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Honoring Marvin Goodfriend

Banking Policy and Monetary Policy

Goodfriend, Marvin, and Robert G. King. 1988. “Financial Deregulation, Monetary Policy, and Central Banking.” Federal Reserve Bank of Richmond Economic Review 74 (May/June): 3-22.


Marvin Goodfriend was a great economist.2 He had a deep understanding of formal theory, but he was also very intuitive and policy oriented. He was rigorous, but he did not use large amounts of math in his theoretical work. One of Marvin's especially insightful and influential papers was Goodfriend and King (1998), hereafter referred to as GK. It discusses a framework for determining if monetary policy, implemented with open market purchases of Treasury securities, is a necessary and sufficient response to a banking crisis. The other possible response is banking policy. Banking policy in GK, whenever it is not redundant, is lending to banks at a rate below the one they could obtain in the market (especially lending to banks that cannot borrow in the market). Marvin later labeled such interventions as a component of "credit policy," but I stick to the earlier terminology and consider the specific interventions discussed in GK. This essay discusses the ideas and contributions of GK and relates it to some of Marvin's other research on banking and monetary policy.

Core elements of GK and my own perspectives

GK provides what is almost a Modigliani and Miller (1958) theorem for banking policy. GK gives conditions under which banking policy has no beneficial effects. The result has two parts: one for idiosyncratic banking policy and the other for system-wide banking policy. The first part deals with lending to individual banks experiencing idiosyncratic funding problems (lending to banks that cannot raise enough deposits or interbank loans to survive). GK outlines a proof that there is no social benefit to this (given an appropriate monetary policy) if individual bank failures can be treated like individual business failures. This is true in partial equilibrium and it seems to me that this is true more generally if individual bank failures generate no externalities.

Banking policy is a special form of credit policy that targets the rescue of individual banks, primarily by lending to them when the market will not. This is a case of lending to (bailing out) the exogenously insolvent that are worth more dead than alive and is consequently undesirable.3 Even worse, when anticipated, it requires ex-ante regulation to prevent excessive ex-ante risk-taking that takes advantage of its subsidized bailout.

The second part of the paper is about banking policy in system-wide financial crises. It is very short but makes several important points. It argues that monetary policy implemented by open market operations is necessary and sufficient to respond to some types of banking crises. The basic model is close to the one implicit in the celebrated Great Contraction chapter in Friedman and Schwartz (1963), which describes the period around 1929 in the United States. In essence, Friedman and Schwartz (1963) views a system-wide banking crisis as a temporary increase in the demand for currency. A monetary policy that provides an elastic currency response to the demand increase (via open market operations expanding the supply of high-powered money) will prevent such crises from bringing down the banking system. In Friedman and Schwartz (1963), the macroeconomic losses from a crisis are due to the implications of the induced fall in the stock of money due to bank failures.

GK considers more general reasons for social losses. I read the GK analysis to include the fire-sale losses from selling assets that arise when the supply of currency is too small to meet the crisis-induced demand. The key conditions for the sufficiency of open market operations are fully integrated markets for government bonds, bank deposits, and interbank loans. Injecting bank reserves into these integrated markets will offset increases in the demand for currency that cause a banking crisis.

As a part of this analysis, GK shows that the United States Federal Reserve System's interest rate smoothing policy (providing an elastic currency to offset all temporary shocks to the demand for currency) will work just as well as Bagehot's lender of last resort policy. Bagehot allows moderate spikes in interest rates (spikes consistent with bank solvency) when borrowing from the lender of last resort. Much of this part of GK is under the assumption that banking crises are caused by an increase in the demand for currency relative to deposits and that there are no other real shocks. GK shows that monetary policy is necessary and sufficient to offset these monetary shocks.

GK also considers a real, nonmonetary shock: a temporary increase in the real rate of interest. This shock could cause bank failures that monetary policy (without banking policy) could not prevent. In essence, an increase in the real rate required by bank deposits can cause a run by making some banks insolvent. No amount of liquidity can overcome this insolvency because the problem is a real shock and not a shock to the demand for currency versus deposits. They argue that the bank failures could cause economic dislocations, but that these are similar to the dislocations caused by the effect of solvency of industrial firms. This makes bailouts via banking policy somewhat unlikely to be desirable. The desirability of banking policy is a cost-benefit analysis based on magnitudes. An alternative view of the implications of an increased real rate of interest described in GK is that many banks might be on the border between full insolvency and insolvency only due to the illiquidity of their assets — these banks are solvent but illiquid. A real rate shock pushes some banks over the insolvency border. If there is incomplete information on the exact value of the individual banks, it could lead all banks near the border to fail in a crisis. If the problem is this incomplete information about which banks are fully solvent, GK suggests that it could be beneficial to have detailed ex-ante supervision and monitoring of banks to determine in advance which ones are insolvent.

