The controversy flared three years ago. The issue is whether banks are special because they can create deposits “out of thin air.” The formative exposure that I had to this issue–and I would bet that the same goes for Krugman–is James Tobin’s Widow’s Cruse paper.

I am now reading a draft of a book that talks about this issue. The author argues vehemently that those of us aligned with Tobin or other mainstream economists fail to appreciate what makes banks special.

I could argue either side of this issue. As you know, I like to say that the nonfinancial sector wants to have a balance sheet with long-term risky liabilities (newly-planted fruit trees) and short-term risk-free assets (money). The financial sector accommodates this by doing the reverse.

The kicker is that financial institutions are owned by people, also. When a bank finances a fruit orchard, what it does is carve the returns of the fruit orchard into two tranches: a debt tranche (deposits at the bank) and an equity tranche (shares of the bank). This carve-up adds value in part because the debt tranche because its relative price is relatively stable and transparent.

First, let me argue against what I see to be the position taken by the author of the draft book that I am reading. He comes across to me to be claiming that banks break the identity between saving and investment. I would express what it seems to me to be saying as something like

S + L = I

where S is saving, I is investment, and L is the banks creating loans at the stroke of a pen. I am not buying that at all. Banks may be able to create loans and deposit balances at the stroke of a pen, but they cannot create real goods at a stroke of a pen.

Banks can do things that indirectly stimulate the production of real goods. But the chain of events has to be something like

1. Banks loosen lending
2. Businesses invest more
3. Saving goes up (not necessarily the rate of saving, but total saving)

The Keynesian explanation for (3) would be that income has gone up. My explanation might be more along the lines that banks have made the risk of the fruit orchard, as perceived by savers, go down. The banks may do this through better diversification of fruit investments, by obtaining and exploiting information that enables them to avoid bad fruit trees, or just by public-relations moves that encourage depositors to be trusting, perhaps too much so. As a result, people are happier about using fruit trees to enhance future consumption opportunities, so that saving and investment go up.

Now let me take the other side. A lot of economic activity in a modern economy depends on credit. Business investment, housing investment, and some consumer spending are dependent on credit. In a mainstream AS-AD macro, a contraction in the supply of credit is going to reduce spending and economic activity. Or, from a PSST perspective, a credit contraction will disrupt those patterns of specialization and trade that require credit to operate.

So, I am willing to go along with the author in attaching importance to credit conditions. However, I am not willing to go so far as to attach special significance to the particular mechanism by which banks create credit.