Why Banks are “Special”: The Short Story
No, not that kind of “special.” Though it sure is tempting…
Paul Krugman, Scott Sumner (seemingly unlikely bedfellows, but…), and most other mainstream economists want to argue that banks are not special — that there’s no reason for economists to understand and analyze their operations in detail, or incorporate those understandings in their (mental and formal) economic models.
Their essential position is that borrowers’ and lenders’ incentives and reaction functions are symmetrical, interacting opposites. (This is the very essence of the Krugman/Eggertsson 2010 patient/impatient-agents paper.)
1. Banks are transparent intermediaries between real-sector lenders (“savers”) and borrowers.
2. The machinery of market portfolio allocation (i.e. as described by Tobin) allows us to model the economy as if #1 were true. cf. Krugman/Eggertsson.
So, in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can ignore the banks.
Steve, Cullen Roche, Scott Fullwiler, and many others suggest otherwise (and at length) — that banks are special and that it is necessary to model that specialness.
I’d like to explain, in brief, why they are special:
Banks aren’t optimizing intertemporal consumption preferences. Unlike real-sector actors, when banks lend they’re not “saving.” The incentives and reaction functions of the economy’s dominant lenders are completely orthogonal to those of the economy’s borrowers.
Now you could argue (back to #2, above) that the inexorable forces of the financial markets force banks (at least in aggregate) to act as if they were optimizing intertemporal consumption preferences (for their borrowers? their shareholders? their lending officers? their directors? their creditors? their depositors?). But I think many will agree that that argument is quite a stretch.
If economics, as I have suggested, is ultimately the study of human (individual and group) reaction functions, it seems irresponsible and misguided to ignore the incentives and reaction functions of some of the most powerful and influential actors in the economy, simply brushing them under the rug.
Mainstream theory tells us we don’t need to understand how banks work. To understand why that theory is wrong, you need understand how banks work.
Cross-posted at Asymptosis.
You use a generic term, “banks”. Is that because Glass-Steagal is no more?
Does this mean that when I – not a bank, though I have met people who are banks – lend money, I am saving? I always considered it spending, buying an asset with a future value stream, ideally included the return of my principal. I always figured saving was lending money to the government since both money and treasury debt seem to be signed by the same people.
Steve: what distinguishes “banks” from other financial intermediaries is that (some of) their liabilities are used as media of exchange.
In other words: if banks are special, it must be because the MOE is a special good.
Money has two essential (i.e defining) functions: Medium of Exchange and Medium/Unit of Account. (forget store of value, because almost every durable good can do that.)
If you want to argue that banks are ‘special”, you need to believe that it is the MOE function of money that is macroeconomically important.
I believe the MOE function of money is macroeconomically important. Do you?
Steve: just for you!: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/08/banks-and-the-medium-of-exchange-are-both-special-or-neither-special.html