Tuesday, 19 May 2015

Maturity transformation is an example of the fallacy of composition error.

Maturity transformation is one of the basic activities of commercial banks: it consists of “borrow short and lend long”. That is, commercial banks accept money from depositors (and bondholders and shareholders) and lend to mortgagors, businesses, etc. The “maturity” of deposits is short: i.e. the money is available on demand or at short notice. In contrast, mortgages last for years if not decades. That is, the “maturity” there is LONG. Thus banks according to the conventional wisdom and according to the text books perform a valuable service: they “transform” short maturity into long maturity, i.e. banks enable those who are only prepared to lose access to their money for relatively short periods to nevertheless gain some of the benefits (i.e. the relatively high interest rates) that come from lending out money for LONG periods.

The fallacy of composition error is where some policy benefits INDIVIDUAL households or firms, with the conclusion being drawn from that that similar benefits must also be conferred on ALL OR MOST households and firms, or on the economy as a whole.

To illustrate the fallacy of composition flaw in maturity transformation, let’s take a simple hypothetical economy, as follows.


A hypothetical economy.

Everyone has stock of base money (in physical form or at an account at the CB) to the tune of £X per person. That amount of money induces the population to spend at a rate that brings full employment. In addition, supply and demand for loans is such that each person in half the population lends £Z to each person in the other half.

Loans by one person to another involve the creditor losing access to their £Z for duration of loan, unless they can find someone else willing to take on the loan, i.e. act as creditor.

A commercial bank sets up in business.

A commercial bank then sets up in business and makes an amazing offer to everyone. The bank says to potential lenders, “instead of lending DIRECT to those who want to borrow, why not deposit your money with us, and we’ll do the lending. Plus we’ll guarantee you instant access to your money instead of your waiting for the above mentioned replacement creditor to appear. Plus you’ll continue to get interest.” That bank also takes over the job of creditor in respect of EXISTING loans.

The bank of course knows that it’s highly unlikely that all depositors or even a significant proportion of them will want to withdraw all their money on the same day, so this amazing wheeze thought up by the commercial bank works.

There is however a problem, which is that lenders’ stock of instant access money has risen: and that means that aggregate demand rises. Indeed on the very reasonable assumption that people keep their stock of instant access money to a minimum and try to spend away any excess stock, then lender’s EXCESS STOCK of instant access money will be £Z per person. So the central bank will have to raise taxes and withdraw base money from the economy (to the tune of £Z per lender). And there’s no question but that peoples’ stock of money is related to their weekly spending: what do people do when they win a lottery?

The fallacy of composition.

So what has the commercial bank achieved? It hasn’t improved the population’s liquidity one iota: that is, the amount of instant access money has not increased.

To summarise, when the commercial bank is first set up, each lender thinks they’re getting a bargain: their stock of instant access money rises, and the only downside is that the bank takes a cut. However, in the aggregate there’s no increase in instant access money after government has taxed away the excess instant access money. And that’s where the fallacy of composition lies.

Other benefits of commercial banks.

Another benefit that commercial banks confer is EFFICIENCY (e.g. they have staff with legal qualifications who specialise in drawing up agreements with mortgagors.) And that’s doubtless more efficient than     INDIVIDUAL lenders and borrowers getting together and trying to cobble together legally binding contracts, or hiring a lawyer on a one off basis for each mortgage or other loan arranged.

That increased efficiency probably compensates for the above mentioned cut that banks take. But the fact remains that increased stock of instant access money brought about by the commercial bank’s maturity transformation system is a mirage: it’s a fallacy of composition.


Of course the above is an over simplified version of the real world. But introducing the complexities of the real world won’t change the basic outcome, far as I can see. For example, people’s weekly spending is no doubt related their TOTAL NET ASSETS as well as being related to one particular form of asset: instant access money.

Thus when government raises taxes in the above scenario so as to cut demand, as well as confiscating instant access money, lenders’ net assets are ipso facto also confiscated. Ergo the demand reducing effect is more powerful than might at first seem, ergo government will not tax away quite as much money as suggested above. Ergo lenders end up with more instant access money than suggested above. Ergo they’ll try to find some other asset to invest their excess instant access money in. But purchasing the latter asset is likely to increase demand, so that’s not allowable (on the above assumption that the economy is already at capacity).

This is complicated!!!

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