Scott Sumner says we should keep banks out of macro. I Think that’s a very strange comment coming from a monetarist or even any economist. Whether he knows it or not, monetary policy works primarily through the banking system via the Fed’s ability to influence interest rates. When the economy is too hot the Fed increases the cost of overnight borrowing thereby reducing the spread at which banks make money in an attempt to tighten the supply of loans. Of course, there’s no such thing as easing the supply of loans because the idea of a “supply of loans” is a confused concept since banks are only capital constrained in their ability to make new loans. So, it’s not like they have a big supply of loans on shelves that are waiting to fly off them. Healthy banks make loans when creditworthy customers walk in their doors.
Anyhow, getting back on track – the Fed has some control over money. After all, it has monopoly power over the overnight rate. But this is merely one piece of the money supply puzzle. The real control of the money supply rests with borrowers demanding loans and the rate at which banks set those loans (of which the overnight rate is an important influence). But the Fed is not the omnipotent entity that most presume. And this cuts right to the core of the problem with Sumner’s statement – modern macroeconomists don’t really know what money is. Nor do they seem to care. If more macroeconomists understood that money is credit they’d care more about banking.
To me, banks are like the circulatory system in the human body. They’re the primary means through which money (most of which is issued by banks in a modern monetary system) is issued and circulated. When the banks aren’t working or consumers aren’t borrowing the system seizes up. If the human body doesn’t have a consistent flow the body dies. The major organs can’t operate otherwise. An economy is no different. Banks are not just a crucial piece of the entire monetary puzzle. They are, arguably, the most important piece. To claim that they should be kept out of macro is patently absurd.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.