George Selgin’s new Cato working paper demolishes the now fashionable view that banks are not intermediaries between savers and borrowers. (It’s a sad comment on our profession that the paper needs to be written.) Toward the end of the essay Selgin makes the following observation (on page 41):
Yet there’s a fundamental sense in which banks are strictly intermediaries. It is the sense one gains by thinking in terms of real, long run or general equilibrium magnitudes. That is, by thinking of banking in the same way economists think of other industries.
That changes in the nominal quantity money are at least roughly “neutral” in the long run is perhaps the most fundamental tenet of neoclassical monetary economics. It doesn’t mean that monetary expansion never has important real short-run
consequences: most obviously, it can lower unemployment when the cause of that unemployment is a lack of aggregate demand. But it doesn’t generally alter the relative size of particular industries, or of firms within them. Instead of depending on the
nominal quantity of money, firms and industry’s success or failure depends on the real demand for their products.
My critics often tell me that I don’t understand banking, and that’s why I believe in a supposedly fictitious “money multiplier”. In fact, I don’t need to understand anything about banking to determine the money multiplier. That’s because the long run money multiplier in banking is exactly the same as the long run money multiplier in any other industry.
This claim may sound a bit over the top, so let me clarify that money multipliers defined in the conventional way do differ from one industry to another. The usual definition is the change in the broad money supply divided by the change in the monetary base. But that’s not a very convenient definition. It makes more sense to define the multiplier as the percentage change in a broad money aggregate divided by the percentage change in the monetary base. By that definition, the long run money multiplier is precisely one. And that follows from the long run neutrality of money:
The long run effect of an exogenous increase in the monetary base is a proportionate increase in all nominal aggregates.
Suppose I’m told that there’s a planet circling Alpha Centauri. And this planet contains a civilization. And the civilization contains an industry entitled @#$%&. We have no information as to what product @#$%& produces. We don’t even know whether it produces a good or a service. My claim is that I can predict the money multiplier for industry @#$%&. In the long run, an exogenous 47% increase in the (fiat) monetary base on this faraway planet will produce a 47% increase in the nominal size of industry @#$%&.
So the problem is not that I don’t understand banking, it’s that my critics don’t understand the long run neutrality of money. An exogenous increase in the monetary base has no long run impact on the real demand for base money. My critics confuse nominal and real variables, assuming that a purely nominal effect is somehow “real”. Nominal shocks can have real effects in the short run, but those effects are due to sticky wages and prices. These short run effects reveal nothing at all about the fundamental role of banking in the economy. Banks are intermediaries between savers (lenders) and borrowers.
PS. Does it matter if this faraway planet has the floor system, where it pays interest on bank reserves (IOR)? It matters for some questions, but it doesn’t matter for the long run money multiplier in response to an exogenous increase in the monetary base. Peter Ireland showed that the best way to think about IOR is as a one-time shift in the demand for reserves. Even with IOR, long run money neutrality continues to hold true.
PPS. By “long run”, I mean in the period after all sticky wages and prices have fully adjusted to the monetary shock.
PPPS. Here’s the M2 multiplier, showing the effect of IOR (in late 2008) and other factors such as changes in nominal interest rates and forward guidance:
