wish to hold new deposits equal in amount to the new loan. Similarly, the outcome for the savings and loan industry depends on whether in the chain of transactions initiated by the mortgage are found individuals who wish to acquire addition- al savings and loan shares. expand its assets either (a) by purchasing, The banking system can or (b by lending to finance new private lending against, existing assets; or investment in inventories or capital goods, buying government securities or (a) financing new public deficits. In case no increase in private wealth occurs in conjunction with the banks' expansion. There is no new private (b) In case saving and investment. private saving occurs, matching new dollar for dollar the private investments or government deficits financed by the banking system. In neither case will there automatically be an increase in savers demand for bank deposits equal to the expansion in bank assets. In the second case, it is true, there is an increase in private wealth. But even if we assume a closed economy in order to abstract from leakages of capital abroad, the community will not ordinarily wish to put 100 per cent of its new saving into bank deposits Bank deposits are, after all, only about 15 per cent of total private wealth in the United States; other things equal, savers cannot be expected greatly to exceed this proportion in allocating new saving So, if all new saving is to take the form of bank deposits, other things cannot stay equal Specifically, the yields and other advantages of the competing assets into which new saving would otherwise flow will have to fall enough so that savers prefer bank deposits. This is a fortiori true in case a) where there is no new saving and the generation of bank liabilities to match the assuned expansion of bank assets entails a reshuffling of existing portfolios in favor of bank deposits. In effect the banking system has to induce the public to swap loans and securities for bank deposits. This can happen only if the price is right. Clearly, then, there is at any moment a natural economic limit to the scale of the cormmercial banking industry. Given the wealth and the asset preferences of the community, the demand for bank deposits can increase only if the yields of other assets fall The fall in these yields is bound to restrict the profitable lending and investment opportunities available to the banks themselves. Eventually the marginal returns on lending and invest- ing, account taken of the risks and administrative costs involved, will not exceed the marginal cost to the banks of attracting and holding additional deposits. At this point the widow's cruse has run dry. 

 
IV BANKS AND OTHER INTERMEDIARIES COMPARED 

In this respect the cormercial banking industry is not qualitatively different from any other financial intermediary system. The same process limits the collective expansion of savings and loan associations, or savings banks, or life insurance companies. At some point the returns from addition- al loans or security holdings are not worth the cost of obtaining the funds from the public There are of course some differences. First, it may well be true that commercial banks benefit from a larger share of additions to private savings than other intermediaries. Second, according to modern American commercial banks are subject to ceilings on the rates pay- legal practice, able to their depositors--zero in the case of demand deposits. Unlike com- commercial banks cannot seek funds by raising peting financial industries, They can and do offer other inducements to depositors, but these rates substitutes for interest are imperfect and uneven in their incidence. In these circumstances the major readjustment of the interest rate structure necessary to increase the relative demand for bank deposits is a decline in other rates. Note that either of these differences has to do with the "money." quality of bank deposits as In a world without reserve requirements the preferences of depositors, as well as those of borrowers, would be very relevant in determining the The volume of assets and liabilities of every volume of bank deposits. competi intermediary, both nonbanks and banks, would be determined in a tive equilibrium, where the rate of interest charged borrowers by each kind of institution just balances at the margin the rate of interest paid its creditors. Suppose that such an equilibrium is disturbed by a shift in savers' preferences. At prevailing rates they decide to hold more savings accounts and other nonbank liabilities and less demand deposits They transfer demand deposits to the credit of nonbank financial institutions, providing these intermediaries with the means to seek additional earning assets These institutions, finding themselves able to attract more funds from the public even with some reduction in the rates they pay, offer better terms to borrowers and bid up the prices of existing earning assets. Consequently commercial banks release some earning assets--they no longer yield enough to pay the going rate on the banks' deposit liabilities. Bank deposits decline with bank assets. In effect, the nonbank inter- mediaries favored by the shift in public preferences simply swap the deposits transferred to them for a corresponding quantity of bank assets. V. FOUNTAIN PENS AND PRINTING PRESSES Evidently the fountain pens of comercial bankers are essentially different from the printing presses of governments. Confusion results from concluding that because bank deposits are like currency in one respect-- both serve as media of exchange--they are like currency in every respect. Unlike governments, bankers cannot create means of payment to finance Bank-created "money" is a their own purchases of goods and services. liability, which must be matched on the other side of the balance sheet. And banks, , as businesses, must earn money from their middlemen's role. Once created, printing press money cannot be extinguished, except by reversal of the budget policies which led to its birth.The community cannot get rid of its currency supply; the economy must adjust until it is The "hot potato" analogy truly applies. willingly absorbed. For bank- created money, however, there is an economic mechanism of extinction as If bank deрosits are well as creation, contraction as well as expansion. excessive relative to public preferences, they will tend to decline; other- wise banks will lose money. The burden of adaptation is not placed entirely on the rest of theе еconomy. 

 THE ROLE OF RESERVE REQUIREMENTS VI. 

