Are banks special? Some notes on Tobin's theory of financial intermediaries

Abstract

Since the 1960s, Tobin has set himself the objective of developing a macroeconomic model more general than that specified by Keynes in the General Theory. In his works, he explicitly deals with financial intermediaries and elaborates a ‘new view’ which, in contrast with the ‘old view’, maintains that there are no reasons to attribute a special role to the banks. This paper critically analyses Tobin's theory and shows that this theory overlooks an important function of banks highlighted by Keynes, and that the specification of this banks’ function is the necessary condition to highlight the most significant aspects of what Keynes calls a monetary economy. These points enable us to draw some observations about the question of the financial system regulation.

Keywords:

• financial intermediaries
• banks
• monetary economy

JEL classifications:

• E12
• E40
• E44
• G21

Notes

1. ‘A model of the capital account of the economy specifies a menu of the assets (and debts) that appear in portfolios and balance sheets, the factors that determine the demands and supplies of the various assets, and the manner in which assets and interest rates clear these interrelated markets’. (Tobin 1969, p. 16)

2. Tobin (1963, p. 411) specifies the factors that allow intermediaries to carry out their functions: ‘The reasons that the intermediation of financial institutions can accomplish these transformations between the nature of the obligation of the borrower and the nature of the assets of the ultimate lender are these: (1) administrative economy and expertise in negotiating, accounting, appraising, and collecting; (2) reduction of risk per dollar of lending by the pooling of independent risks, with respect both to loan default and to deposit withdrawal; (3) governmental guarantees of the liabilities of the institutions and other provisions … designed to assure the solvency and liquidity of the institutions’.

3. Tobin (1963, p. 415) concludes that even in the absence of reserve requirement, banks’ dimensions are limited by the same factor that determines the size of other intermediaries: the presence of wealth owners who wish to hold intermediaries’ liabilities. He maintains that ‘it is more accurate to attribute the special place of banks among intermediaries to the legal restrictions to which banks alone are subjected than to attribute these restrictions to the special character of bank liabilities’. (Tobin 1963, p. 416)

4. ‘Intermediation permits borrowers who wish to expand their investments in real assets to be accommodated at lower rates and easier terms than if they had to borrow directly from lenders’. (Tobin and Brainard 1963, p. 385)

5. Keynes uses the term real exchange economy to denote an economy in which money is just an instrument that makes it possible to reduce the costs of the exchange; the use of money does not change the structure of the economic system with respect to a barter economy. By the term monetary economy, Keynes refers to an economy in which the presence of fiat money radically changes the nature of transactions compared with a real-exchange economy. (Keynes 1933a, p. 408)

6. ‘Ex ante investment is an important, genuine phenomenon, inasmuch as decisions have to be taken and credit or “finance” provided well in advance of the actual process of investment … In what follow I use the term “finance” to mean the credit required in the interval between planning and execution’. (Keynes 1937c, p. 216)

7. ‘Surely nothing is more certain than that the credit or “finance” required by ex ante investment is not mainly supplied by ex ante saving’. (Keynes 1937c, p. 217)

8. To describe the action of intermediaries, Tobin also specifies two distinct markets: that of their liabilities, the deposits in the case of the banks, and that of their assets. The difference between Tobin's analysis and the model described here is the fact that in this paper the credit demand is associated with investment decisions and therefore the credit market is associated with the income account.

9. This way of specifying the ‘finance motive’ differs from Keynes's definition, which considers finance as ‘essentially a revolving fund’ necessary to finance ‘the planned activity by the entrepreneur or the planned expenditure by the public’ (Keynes 1937c, pp. 219 and 221). The definition used in this paper coincides with that elaborated by Dow (1997, p. 72). It is moreover assumed that credit serves to finance only investments and not consumption. The demand for investment goods and consumption goods is financed in different ways: the first is financed by new money created by the banks while the second is financed by income received by workers. This point was underlined by Minsky (1980) and Dalziel (1996, 2001).

10. As Arestis and Howells state (1996, p. 541): ‘The (flow) demand for new bank lending, on which the endogeneity case focuses, originates with one set of agents while the (new) deposits that are created by this lending have to be held by a different set. The first set, (“deficit units”) is a subset of the latter (“wealth holders”). For the former, what is involved is an income–expenditure decision; for the latter it is a portfolio consideration’. See also Wray (1990, 1992), Howells (1995, 2006), Dow (1997), Palley (1996), Rochon (1999), Bertocco (2001, 2005), Fontana (2003) and Docherty (2005).

