ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Can banks create money out of thin air?
, May 24, 2014
The global financial crisis in 2007/08, which came close to destroying the world economy, had its beginnings in a banking crisis. The reasons why need not bother us here. But a consequence of it has been to cast the spotlight on banking and money mismanagement associated with the GFC.
Economists who adhere to neo-classical free-market orthodoxy insist that modelling the real economy need take no account of banks. Modern money, they say, was nothing more than a convenient move away from pure barter.
Former governor of the
Bank of England Sir Mervyn King.
Once upon a time, before money came into widespread use, people used to conduct their commercial transactions using consumable goods. A farmer, say, might exchange eight sheaves of wheat for one cow.
Later, people found it more convenient to make purchases using money, because notes and coins are less perishable and more portable than quantities of grain and cattle.
Money, as every first-year economics student learns, has three important attributes: it is a store of value, a unit of account and a medium of exchange. It is difficult to envisage a sophisticated modern economy operating without it.
Electronic payment, the latest evolution of money, is a great time-saver.
Orthodox economic opinion holds that banks, being mere intermediaries between savers and borrowers, do nothing that otherwise impacts on the real economy — that is, the part of a country’s economy that produces goods and services, as distinct from the financial sector.
Since banks do nothing more than accept depositors’ savings and lend out these funds to borrowers for whatever purpose, be it home-buying, consumer purchases or increasing a firm’s productive capacity, they cannot introduce new money into the economy. This is why banks are categorised as financial intermediaries.
But this widespread though misguided view leads to the erroneous conclusion that capital for investment is a scarce resource limited by the sum of available savings.
There is a small measure of truth in this proposition. Whether capital is scarce or plentiful, it will always make sense to invest only in activities which will yield sound economic outcomes.
In fact, banks do influence the real economy. Surprising though it might appear at first, they don’t lend their deposits; they actually have the capacity to create loan money, as it were, “out of thin air”.
It follows, then, that banks’ money for sound investment purposes should always be readily available.
The problem is not a shortage of funds but a dearth of good investments. If commercial banks lend irresponsibly, causing booms and busts, they can, as we recently observed, destabilise the real economy.
Nevertheless, how banks operate is still misunderstood by both the conservative and progressive wings of mainstream economics. Two left-of-centre economists, America’s Nobel Prize-winning Paul Krugman and Australia’s Steve Keen, author of Debunking Economics: The Naked Emperor Dethroned? (revised and expanded edition, 2011), became embroiled in a heated debate during 2011/12 on just this point.
Keen argues that banks are an essential part of a capitalist economy. For capitalism to work there is necessarily interaction between three parties in every transaction — buyer, seller and bank. Failure to acknowledge that fact was one reason why the GFC took economic orthodoxy completely by surprise.
Krugman prefers to believe that banks merely invest the savings of their depositors, and that, therefore, they do not influence the functioning the real economy.
That debate might have ended there had it not been for the timely intervention of the Britain’s central bank, the Bank of England. Earlier this year the bank produced a landmark 14-page paper, “Money creation in the modern economy” (Bank of England Quarterly Bulletin, Vol. 54, No. 1, 2014).
The stated purpose of its authors, Michael McLeay, Amar Radia and Ryland Thomas, was to set the record straight on the nature of banking and money creation.
Here is what is said in the paper’s introduction:
• This article explains how the majority of money in the modern economy is created by commercial banks making loans.
• Money creation in practice differs from some popular conceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they “multiply up” central bank money to create new loans and deposits.
• The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or “quantitative easing”.
The authors of the Bank of England report remind us that, these days, most settlement of financial transactions involves changing the amounts in personal deposit accounts held in banks. Against popular belief, and textbook economics, these deposits definitely do not fund bank lending.
When a bank makes a loan, it simultaneously creates a debt with new money. The agreed amount of the loan is credited to the borrower’s account. The other side of the bank’s ledger records a debt of equal value owed by the borrower to the bank.
The borrower’s obligation is gradually diminished as the debt is paid off.
The Bank of England justifies the constraints that it places on banks’ ability to create money at will as being necessary to maintain stability in the real economy.
Central banks no longer place money limits on the amounts commercial banks can lend. Instead, they set a “bank rate” of interest which they charge commercial banks on amounts borrowed from the central bank to settle transactions between commercial banks.
The Bank of England believes that its indirect influence over the creation and cost of commercial bank money allows the commercial banks adequate room to compete with each other, while providing the necessary safeguards against imprudent lending.
