Scott Sumner ignores banks, so what?

Beranda › David Glasner › medium of account › Scott Sumner › unit of account

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."

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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.