by From Lars Syll This year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel honours Ben Bernanke, Douglas Diamond and Philip Dybvig. In the view of the Royal Swedish Academy of Sciences, the laureates ‘have significantly improved our understanding of the role of banks in the economy’. But what is the role of banks in the economy? The academy describes it this way: ‘To understand why a banking crisis can have such enormous consequences for society, we need to know what banks actually do: they receive money from people making deposits and channel it to borrowers.’ According to this view, banks are thus pure intermediaries or dealers of savings between saving households and investing companies. It is a view widespread in economics today but there has long been a
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from Lars Syll
This year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel honours Ben Bernanke, Douglas Diamond and Philip Dybvig. In the view of the Royal Swedish Academy of Sciences, the laureates ‘have significantly improved our understanding of the role of banks in the economy’.
But what is the role of banks in the economy? The academy describes it this way: ‘To understand why a banking crisis can have such enormous consequences for society, we need to know what banks actually do: they receive money from people making deposits and channel it to borrowers.’ According to this view, banks are thus pure intermediaries or dealers of savings between saving households and investing companies. It is a view widespread in economics today but there has long been a completely different theory of the function of banks.
This was formulated, among others, by Joseph Schumpeter. In his Theory of Economic Development Schumpeter wrote: ‘The banker, therefore, is not so much primarily a middleman in the commodity “purchasing power” as a producer of this commodity.’
In this vein, in 2014 the Bank of England affirmed: ‘Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them.’ Three years later, the Deutsche Bundesbank similarly spoke of the ‘popular misconception that banks act simply as intermediaries at the time of lending—ie that banks can only grant loans using funds placed with them previously as deposits by other customers’ …
It is hard to understand how the Swedish academy could decide to honour a theory which—due to its ‘real analysis’—is unsuitable to represent monetary processes in reality. In terms of economic policy, it makes a fundamental difference whether banks are merely intermediaries of savings or insurance companies or whether they are producers of purchasing power. The ‘real analysis’ was an important factor in the inability of the economics profession to anticipate the Great Financial Crisis in time.
After that painful experience, to extol with the Nobel prize for economics the intermediation approach to banking is akin to posthumously offering Ptolemy the prize for physics—because he discovered that the sun revolved around the earth.
Yes indeed — money doesn’t matter in mainstream macroeconomic models. That’s true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enable mainstream economics to depict the economy as basically a barter system.
But in the real world in which we happen to live, money certainly does matter. Money is not neutral and money matters in both the short run and the long run:
The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.
J. M. Keynes A monetary theory of production (1933)
What is also ‘forgotten’ in mainstream economic theory, is the insight that finance — in all its different shapes — has its own dimension, and if taken seriously, its effect on an analysis must modify the whole theoretical system and not just be added as an unsystematic appendage. Finance is fundamental to our understanding of modern economies and acting like the baker’s apprentice who, having forgotten to add yeast to the dough, throws it into the oven afterward, simply isn’t enough.
All real economic activities nowadays depend on functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channeling money/savings/credit — are more or less left in the dark in modern mainstream formalizations. Awarding people developing that kind of models is nothing short of gobsmacking!