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Monetary Policy has Everything to do With Banking

Here’s Scott Sumner saying that banking doesn’t matter to monetary policy:

“What in the world does banking have to do with monetary policy?  Yes, it may or may not boost bank lending, but it doesn’t matter, as monetary policy is about the hot potato effect.  And yes, the Fed should not be trying to boost lending, any more than it should try to boost sales of microwave ovens.  NGDP is what matters.”

This is the sort of commentary from economists that drives market practitioners like myself mad. “Monetary policy” is implemented via a centralized bank. Yes, a “central bank” is really nothing more than a normal bank with some special powers resulting from its legal structure within the financial system. If you don’t understand banking then you’re going to have a hard time understanding how central banking works because the balance sheet expansion of both types of entities is very similar. Monetary policy is very nearly synonymous with banking. Saying that monetary policy has nothing to do with banking is, to be nice, totally absurd.

I’ve long argued that the problem with traditional monetary policy is that it does not have a powerful transmission mechanism through which it can impact the economy.  This makes sense if we take an operational perspective of what a Central Bank is. In essence, a Central Bank is a fringe player in an extremely complex financial system. The Fed, for instance, was founded as a clearinghouse for interbank payments to help stabilize the private banking system. In other words, Central Banks are entities designed to facilitate the daily operations of the banking and payment systems.  These are crucial components of the monetary system, but they are by no means the components that drive the economic ship. They are more like the circulatory system to our nervous system. As a result of this peripheral institutional existence in the financial system the Central Bank doesn’t have a direct transmission mechanism through which it can influence the economy.

Monetarists like Scott Sumner would disagree with this view, saying that monetary policy has nothing to do with “transmission mechanisms” and everything to do with the “hot potato effect” (HPE). Okay, but THAT is the transmission mechanism then. In my view, that transmission mechanism isn’t nearly as powerful as people like Sumner claim. If you’re looking for a description of the HPE here’s a good one via Sumner.  The problem is, if you don’t understand banking then you don’t understand why the HPE isn’t nearly as powerful as you might think.  Let’s be specific regarding Sumner’s thoughts though….Here’s Sumner explaining the HPE:

Assume gold sells for $1200.  Interest rates are low, so the expected future price is roughly the same, maybe a bit higher.  Now assume a company discovers a gold hoard so vast that world output soars.  Over a period of years the extra output causes gold prices to fall in half.  But why?  Because before the discovery people were already in equilibrium, they held as much gold as they wanted to hold at existing prices.  The extra gold is a sort of “hot potato” that people try to get rid of.  But obviously not by throwing it away!  They get rid of it by selling it.  But notice that while that works at the individual level, it doesn’t work in aggregate.  Now someone else has the extra gold. (That’s why attempts to understand money at the level of the representative consumer fail.)  The only way for society as a whole to get rid of the extra gold is by driving down the price of gold until people want to hold the new and larger quantity.  Assume the price falls in half.  That also means the value of gold relative to other goods and services falls in half.

He later says that you can replace cash with gold and it’s the exact same thing. There’s multiple problems there though. First, gold is a non-financial asset. It is pure net worth for the private sector. If the Central Bank could create gold from nothing then it could literally expand the net worth of the private sector at will. When the Central Bank expands its balance sheet via operations like QE it doesn’t expand the net worth of the private sector. It injects an expansion of base money into the private sector in exchange for a reduction in the quantity of T-bonds being held by the private sector. This has no impact on the quantity of net financial assets held by the private sector. So no, this absolutely IS NOT the same thing as a discovery in gold because a discovery of gold directly increases the net worth of the private sector.*

Sumner’s thinking isn’t just wrong from the perspective of banking. It is wrong from the most basic perspective of financial accounting.  Of course, this doesn’t mean that portfolio rebalancing effects and Monetarist Policy have no impact on the private sector. But the Central Bank is not some omnipotent alchemist as Monetarists often project.

Monetarists are stuck in a world of the theoretical. They often times reject accounting, banking and all the important operational understandings that help us comprehend the efficacy of certain policies. Of course, this doesn’t mean that monetary policy is ineffective. I believe that it can be quite effective. Monetarists have a naive faith in monetary policy’s potency and that naivete stems from an ideological rejection of the operational realities of the monetary system.

Some related work:

* If the HPE were that effective then multi trillion dollar policies like QE would have had massive impacts on the economy, but they didn’t. And no, the ineffectiveness of QE isn’t solely due to money hoarding and low expectations. These ideas are based on erroneous understandings that I have explained in the “expectations transmission mechanism paradox” and the myth of the money multiplier.