Following the GFC, there is at least some justification for reconsidering the effectiveness of this approach. Indeed, the former governor of the Bank of England, Sir Mervyn King, has himself expressed misgivings about its merits.
Various modifications have been floated. Some have argued the case for money creation to be in the exclusive hands of the government through the central bank — with commercial banks confined to managing depositors’ accounts. A contrary position argues that central banks, whether or not they are nominally independent, will not always be able to resist firm government pressure to create money indiscriminately in pursuit of purely party political ends.
There is no easy way to settle this debate, because ultimately the merit of one position over the other turns on the matter of risk. Where lies the greater risk? Recent events clearly demonstrate that the central banks’ safeguards then in place did not prevent a lending spree by commercial banks leading to “boom and bust”.
At the time, robust discussions took place about what must be done to prevent a repeat of the 2007/08 GFC; but steadily-growing opposition from the commercial banks has stifled the prospect of any convincing measures for curtailing bank excesses.
Given the circumstances, nothing the Bank of England has said, or could say, can help much in solving the problem. Still, the publication of the report in its Quarterly Bulletin has done us a great service. Certainly, we can hope that students of economics will be instructed in the way finance and money really operate, rather than the way one group of economists would prefer to believe they operate.
We should not be too optimistic here, but it surely will be embarrassing for university lecturers to continue to teach an incorrect version of how banks operate when that view is contradicted by one of the world’s most experienced central banks.
The views expressed in the Quarterly Bulletin are also notable for a quite different and even more compelling reason. The authors of the paper make a number of vitally important points.
First, it is now an incontestable fact that commercial banks can, and do, create money for investment purposes — and bank deposits play no part in this function.
This, however, leaves unresolved the question of whether the existing relationship between the central bank and commercial banks can adequately protect the real economy from the instabilities arising from irresponsible commercial bank lending practices.
Meanwhile, more radical ideas for restructuring banking and financial arrangements are waiting in the wings. It would be misleading to suggest that any of these is imminently under serious consideration.
Indeed, informed commentators agree that, for the moment, they are unlikely to find support in any current policy discussions.
That same group of commentators is, however, convinced that the serious flaws in existing arrangements remain unaddressed. They are therefore further convinced that another crisis, likely more extreme than the one recently experienced, is inevitable.
In that event there will be much greater pressure to reconsider the fundamentals of banking and finance.
Since the Bank of England research paper makes it clear that the source of commercial bank loans is the central bank itself, that almost certainly will be the starting point for discussion. Surely then the question will be asked whether the role of credit-creation might not better be undertaken by the central bank — or even by the government.
Once we accept that money-creation at the appropriate level is necessary in order to maintain a desired level of economic activity, the question then becomes how best to create new money without destabilising the economy.
With this in mind, the direction of any future “reform” of banking will certainly need to re-assess how private banks operate — since their existing practices will, by that time, have been decisively associated with economic instability.
In that event, a ready-made alternative is at hand in the form of the so-called “Chicago Plan”, an arrangement for promoting financial stability advocated by the University of Chicago in response to the 1930s Great Depression and the failure of American banks to contribute to economic recovery.
The plan has been revived in two exploratory discussion papers produced by researchers from the International Monetary Fund.
This writer outlined the first of these plans in two issues of News Weekly (December 8, 2012, and May 25, 2013). It was elaborated in a 71-page discussion paper, entitled The Chicago Plan Revisited (August 2012), published by the International Monetary Fund and written by IMF researchers Jaromir Beneš and Michael Kumhof.
These authors have taken their researches to a further level and are now even more convinced of both the merits and feasibility of the Chicago Plan. The plan, moreover, has gained added credibility now that the Bank of England has made clear how investment money is really created.
This writer intends to examine the current standing and merits of the Chicago Plan in a future issue of News Weekly.
Colin Teese is a former deputy secretary of the Department of Trade.
Jaromir Benes and Michael Kumhof, The Chicago Plan Revisited, IMF Working Paper: WP/12/202, (Washington DC: International Monetary Fund, August 2012).
Colin Teese, “Radical bank reform that could help end economic instability”, News Weekly, December 8, 2012.
Colin Teese, “A debt-free way to lift output and employment”, News Weekly, May 25, 2013.
Michael McLeay, Amar Radia and Ryland Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin, Vol. 54, No. 1 (2014), pages 1–14.