The Crowding-out Effects of Bank Money Creation Oz Shy ∗ Hanken
Rune Stenbacka∗ School of Economics
Tufts University Seminar September 12, 2017 The views expressed in this presentation are those of the presenters and do not necessarily represent the views of the affiliated institutions.
:
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Motivation and goals of this research Commercial banks create money. The amount of money created is captured by the so called “money multiplier.” We investigate the following question: Are there any “side effects” associated with letting banks create money? We identify some welfare-reducing effects of bank money creation: Bank money creation crowds-out some real investment. Bank money creation increases banks’ profit and value (inflating the value of the financial sector) thereby diverting youngs’ savings from real investments to the acquisition of more expensive bank ownership (equity). Opens up an old policy question: Should money continue to be created by commercial banks or only by governments/central banks? Introduction: Research goals
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How commercial banks create money The standard “textbook” explanation tells us that “deposits create loans” (deposits =⇒ loans).
Suppose banks maintain r = 10% reserve ratio. One day, a person deposits $100 in Bank A. Bank A lends 0.9 × $100 = $90 to another person who deposits it in Bank B. Bank B lends 0.9 × $90 = $81 to a third person who deposits it in Bank C . Total money in the economy: 100 $100(1 + 0.9 + 0.92 + 0.93 + . . .) = 1−0.9 = $1, 000 =⇒ µ = 1r = 10 . Introduction: Bank money creation (1 of 2)
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How commercial banks create money (con’d) Textbooks may need to reverse causality A 2014 Bank of England paper raises the following question: “Where did the initial $100 come from?” Answer: Withdrawal from that person’s employer bank account! Conclusion: No new money was created! (w/o open market operation) Back to our question: How do banks create money? Answer: By the stroke of a banker’s pen when the bank approves a loan! Often called “fountain pen money,” or “alchemy” (Mervyn King’s book.) Conclusion: “Loans create deposits” (loans =⇒ deposits ) [and NOT (deposits =⇒ loans), as implied by textbooks]. Introduction: Bank money creation (2 of 2)
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Crowding-out of real investment in OLG models “...we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. James Tobin (1984) period t
ωt (youngs’ endowment) )
Real investment
q
Ownership (equity) period t + 1
?
?
Real investment return
Profit plus sales of ownership (equity)
ct+1 (old-age consumption) 9 Note: Equity trade constitutes a change of ownership and not new capital that can be invested. z
Introduction: Crowding-out in OLG
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Crowding-out of real investment: Literature Laitner (RAND, 1982) shows how imperfect competition affects aggregate output and capital accumulation. Chou & Shy (J Macro, 1991) and Jones & Manueli (JET, 1992) implications for optimal growth. Chou & Shy (RAND, 1993) demonstrate the crowding-out effects of long duration of patents. Empirical papers documenting crowding-out effects by large financial sectors include Philippon (2010), Cecchetti & Kharroubi (BIS 2012, 2015), Arcand, Berkes, Panizza (JEG, 2015), Epstein & Montecino (Roosevelt Inst. 2016). The following graph is from Barajas et al. (IMF, 2015):
Introduction: Crowding-out literature
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Our approach and results The paper constructs an OLG model. The model abstracts from the question (just discussed) how banks create money and assumes a given “textbook” money multiplier, µ. The young allocate their endowment ωt among consumption, deposits (banks’ investment lending) and buying bank equity (ownership). We identify some welfare-reducing effects of bank money creation: Bank money creation crowds-out some real investment. Bank money creation increases banks’ profit and value thereby diverting youngs’ savings from real investments to the acquisition of more expensive bank ownership (equity). Crowding-out increases with the money multiplier µ. Another finding: Intensified deposit market competition mitigates the crowding-out effect. Introduction: Our approach
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Consumers In each period t = 0, 1, 2, . . . there is a representative young (generation t) and a representative old (generation t − 1). Initial old at t = 0 (generation t = −1) initially own the bank (valued q0 ). Young of generation t are endowed with ωt = ω(1 + γ)t . The young at t decides how to allocate the endowment so that cty + dt + qt = ωt . | {z } savings
cty = consumption when young, dt = amount deposited with bank accounts, qt = purchase of bank ownership (equity). o Consumption when old is: ct+1 = dt (1 + r ) + πt+1 + qt+1 . {z } | {z } | as a depositor
as bank owner
dt (1 + r ) = bank deposit plus interest. πt+1 = period t + 1 bank profit. qt+1 = proceeds from selling bank ownership (equity) to the young. The representative young maximizes o o ), U t = U cty , ct+1 = ln(cty ) + δ ln(ct+1 0 < δ < 1, anticipating (rational expect.) the equilibrium values of πt+1 and qt+1 . The model: Consumers
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Banks and money creation The representative bank lends the period t deposits dt to investment projects that return dt (1 + ρ) in t + 1 (where ρ > 0). Assume ρ is a“safe” return (or FDIC/government bailout).1 µ = money multiplier (µ > 1, inverse of the reserve requirement). ⇒ banks can fund (µ − 1)dt investment projects. Period t + 1 bank profit πt+1 =
(µ − 1)dt ρ − | {z }
investment returns
dt r |{z}
.
