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I was trained in a mainstream economics department (UCLA), and as a result came to circuit theory backwards. In graduate school I was frustrated by the superficial treatment of money in the mainstream models, which didn’t even try to engage with what money is, with its relationship to the banking system, and with the implications of an institutional understanding of money. Thus, for me Graziani’s ‘The Monetary Theory of Production’ was a breath of fresh air – a model that answers the question: what does money do? And that tackles the complicated relationships between money and banking.

Graziani starts with the observation that ‘in a monetary economy any payment between two agents necessarily involves a third agent recognized as a producer of means of payment’ (Graziani 2003: 65), and then develops a model with three actors: the banks, the producers, and the workers. Because producers have to pay the workers before they can engage in production, the model starts with banks lending deposits to the producers. These deposits allow the producers to pay their workers and engage in production. And the model is closed when the workers spend their deposits either on the producers’ output or in savings (which are held as securities issued by the producers). The contrast of this sequential process with the timeless, frictionless exchange of the neo-classical model is stark.

While Graziani’s work is frequently framed as a response to the neo-classical model and its approach to money, Graziani himself was very conscious of the fact that he was also critiquing the neo-classical approach to banking. So here I will focus on Graziani’s work as a model of banking and as a response to the mainstream approach to ‘what is a bank?’ Graziani offers profound critiques of both Tobin’s portfolio choice approach to banking and Diamond & Dybvig’s model of bank runs.

Graziani (2003) addresses Tobin’s critique of ‘commercial banks as creators of money’ in which Tobin claimed that the only things that made banks special intermediaries were reserve requirements and interest rate ceilings (Tobin 1963: 419). Other financial institutions could thus issue liabilities that compete with bank liabilities, and Tobin framed deposits as a matter of ‘portfolio choice.’ Consumers could choose to hold or not to hold deposits just like any other asset. According to Tobin, whatever banks could do, another financial institution, such as a money market fund, could do too.

Graziani (2003: 85-86) pinpoints the problem with this argument directly: in the aggregate – from the macro perspective – consumers can only ‘choose’ to reduce their holdings of deposits by paying off loans. The individual consumer who wants to buy a security transacts with a seller of the security who ends up with deposit balances. In short, in aggregate the deposit balances are not reduced until the deposits are returned to the bank.

Graziani’s logic provides a much better framework for understanding non-bank financial intermediaries (or shadow banks) than Tobin’s. The individual consumer who wants to hold money market fund (MMF) balances instead of deposits can purchase shares in the MMF, but the deposits still exist. In practice, we find that the MMFs just lent the funds on to the banks (Sissoko 2024), thus closing the circle. Introducing the MMF as a shadow bank into the monetary circuit, then has as a result that banks now have to deal with flighty wholesale funding from MMFs instead of relying on ‘sticky’ deposits. In short, as Graziani (2003) pointed out, consumer portfolio choice can affect banks’ liability structure, but cannot draw funding away from banks – unless consumers choose to pay off loans.

Graziani’s work is responsive to another model of banking that has profoundly influenced the mainstream approach to finance: Diamond and Dybvig (1983). DD83 has correctly been criticized for failing to model the fact that banks lend money (or deposits) and not goods. However, even if one embraces the intuition of DD83 as it is understood by mainstream economists, Graziani’s work offers a robust critique of the model. In DD83 the fundamental problem of banking is that in exchange for the deposit of a good, banks issue a liability that promises to pay a fixed amount of the good in any period. The banks, however, invest part of the deposit in a long-term project, and as a result they will not have the funds to pay off all depositors in the interim period. This is fine, as long as the expected number of withdrawals take place in the interim period. If however too many withdrawals take place, the bank will be forced to sell off the long-term project early and at a loss – in which case some depositors will lose their money. In short, DD83 models a bank run and frames banks as a fundamental source of liquidity risk that must be solved by deposit insurance (or a lender of last resort) in order for the economy to have financial stability.

What Graziani’s work offers is not just a model that takes money seriously by modeling the relationship of banks to the production process, but also an entirely different vision of what money and banking mean. In Graziani’s model, banks are not a source of liquidity risk; on the contrary, banks are the liquidity providers who make it possible for production to take place.

Graziani (2003: 56) emphasizes the failure in the mainstream literature to distinguish between financing the act of production and financing investment. The finance of production is temporary (or initial) finance (ibid: 69). It is where the banks provide the essential liquidity that makes it possible for production to take place – and the whole point is that this ‘working capital’ is paid back very quickly. As long as it is being used for production, there is no reason for this temporary finance to be limited or in any way related to ‘savings’. In short, this is where the liquidity provision function of the banking system is located.

The finance of investment (or final finance) is where long-term capital financing takes place – and this does require savings (Graziani 2003: 71). The focus of the mainstream literature is entirely on the finance of investment – as DD83 indicates – and thus the literature misses entirely the economic function played by bank-based liquidity in the production process. By contrast, Graziani (2003: 151), like Schumpeter, views ‘the banker as the ultimate judge of the entrepreneur’s plans’ and as a core determinant of what production does and does not take place. Both GDP and growth are fundamentally dependent on the banking system.

In my work I rely on this intuition to explore how the modern financial system has begun to undermine the processes of economic productivity and growth: I ask where did financial regulation go wrong? In my view, financial regulation has erred by treating DD83 as the canonical model of bank liquidity, and thus by focusing on the risks of bank financing as a problem to be solved. In fact, the most important form of bank liquidity is what Graziani calls ‘temporary finance’ which is both inherently low risk (and subject to prompt feedback) and absolutely essential to the process of production.

Modern financial regulation addresses the so-called risks of bank lending by promoting collateralized lending and the repo/derivatives market and by discouraging the unsecured bank lending that takes place in the ‘temporary finance’ stage of the production process. (For example, Basel III puts a 100% capital risk weight on an unsecured commercial loan, a 20% weight on a senior loan secured by the assets of a private lending fund and as low as a 0% weight on a loan secured by sovereign debt such as Treasuries Gilts or Bunds.)

Unfortunately ‘safe’ collateralized lending is not well suited to promoting the production process, precisely because the production hasn’t happened yet, and thus there is nothing to serve as collateral. In short, the lending that – as Graziani demonstrated so clearly – the economy needs to engage in production is actively discouraged by current bank capital requirements. As a result, regulation based on the DD83 approach to banking has undermined the capacity of the banking system to perform its core function, as was carefully modelled by Graziani.

So what do we have now? Banks that focus on ‘fixed income financing’ or in other words on lending to support the activities of private equity, hedge funds and other institutional funds, instead of financing the production process. If regulators had paid closer attention to the economic principles about the banking system that Graziani set forth, our financial system today would almost certainly be much more effective at supporting SMEs and fostering the creative destruction that underlies the process of growth.