I have a somewhat different view of the desirability of banking policy and favor a lender of last resort policy that goes beyond open market operations. Nonetheless, the analysis in GK greatly clarifies the important issues in understanding banking policy. In my view, the case for saving a just-insolvent bank is almost identical to a bank that is slightly solvent if there are large social and external costs to bank failure. I view illiquidity and solvency as part of a general equilibrium effect with externalities, as in Diamond and Rajan (2005, 2012). In addition, a forecast of a run can be self-fulfilling if enough depositors believe that no one will lend directly to the bank or banking system, as in Diamond and Dybvig (1983). One way to approximate these two points in the GK framework is that bank failures themselves could have an impact on the real rate of return that depositors require on bank deposits and other assets. An open market operation to buy Treasury bills with high-powered money in response to a banking crisis will not work if the holders of the high-powered money or currency are not willing to lend to the banks at an interest rate that leaves the bank solvent.

If the bad effects of bank failures are very large, then banking policy can be desirable ex-post. GK notes that banking policy is a form of desirable insurance beyond the insurance against money demand shocks provided by open market operations.4 Because a lender of last resort that goes beyond open market operations provides a discretionary injection of subsidized funds with ex-post benefits to society, it (like monetary policy) faces a problem of limited commitment. Marvin and Jeff Lacker provided a very nice analysis of this in Goodfriend and Lacker (1999)5; see also, the related analysis in Diamond and Rajan (2012).

GK notes that insurance that provides a subsidy generally requires ex-ante pricing and regulation. GK does not discuss deposit insurance, but it would be interesting to understand how their perspective applies to this pervasive feature of modern banking systems. Unlike a lender of last resort, deposit insurance is explicit and contractual. This commits the deposit insurer and avoids the discretionary element of lender of last resort policy.

Later work on banking policy, monetary policy, and macroeconomics

Marvin was one of the pioneers who brought ideas from banking theory into macroeconomics. I thought it was a sad situation when "Money and Banking" (the former name for this field of research) became a completely inaccurate description of the current research in macroeconomics.6 Many know Marvin best from his work on monetary economics, but I found him to be aware of developments in banking, both practical and theoretical. Marvin did continue to work on banking topics intermittently, and I briefly comment on two later, related contributions. Goodfriend (2005) describes how frictions in the banking sector can impact the effect of shocks to the economy and also influence the information content of various interest rates as indicators of macro shocks. Goodfriend and McCallum (2007), GM hereafter, took these ideas and made them quantitative. It has very useful implications for monetary policy, providing a different approach to using yield spreads as measures of economic conditions than those provided in Bernanke, Gertler, and Gilchrist (1999).

GM introduces a wedge between banking markets and Treasury markets and studies the interest rate spread between bank rates and Treasury rates. Marvin had an open mind. He believed that open market operations were the right way to implement monetary and banking policy, with the least moral hazard, but that bank liquidity services and the collateral role of banks complicated the argument. He viewed the banking sector as important, along with the final goods production sector, because loan production was subject to a moral hazard problem as in Diamond (1984).

The GM model allows differentiated financial products where loans differ from bonds and where collateralized bank deposits are different from uncollateralized liabilities. GM's integrative model features New Keynesian sticky price frictions and a deposit in advance constraint (similar to a cash in advance constraint).

GM does not assume that currency, government bonds, bank deposits, and bank loans are in an integrated market as in GK. There are separate markets for each, with separate shocks to supply and demand. There can be yield spreads between them, which could be time varying. Open market operations would be sufficient to offset any shock in the markets, but the size of the intervention cannot be determined by examining a single rate of interest. For example, interest rate smoothing of government bonds would not be sufficient to offset all shocks. The central bank also needs to look at the various yield spreads to determine the economic shocks that require a monetary policy response.

GM does not consider banking policy, but it does generalize the framework of GK. The focus in GM is on the measurement needed to calibrate an appropriate monetary policy. Implicitly, an appropriate open market operation can deal with any bank funding problems that need to be addressed.

Reviewing the GM framework, I have some similar reservations as those I expressed earlier about the GK setup. I'd prefer a framework that could allow bank failures or runs to temporally impact the real rate of interest required by those individuals and institutions funding banks. My view is that the supply of short-term funding to banks and other financial institutions is not sufficiently integrated with the market for Treasury securities (substitution across the markets is too limited) for increased purchases of Treasuries to substitute for a lender of last resort lending directly to all or most banks using bank loans as collateral. It might even be possible that lending to them in times of crisis could be profitable for a central bank and could result in smaller disruptions than an alternative policy that is restricted to open market operations in Treasury security markets.