11. Examples of more elaborated models are contained in Godley (1999), Bossone (2001), Dalziel (2001) and Docherty (2005).

12. The relation between the presence of bank money and the causal nexus between investments and saving has been underlined in particular by Chick (1986). See also Kaldor (1982, 1985) and Kaldor and Trevithick (1981).

13. ‘There is, I am convinced, a fatal flaw in that part of the orthodox reasoning which deals with the theory of what determines the level of effective demand and the volume of aggregate employment; the flaw being largely due to the failure of the classical doctrine to develop a satisfactory theory of the rate of interest’. (Keynes 1934, p. 489)

14. ‘There is … a necessary condition failing which the existence of a liquidity-preference for money as a means of holding wealth could not exist. This necessary condition is the existence of uncertainty as to the future of the rate of interest, i.e. as to the complex of rates of interest for varying maturities which will rule at future dates’. (Keynes 1936, p. 168)

15. ‘The conditions required for the “neutrality” of money … are, I suspect, precisely the same as those which will insure that crises do not occur’. (Keynes 1933b, pp. 410–411)

16. ‘It is the essence of an entrepreneur economy that the thing (or things) in terms of which the factors of production are rewarded can be spent on something which is not current output, to the production of which current output cannot be diverted … and the exchange value of which is not fixed in terms of an article of current output to which production can be diverted without limit’. (Keynes 1933a, p. 85)

17. ‘The whole object of the accumulation of wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth accumulation the more essential does such amendment become’. (Keynes 1937a, p. 113)

18. ‘There is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the prices of shares, rather than by the genuine expectations of the professional entrepreneur’. (Keynes 1936, p. 151)

19. Several economists have emphasised the desirability of integrating the Keynesian theory of income determination with Schumpeter's theory of economic development; see for example Minsky (1986, 1993), Goodwin (1993), Morishima (1992) and Vercelli (1997); for a more detailed analysis see Bertocco (2007).

20. ‘A large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animals spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die’. (Keynes 1936, pp. 161–162)

21. In Bresciani-Turroni (1936) there is a similar example.

22. If we consider the discussion in the previous section regarding animal spirits and uncertainty, it does not necessarily follow that there must be a value of the rate of interest rate higher than zero with these characteristics.

23. The concept of optimal rate of interest indicates the rate of interest coherent with full employment: ‘In equilibrium the production of capital goods is determined by equality between the marginal efficiency of capital and the normal rate of interest but this need not imply full employment unless the normal rate of interest happens to coincide with the optimum rate; the optimum rate being the rate consistent with full employment’. (Rogers 1997, p. 21)

24. See for example Tobin (1980), Lavoie (1992, 2006) and Wolfson (1996). The credit rationing described in these works has different characteristics from that defined on the basis of the presence of asymmetric information (see Bertocco 2005, 2009).

25. ‘[Banks] must first be independent of the entrepreneurs whose plans they are to sanction or to refuse. This means, practically speaking, that banks and their officers must not have any stake in the gains of enterprise beyond what is implied by the loan contact. … But another kind of independence must be added to the list of requirements: banks must also be independent of politics. Subservience to government or to public opinion would obviously paralyze the function of that socialist board. It also paralyzes a banking system. This fact is so serious because the banker's function is essentially a critical, checking, admonitory one. Alike in this respect to economists, bankers are worth their salt only if they make themselves thoroughly unpopular with governments, politicians, and the public’. (Schumpeter 1939, p. 92)

26. Schumpeter considers the bank/industry collusion as an element that can destroy entrepreneurial activity and innovations (see e.g. De Vecchi 1995, chap. 8).

27. Perez (2002, 2007) uses the Schumpeterian concepts of innovation and credit to explain the occurrence of boom phases marked by phenomena of speculation, financial innovation and ‘irrational exuberance’.

28. With the introduction of innovations: ‘Opportunities grow explosively. Innumerable entrepreneurs will offer their projects to the also growing number of financiers. If they seem to follow the new paradigm, all projects, good and bad, honest and crooked, are likely to have access to the required funds’. (Perez 2007, p. 792)

29. ‘We don't mean to suggest that policy makers should impose drastic interest hikes to curtail bubbles. That would be dangerous. But a moderate, preemptive approach is appropriate, and far preferable to the current policy of doing nothing as bubbles grow, and then pulling out the stops when they finally pop’. (Roubini and Mihm, pp. 235–236) See also European Central Bank (2010).

30. See for example Krugman (2009).