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Why Are Banks Special?

The concept of endogenous money and banking is back in the spotlight these days with more and more prominent “mainstream” economists coming around to the idea that banks are special and that private debt levels are an important element in understanding the business cycle.

In just the last few days David Andolfatto and several Harvard economists have published new work that considers the importance of banks and private debt. This is not surprising to any regular reader of my research as private debt strikes me as an essential element to understanding how the modern monetary system works. But this is somewhat new for more mainstream economists who have often constructed models that dismissed banks and private debt as an intermediary element of the economy. That has started to change following the financial crisis and the obvious negative impact that private debt levels had on the economy.

David’s paper is particularly interesting to me as it’s well balanced and tries to reconcile the difference between the more heterodox view (in which banks have always been an essential element) and the more orthodox view (in which banks are largely dismissed as one of many types of lenders in a loanable funds market).

Without getting too deep in the weeds here I want to try to answer what I believe is David’s most essential question – what makes banks special? As a market practitioner and someone who is more concerned with operational facts and not politics I think I come at this debate with a somewhat objective approach so let me see if I can explain why banks are special in the context of the modern financial system.

I take a slightly different approach than some heterodox economists and most mainstream economists. I think banks are essential to understand if you want to understand how the economy functions and how booms and busts develop. Banks are the piping and manage the water in our economic system so if you want to understand how our economic “house” functions then it is imperative that you understand the banking system.

While I find the orthodox view largely wrong (the idea that banks are mere intermediaries) I also find that some heterodox economists go too far with this idea that banks are “special”. Most heterodox economists (like Post-Keynesians and MMTers) will argue that banks are not just special, but that they are special because the government makes them special. This argument is not convincing for me.

I basically think of banks as regular old corporations that manage a relatively simple technology – a payment system. They manage a network of systems than help people pay for things. And the liabilities they issue are essential to allowing that system to operate. Banks are “special” because they manage the payment system through which most economic payments are made. They are the functional equivalent of the water company connecting the transfer of water to and from all of our homes.

Or perhaps a better analogy is the cars on our roads. Banks not only create the cars that drive on the road (deposits), but also manage the roads on which those cars drive (the payment system). This system is important because it is how we all get money from point A to point B. When this system shuts down (as it virtually did in 2008 or in 1907 and many times before) then it threatens the well-being of all of us as it makes it impossible for us to perform basic economic functions.

So, banks are clearly special because of their importance to the way our economy transfers payments for goods and services. But where does this specialness come from? Some economists would argue that it comes from the government in the form of the Central Bank which issues reserves and allows banks to lend out those reserves in a multiplied fashion. This theory must be wrong because banks don’t need reserves before they make loans. The money multiplier theory is wrong. Other economists (like MMTers or some Post-Keynesians) would argue that banks are special mainly because their deposits are insured by the government and will always be redeemed at par value. This is a more convincing theory than the money multiplier theory, but also a view that holds the tail of the elephant when it is believed to be the trunk.

The car analogy is useful in this sense. Banks are special because they are essential to our mode of payment transfer. We use banks because they are very efficient at what they do. Yes, they aren’t always the most altruistic entities in our economy so I guess we could say they run a payment system that is the worst payment system except for all the rest. The specialness of this system is not derived from the rules of the road or the way the government helps it function. The specialness is derived from the competitive nature that makes it an efficient technological payment system.

If we think of banks through history we can basically show that they took a simple cash based payment system run mostly by the government and said “we can make this better”. That system has evolved over time into a system of loans, checks and now electronic payments. And as this system evolved and consumers found it increasingly valuable a network effect took hold in which consumers adopted the use of banks because it was a simple way to process payments for goods and services.¹ In other words, we open bank accounts when we become adults for much the same reason that we get a drivers license – just like you need a drivers license to get from point A to point B via a car you need a bank account to move money from point A to point B when you want to buy goods and services. Everyone just does it because it is the dominant network effect to achieve basic economic functions.

But we should not mistake the tail for the trunk here – although the government certainly helps reinforce the specialness of banks via regulations and central clearing of payments it would be a mistake to say that banks are special mainly because of the government. This would be like saying that cars are special because the government allows them to be sold onto our roads. No, cars are special because of the competitive private nature in which they are constructed as efficient modes of transportation. Similarly, banks are special because of the technology they manage that has resulted in a highly efficient and low cost payment system.

So, to summarize – banks are special because:

  1. They run the dominant system for economic payments.
  2. They run this system in an efficient manner because they must compete for the users of that system.
  3. A reinforcing network effect has taken hold in the banking system that makes this system essential to our economic system.
  4. The government has helped reinforce this network effect by facilitating banks in the course of regulations and central clearing.

¹ – This network effect is especially interesting in the context of the banking system and its relationship with the government. One can argue that the modern banking system is the greatest form of regulatory capture that has ever existed in a capitalist system. In other words, the network effect in banking is so powerful that banks have implanted themselves as essential entities in our economy. So essential that they essentially control the way they are regulated. In other words, they hold the government over a barrel and have slowly reinforced their own network effect by making the government beholden to private banks in many ways.