Marvin as a wonderful colleague

I have had many long discussions with Marvin about research. I met Marvin at Brown University in 1974 or 1975 when he and Bob King were graduate students and I was an undergraduate student taking graduate macroeconomic and monetary theory courses with Herschel Grossman and Bill Poole. I did not know either of them well, and these banking issues were not ones that any of us were then thinking about. Much later, I talked to Marvin many times when he was a visiting professor at the University of Chicago, and to both Marvin and Bob after 1990 when I became a long-term visiting scholar at the Federal Reserve Bank of Richmond. Marvin was an incredibly kind person who was very generous with his time. In addition to his outstanding skill as an economist, he was a great electric guitar player.

Marvin said to me many times that he saw important insights for macroeconomics in the microeconomic theory of financial intermediation, but that the theories needed to be embedded into the standard quantitative macroeconomic models in order to actually have that impact. He encouraged me to work in this area, but I did not have the skills or the inclination to undertake this integration. But working alone and with Ben McCallum, Marvin later provided his own approach to this integration, as described above.

Summing up

Marvin Goodfriend had deep insights into money and banking. I regret that Marvin did not continue to work to integrate the analysis in GM with the study of a lender of last resort as in GK, but, of course, there are opportunity costs in research as elsewhere. His combination of a clear theoretical perspective, a detailed understanding of institutions, and an open mind led him to make major contributions to economic policy analysis.

References

Bernanke, Ben S., Mark Gertler, and Simon Gilchrist. 1999. "The Financial Accelerator in a Quantitative Business Cycle Framework." In Handbook of Macroeconomics, vol. 1C, edited by J.B. Taylor and M. Woodford, 1341-93. Amsterdam: North-Holland Publishing Co.

Diamond, Douglas W. 1984. "Financial Intermediation and Delegated Monitoring." Review of Economic Studies 51, no. 3 (July): 393-414.

Diamond, Douglas W., and Raghuram G. Rajan. 2005. "Liquidity Shortages and Banking Crises." Journal of Finance 60, no. 2 (April): 615-47.

Diamond, Douglas W., and Raghuram G. Rajan. 2012." Illiquid Banks, Financial Stability and Interest Rate Policy." Journal of Political Economy 120, no. 3 (June): 552-91.

Friedman, Milton, and Anna Schwartz. 1963. A Monetary History of the United States 1867-1960. Princeton: Princeton University Press.

Goodfriend, Marvin. 2005. "Narrow Money, Broad Money, and the Transmission of Monetary Policy." In Models and Monetary Policy: Research in the Tradition of Dale Henderson, Richard Porter, and Peter Tinsley, edited by J. Faust, A. Orphanides, and D. Reifschneider. Washington, DC: Board of Governors of the Federal Reserve System.

Goodfriend, Marvin, and Robert King. 1988. "Financial Deregulation, Monetary Policy, and Central Banking." In Restructuring Banking and Financial Services in America, edited by William S. Haraf and Rose Kushmeider, 216-53. Washington, DC: American Enterprise Institute.

Goodfriend, Marvin, and Jeffrey M. Lacker. 1999. "Limited Commitment and Central Bank Lending." Federal Reserve Bank of Richmond Economic Quarterly 85, no. 4 (Fall): 1-27.

Goodfriend, Marvin, and Bennett T. McCallum. 2007. "Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration." Journal of Monetary Economics 54, no. 5 (July): 1480-1507.

King, Mervyn. 2016. The End of Alchemy: Money, Banking, and the Future of the Global Economy. London: W.W. Norton.

Modigliani, Franco, and Merton H. Miller. 1958. "The Cost of Capital, Corporation Finance and the Theory of Investment." American Economic Review 48, no. 3 (June): 261-97.


Cite as: Diamond, Douglas W. 2022. "Banking Policy and Monetary Policy." In Essays in Honor of Marvin Goodfriend: Economist and Central Banker, edited by Robert G. King and Alexander L. Wolman. Richmond, Va.: Federal Reserve Bank of Richmond.

 
1

I am grateful to Bob King, Alex Wolman, and Luke Zinnen for helpful comments on an earlier draft.

2

I met Marvin when I was an undergraduate and will discuss my interactions with him more fully at the end of this essay.

3

If the authority conducting a bailout could have better information than depositors, GK points out that the argument becomes more nuanced.

4

A recent analysis of lender of last resort policy as explicit insurance is presented in Mervyn King (2016).

5

See the essay by Athreya and Williamson elsewhere in this volume.

6

As I describe below, Marvin had previously encouraged me to attempt to bring more of banking theory into macroeconomics.

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