Parsing George Selgin’s Debate on Credit Intermediation

This post is the companion to the latest InFi podcast episode, featuring economist George Selgin and his new Cato Institute working paper, “Banks Are Intermediaries of Loanable Funds.” Because this topic is so technical, I thought it would help if I gave a roadmap to the dispute in written form.

What Is a Credit Intermediary?

To say that a bank is a credit intermediary means that it is a “middleman” standing in between savers and borrowers. For example, imagine a thousand different families each putting an extra $500 into their bank checking account, and the bank then granting a new mortgage of (say) $400,000 to a couple who wants to buy a home.

In this scenario, the bank performs the economic function of channeling the household savings into particular loans, because (presumably) the bank’s credit officers are better judges of default risk than the average family. Furthermore, the households can safely earn a modest interest return with the safe commercial bank, rather than having to identify individual mortgage applicants and put all of their eggs in one basket. The bank, for its part, earns the spread between mortgage rates and checking account yields, in order to generate a return for conducting this business.

In this old-school way of thinking, the bank has to passively wait for depositors to place new funds into the bank’s vault, in order for it to lend some of them out to borrowers. In this view, there is nothing special about the bank per se, that would distinguish it from any other financial institution that acted as an intermediary in the credit markets.

The “Thin Air Money Creation” Dissenters

In contrast to the simplistic tale told above, many modern economists and policy wonks emphasize the special powers that commercial banks possess, in which they can effectively create money “out of thin air” merely in the act of granting a new loan to a borrower. Since the bank’s assets and liabilities move up simultaneously in the act of granting a new loan—so this thinking goes—it’s obviously archaic at this point to be talking about “credit intermediation.” The bank doesn’t need to sit around and wait for a deposit to make a new loan.

A good representative of this perspective is a 2018 working paper from two economists affiliated with the Bank of England. After theoretically modeling the two perspectives, the authors look at the stylized facts of the business cycle. They conclude that the “money creation” approach matches the data better than the “credit intermediary” approach. For example, bank balance sheets swing much more wildly in practice than one would expect if banks were merely the “middlemen” between savers and borrowers.

Selgin’s Position

Selgin enters this dispute by first conceding that banks can advance new loans without having the necessary reserves already in the vault. However, he emphasizes (what he believes is) the crucial fact that in a competitive banking system, if any individual bank made loans willy-nilly without regarding to “funding” them, it would soon be brought to its knees. Specifically, banks use a clearinghouse process but ultimately still periodically settle up with each other for net payments due. 

For example, if Acme bank grants new credit to its own customers, allowing them to write more checks (and swipe their debit cards more) when interacting with other members of the community who don’t bank at Acme, then soon enough Acme on net will owe funds to the other banks in the economy. Because Acme’s competitors aren’t going to allow their own accounts with Acme (if they even have them) grow without limit, Acme will have to settle these net payments by sending over reserves. In our current system in the United States, this means sending either truckloads of physical currency, or electronically transferring reserves held on deposit at the Federal Reserve.

Selgin’s point is that the more accurate depiction of bank operations merely adds a margin of time to the traditional analysis. Ultimately, a given commercial bank needs to “fund” its loans from other lenders, whether they be customer deposits, other banks, or the Fed itself. Even though a superficial analysis might make it seem as if a commercial bank has the same power to create money as the Fed, this is a misleading conclusion. 

Hence, Selgin thinks it is still appropriate to view commercial banks as credit intermediaries, notwithstanding some of the nuances of modern banking practice.

Murphy’s Take

As we mysteriously allude to in the episode itself, six years ago Selgin and I had a public debate at the Soho Forum in New York City on the topic of “fractional reserve banking.” Specifically, I argued that whenever banks “lend money out of thin air,” it sets in motion the boom-bust cycle that the great Austrian economist Ludwig von Mises described. In contrast, Selgin argued that so long as this practice wasn’t artificially subsidized through the central bank backstop and/or government deposit insurance, the resulting amount of bank-created money was optimal and would promote economic stability.

To tie my debate with Selgin to the present issue, I would say this: The Bank of England economists are right that banks don’t necessarily act as credit intermediaries. That is, some of their lending doesn’t directly correspond to saving on the part of other members of society. However, that’s a bad thing in my book. The purpose of credit markets is to channel society’s scarce savings into the most appropriate outlets (taking into account risk, reward, liquidity, etc.). When banks deviate from a 100% reserve (on checking accounts) policy, they distort the tight correspondence between savers and borrowers. 

To summarize my view in a single sentence: Modern banks don’t always act as credit intermediaries, but they should.

NOTE: This article was released 24 hours earlier on the Infinite Banking (IB) 3.0 - The Future of Finance Group

Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

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