The concept of endogenous money and banking is back in the spotlight these days with more and more prominent “mainstream†economists coming around to the idea that banks are special and that private debt levels are an important element in understanding the business cycle.
In just the last few days David Andolfatto and several Harvard economists have published new work that considers the importance of banks and private debt. This is not surprising to any regular reader of my research as private debt strikes me as an essential element to understanding how the modern monetary system works. But this is somewhat new for more mainstream economists who have often constructed models that dismissed banks and private debt as an intermediary element of the economy. That has started to change following the financial crisis and the obvious negative impact that private debt levels had on the economy.
David’s paper is particular interesting to me as it’s well balanced and tries to reconcile the difference between the more heterodox view (in which banks have always been an essential element) and the more orthodox view (in which banks are largely dismissed as one of many types of lenders in a loanable funds market).
Without getting too deep in the weeds here I want to try to answer what I believe is David’s most essential question – what makes banks special? As a market practitioner and someone who is more concerned with operational facts and not politics I think I come at this debate with a somewhat objective approach so let me see if I can explain why banks are special in the context of the modern financial system.
I take a slightly different approach than some heterodox economists and most mainstream economists. I think banks are essential to understand if you want to understand how the economy functions and how booms and busts develop. Banks are the piping and manage the water in our economic system so if you want to understand how our economic “house†functions then it is imperative that you understand the banking system.
