Myth Busting

On Leaving Banks out of Macro & the Myth of the Fed’s Archimedean Lever

I focus quite a bit on banks in my work.  My entire view of the economy and monetary system starts by understanding what is.  By understanding the institutions and entities that operate within the system and how they act in various ways to influence outcomes.  It’s kind of like understanding how the human body works.  If you want to understand what causes growth and even disease then it helps to start by understanding the system at the operational level.

Now, some economists don’t view this the same way.  For instance, Scott Sumner of Market Monetarist fame (who, I am pretty sure hates me after I asked a few questions on his site over the weekend), says we should “leave banks out of macro”.  To me, that’s like trying to understand the human body by leaving out the circulatory system.  I guess you don’t need to understand it, but it sure would help!

Anyhow, JP Koning, who is always very fair, thoughtful and insightful (you should read his blog, btw), says that Sumner’s not wrong to leave banks out of macro because his world view doesn’t require banks.  JP says:

“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 the 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.”

(Well, I wouldn’t totally align myself with Minsky, but I certainly do have PKE influences and believe that Minsky’s Financial Instability Hypothesis is incredibly insightful.)

He goes on to say:

“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.”

This is really the crux of the issue though.  The Central Bank in the USA does not have an Archimedean lever.  Or if it does, it certainly doesn’t use it regularly.  The assets the Fed can buy are actually fairly limited (basically government guaranteed assets).  The Fed is not a true money printer in the sense that some might think.  It’s mostly a big asset swapper.  So, when it implements QE it swaps existing private sector held assets with deposits (via non-bank QE + reserves for the bank who plays middleman) or a clean reserve for asset swap (via QE with bank).  There’s no direct change in private sector net worth after this policy is implemented (aside from side effects like the “wealth effect” if such a thing exists).

Now, if the Fed could go out and buy bags of dirt for $10 from anyone who wants them then that would be an Archimedean lever.  They could literally fire dollar bills as base money out the front door of the Fed in exchange for bags of dirt.  Of course, they can’t do that.  They have to work through influencing the inside money system (the banking system where money is created inside the private sector as opposed to money like cash which is created outside the private sector) in some way.  And no, the Fed can’t force depositors to withdraw cash.  That’s simply not how the current Fed system works (cash is ordered from reserve banks and printed up by the US Treasury when demand from depositors increases).

Now, one could argue that the Fed could exert unusual powers using the exigent circumstances clause in the Fed Act, but then we’re entering the realm of making “exigent” = “permanent”.  That doesn’t make much sense and it wouldn’t fly in Congress.  So I don’t see how it makes sense to remove banks.  We have a monetary system that is designed entirely around inside money.  The Fed only exists because it serves the needs of the inside money system.  In my opinion, those who want to remove banks from the system are getting it all backwards.  They think the Fed steers the monetary machine when the reality is that the inside money system steers the monetary machine and the Fed just acts as a facilitating entity.  The Fed is basically a big bank with unusual powers that supports a private competitive money system run by private banks.

Perhaps more importantly though, the Archimedean Lever is really a fiscal lever.  If the Fed could actually print cash and push it out the doors in exchange for bags of dirt then it would essentially be executing a form of fiscal policy by directly changing the financial net worth of the private sector (buying bags of dirt in exchange for cash would directly change private sector net worth by adding a net financial asset).  But the laws create a rather fine line here.  And as the laws currently define and as policy is currently executed, the Fed is left to policy that basically comes down to influencing prices by swapping assets and making loans.  I guess some might call that an Archimedean Lever, but it’s not the power of the purse.  That power rests with the US Congress and by extension, the US Treasury.  Eliminate the banking system from your model and you eliminate the need for the Fed (which exists to support the inside money system).  And that leaves you with an entity that executes the power of the purse (without a banking system the Fed and Treasury basically become the same entity serving the same master – the US Congress).  As it currently exists, the Fed does not execute such powers and must rely on its influence over the inside money system primarily.  In other words, if the Fed has an Archimedean Lever, it’s an inferior one to the one the US Congress and by extension, the US Treasury wields.

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