interest payments
The deposit rate r is exogenous, but serves as an indication of the degree of bank competition: r = 0 ⇒ monopoly (cartel) banking industry (banks don’t pay interest). r = (µ − 1)ρ ⇒ perfectly-competitive banking industry (normal profit). 0 < r < (µ − 1)ρ ⇒ imperfectly-competitive banking sector. 1
Shy & Stenbacka (SSRN, 2017) analyze bank failures and bailout taxes in an OLG environment (with implications for crowding out effects). The model: Banks
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The (equity) value of banks The old in period τ sell the bank to the young in τ for a price qτ .
qτ = qτ = the present value of discounted sum of bank profits starting from period τ + 1. qτ =
∞ X
δ t−τ πt = δ (πτ +1 + qτ +1 )
t=τ +1
which is also next-period’s (bank profit + sale value of the bank).
The model: Bank equity value
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Equilibrium derivation The representative young in period t chooses the bank deposit amount to solve: max U t = ln (ωt − dt − qt ) +δ ln (dt (1 + r ) + πt+1 + qt+1 ), {z } {z } | | dt cty
o ct+1
yielding δω(1 + r )(1 + γ)t [1 − δ(1 + γ)] , λ1 δω(1 + r )(1 + γ)t [(µ − 1)ρ − r ] [1 − δ(1 + γ)] πt+1 = , λ1 δ 2 ω(1 + r ) [(µ − 1)ρ − r ] (1 + γ)t+1 = qt (1 + γ), qt+1 = λ1 λ1 = 1 − ρ + µρ + δ 2 (µρ − ρ − 1) − γδ(1 + δ) dt =
where
− r δ[γ(1 + δ) − δ(µρ − ρ − 2)] − r 2 δ 2 . Equilibrium: Derivation
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Equilibrium: Discussion of rates of return The period t representative young allocates the resource endowment ωt to cty (consumption), dt (bank deposits), and qt (buy bank ownership). Question: Why would the young buy bank equity? Answer: If the return on bank equity is sufficiently high. The equilibrium rate of return on bank equity turns out to be: roe =
1−δ (πt+1 + qt+1 ) − qt = . qt δ
Therefore, we assume that the interest paid on deposit (deposit rate) satisfies r ≤ 1−δ δ as otherwise, the young will not buy bank ownership. Intuitively: The young first buy bank ownership qt , and then allocate the remaining endowment between deposits dt and consumption cty . Equilibrium: Technical note
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Equilibrium: Results
Deposits dt and bank equity qt
Deposits (hence, bank investments) decrease with: 1 An increase in the return on bank investments (funded by deposits): ρ ↑⇒ πt+1 ↑⇒ qt ↑⇒ dt ↓ 2 An increase in the money multiplier: µ ↑⇒ πt+1 ↑⇒ qt ↑⇒ dt ↓
dt qt
µ 1
6
Intuition: Higher profit and equity value divert funds (youngs’ savings) away from deposits (investments) into higher-price equity. Equilibrium: Results (1 of 2)
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Equilibrium: Additional results
Equilibrium values: dt and qt
Deposits (hence, bank investments) increase with an increase in the deposit rate r : r ↑⇒ πt+1 ↓⇒ qt ↓⇒ dt ↑
dt qt
r 0
1−δ δ
Intuition: Lower profit and equity value divert funds (youngs’ savings) away from bank equity, thereby leaving more funds available for deposits (bank investments). Equilibrium: Results (2 of 2)
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Bank money creation and investment crowding out Period t deposits dt (bank investments) grow to (µ − 1)dt (1 + ρ) in period t + 1. However, we showed that µ ↑⇒ dt ↓ (investment crowding out). We define a (period t) measure of investment crowding-out by: qt def kt = . dt + qt By definition, 0 ≤ kt ≤ 1. kt is the ratio of equity-based financial investments to total savings [deposits (real investments) plus equity-based financial investments]. If kt > 0 we say that acquisition of bank ownership crowds out deposits and hence real investment.