Without reserve requirements, expansion of credit and deposits by the commercial banking system would be limited by the availability of assets at yields sufficient to compensate banks for the costs of attracting and hold- ing the corresponding deposits. In a regime of reserve requirements, the limit which they impose normally cuts the expansion short of this competi- tive equilibrium. When reserve requirements and deposit interest rate ceilings are effective, the marginal yield of bank loans and investments exceeds the marginal cost of deposits to the banking system. In these cir- cumstances additional reserves make it possible and profitable for banks to acquire additional earning assets. The expansion process lowers interest rates generally--enough to induce the public to hold additional deposits but ordinarily not enough to wipe out the banks' margin between the value and cost of additional deposits. It is the existence of this margin--not the monetary nature of bank liabilities--which makes it possible for the economics teacher to say that additional loans permitted by new reserves will generate their own deposits. The same proposition would be true of any other system of financial institu- tions subject to similar reserve constraints and similar interest rate ceilings In this sense it is more accurate to attribute the special place of banks among intermediaries to the legal restrictions to which banks alone are subjected than to attribute these restrictions to the special character of bank liabilities. But the textbook description of multiple expansion of credit and given reserve base is misleading even for a regime of reserve deposits on a There is more to the determination of the volume of bank requirements. deposits than the arithmetic of reserve supplies and reserve ratios The redundant reserves of the thirties are a dramatic reminder that economic opportunities sometimes prevail over reserve calculations. But the sig- nificance of that experience is not correctly appreciated if it is regarded as an aberration from a normal state of affairs in which banks are simply fully "loaned up" and total deposits are tightly linked to the volume of phenomenon which is The thirties exemplify in extreme form a reserves. always in some degree present: The use to which commercial banks put the reserves made available to the system is an economic variable depending on lending opportunities and interest rates. An individual bank is not constrained by any fixed quantum of reserves. It can obtain additional reserves to meet requirements by borrowing from the Federal Reserve, by buying "Federal Funds" from other banks, by selling or 1# running off" short term securities In short, reserves are available at price This cost the bank the discount window and in the money market, at a must compare with available yields on loans and investments. If those yields are low relative to the cost of reserves, the bank will seek to avoid borrow- ing reserves and perhaps hold excess reserves instead. If those yields are high relative to the cost of borrowing reserves, the bank will shun excess reserves and borrOw reserves occasionally or even regularly. For the banking C system as a whole the Federal Reserve's quantitative controls determine the supply of unborrowed reserves. But the extent to which this supply is left unused, or supplemented by borrowing at the discount window, depends on the economic circumstances confronting the banks -on available lending opportuni- ties and on the whole structure of interest rates from the Fed's discount rate through the rates on mortgages and long term securities. The range of variation in net free reserves in recent years has been from -5 per cent to +5 per cent of required reserves. This indicates a much looser linkage between reserves and deposits than is suggested by the text- book exposition of multiple expansion for a system which is always precisely and fully "loaned up. (It does not mean, however, that actual monetary authorities have any less control than textbook monetary authorities. Indeed the net free reserve position is one of their more useful instruments and barometers Anyway they are after bigger game than the quantity of o "money" Two consequences of this analysis deserve special notice because of their relation to the issues raised earlier in this paper. First, an in- crease--of, say, a billion dollars--in the supply of unborrowed reserves will, in general, result in less than a billion dollar increase in required Net free reserves will rise (algebraically) by some fraction of reserves the billion dollars-a very large fraction in periods like the thirties, much smaller one in tight money periods like those of the fifties. Loans and deposits will expand by less than their textbook multiples. The reason is simple. The open market operations which bring about the increased supply of reserves tend to lower interest rates. So do the орerations of the commer- cial banks in trying to invest their new reserves. The result is to diminish the incentives of banks to keep fully loaned up or to borrow re- serves, and to make banks content to hold on the average higher excess reserves. Second, depositor preferences do matter, even in a regime of frac- tional reserve banking. Suppose, for example, that the public decides to switch new or old savings from other assets and institutions into commercial banks This switch makes earning assets available to banks at attractive yields--assets that otherwise would have been lodged either directly with the public or with the competing financial institutions previously favored with the public's savings. These improved opportunities for profitable lend- ing and investing will make the banks content to hold smaller net free re- Both their deposits and their assets will rise as a result of this serves. shift in public preferences, even though the base of unborrowed reserves re- mains unchanged. Something of this kind has occurred in recent years when commercial banks have been permitted to raise the interest rates they offer for time and savings deposits. IIA CONCLUDING REMARKS The implications of the "new view" may be summarized as follows The distinction between commercial banks and other financial inter- mediaries has been too sharply drawn. The differences are of degree, not of kind In particular, the differences which do exist have little intrinsically 2. to do with the monetary nature of bank liabilities. The differences are more importantly related to the special reserve re- quirements and interest rate ceilings to which banks are subject. Any other financial industry subject to the same kind of regulations would behave in much the same way» 4. Commercial banks do not possess, either individually or collectively, a widow's cruse which guarantees that any expansion of assets will generate a corresponding expansion off deposit liabilities. Certainly this happy state of affairs would not exist in an unregulated competitive financial world. Marshall's scissors of supply and demand apply to the "output" of the bank- ing industry, no less than to other financial and nonfinancial industries. Reserve requirements and interest ceilings give the widow's cruse myth 5. somewhat greater plausibility. But even in these circumstances, the scale of bank deposits and assets is affected by depositor preferences and by the lending and investing opportunities available to banks. I draw no policy morals from these observations. That is quite another story, to which analysis of the type presented here is only the preface The reader will misunderstand my purpose if he jumps to attribute to me the conclusion that existing differences in the regulatory trestment of banks and competing intermediaries should be diminished, either by relaxing constraints on the one or by tightening controls on the other.