Money, Banks and Finance in Economic Thought

A post-crisis evaluation of the Tobin-Black-Fama theory of banking

Molavi Vassei Arash, University of Hohenheim

To be able to explain the most recent financial crisis and, as some hope, to predit the next one, macroeconomic models are often augmented with a banking sector, justified by financial frictions. Most of the work is applied, often chasing the financial cycle or using banks as quite mechanic accelerators. Not motivated by foundational questions, modelling choices are made pragmatically. Foundational questions seem to be settled, as they are usually not raised. Most contributions are consistent with what James Tobin famously coined as "The New View" of banking, as opposed to the "Old View", which describes early neoclassical monetary and business cycle analysis, associated with Wicksell, Schumpeter, Hayek, Mises, and Fisher. The New View is the view that banking is passive in the absence of financial frictions und regulation. Irrelevance propositions like the Modigliani-Miller theorem apply. Financial securities produced by transaction-cost saving intermediaries like banks are fairly priced relative to a unique pricing kernel. Further, according to the New View, private money creation is not necessarily inflationary, because "deposits" are not return-dominated, even if they provide transaction services. The most adamant proponent of the New View was Fischer Black, who perfected it by applying the Black-Scholes formula. Black's approach gives us the banking sector that is hidden in Michael Woodford's "Interest and Prices". It is also applied by Eugene Fama (1980). In this paper, I ask three questions: (1) Is the crisis evidence that the Tobin-Black-Fama view is missing something outside its reach, something that cannot be introduced by injecting financial frictions? (2) Is the crisis evidence that the Old View with active banks and inflationary money creation is superior in some respects? (3) Is Black's view a variant of Dennis Robertson's loanable funds theory, or at least related, as is so often claimed? In each case, my answer is "No". It is also argued that the two competing views imply very different regulations. The discussion therefore matters.


Keywords: Fischer Black, James Tobin, bank, asset pricing, Modigliani-Miller, money creation, neutrality

Paper file