Crowding out: Defining a measure
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Equilibrium investment crowding out Substituting the equilibrium deposit levels dt and equity values qt yields
Crowding-out measure: k
kt = k =
δ[(µ − 1)ρ − r ] . 1 − δ(r + γ − µρ + ρ + 1)
k (γ = 0.00) k (γ = 0.05)
µ 1
6
Main result: The money multiplier associated with bank money creation amplifies real investment crowding out. Formally, µ ↑⇒ k ↑. (Further intensified with higher endowment growth rates, γ ↑⇒ k ↑). Crowding out: Results
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Market structure and investment crowding-out The deposit rate r is an indicator of the degree of bank competition: r = 0 ⇒ monopoly (cartel) banking industry (banks don’t pay interest). r = (µ − 1)ρ ⇒ perfectly-competitive banking industry (normal profit). 0 < r < (µ − 1)ρ ⇒ imperfectly-competitive banking sector. Question: Is there a relationship between investment crowding-out and the degree of competition in the banking sector?
Crowding-out measure: k
Results: Investment crowding out (measured by k) k (γ = 0.00) k (γ = 0.05)
r 0 Market structure: Effect on crowding-out
1−δ δ
1
declines with more intense competition (r ↑⇒ k ↓)
2
increases with endowment growth rate (γ ↑⇒ k ↑)
3
increases with the return on bank investments (ρ ↑⇒ k ↑). 17/21
Money creation and consumption
ωt [r δ(1 + γ) + γδ + δ − µρ + ρ − 1] λ2
Deposit dt , equity qt , consumption
cty =
o and ct+1 = δ(1 + r )cty
Results: Equilibrium consumption of young and old: dt qt cty o ct+1
µ 1
Consumption: Results
6
1
both increase with the money multiplier o (µ ↑⇒ cty ↑ & ct+1 ↑)
2
but at a very slow rate (see top 2 curves).
3
o cty > ct+1 because r <
1−δ δ .
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Money creation and welfare Searching for Pareto-improving allocations in an OLG environment must take into account the welfare of the initial old at t = 0 (generation t = −1) as they should not be made worse off! Therefore, we evaluate the lifetime utility of generation t = 0 by reducing consumption when young by , investing it, and consuming (1 + ρ) when old: U 0 = ln(c0y − ) + δ ln (c1o + (1 + ρ)) . c y δ(1 + ρ) − c1o − (1 + δ)(1 + ρ) c0y δ(1 + ρ) − c1o ∂U 0 = 0 −→ . →0 ∂ (c0y − )[c1o + (1 + ρ)] c0y c1o Results: c0y δ(1 + ρ) − c1o > 0 is a sufficient condition for Pareto-improving allocations to exist. ∂ [c0y δ(1+ρ)−c1o ] Furthermore, if ρ > r then > 0, hence the potential for ∂µ Pareto improvement increases with the money multiplier µ. Welfare: Searching for Pareto-improving allocations
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Other distortions Several papers from Simons (JPE, 1936) to Krainer (JFS, 2017) analyze inefficiencies associated with bank money creation because it amplifies the business cycle: (a) banks create “cheap” money during booms, (b) contract very fast during recessions. Another distortion (not analyzed here) associated with bank money creation, is governments’ loss of seigniorage defined as the difference between the face value of money and the associated production costs.
Source: Estimations by Macfarlane et al. (2017). Discussion: Other distortions
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Concluding remarks 1
This research identifies a distortion generated by bank money creation.
2
Letting banks create money inflates bank profit and bank equity value.
3
Trade in inflated bank equity diverts resources from real investments to financial investments.
4
The magnitude of this crowding-out effects is intensified with the money multiplier,
5
but is mitigated with more intense competition among banks.
6
The model underestimates the magnitude of this distortion because it assumes that banks do not allocate depositors’ money to less-productive activities such as: credit-default swaps and other derivatives.
7
Our approach introduces a new dimension to the old debate on bank money creation versus government money creation.
Conclusion: Summary
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