WHY BANKS DON’T CREATE MONEY

ending the myth of private money creation

economics@jnani.org

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"Many eminent economists, and a number of well-funded organisations, believe that high-street banks ‘create’ money out of nothing when they make loans. I believe that they are mistaken."

 

positive money

introduction

Hi, I am Mike King and my webpage is devoted to ending the myth of money creation by private banks. Many eminent economists, and a number of well-funded organisations, believe that high-street banks ‘create’ money out of nothing when they make loans. I believe that they are mistaken.

In the first instance I take the published ideas of the UK organisation Positive Money as representative of the ‘money out of nothing’ school, and show why I believe them to be wrong. You can download an 18,000-word paper I have written which details my arguments: Why Positive Money is Wrong: An Obligations Analysis of Broad Money Growth (PDF). Here I summarise the main points of it.

First a brief note on Darius Guppy who set out to wreak revenge on Lloyds of London after an investment there bankrupted his father. As a result of his attempted fraud Darius was imprisoned in a cell next to a counterfeiter and in 2010 wrote a piece for The Telegraph which is a classical expression of the idea that private banks create money out of nothing. Crucially, Darius equates what the banks do with the actions of his friend, the counterfeiter. I show that nothing could be more mistaken.


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"There is nothing a bank can do to ensure that any one loan it makes will create a net new deposit."

why banks don’t create money: the summary

All ‘money out of nothing’ theorists begin with this statement, or a variation on it: ‘Every new loan that a bank makes creates new money.’ (This one is taken directly from the Positive Money website.) It is incorrect, or rather it is only correct under very narrow conditions, making the statement highly misleading, especially for the general public unacquainted with monetary economics. For a start, while it may be acknowledged that this new ‘money’ is only an IOU, the distinction between such IOUs and cash is usually blurred. The holder of cash, the sole party, has a call on the market for goods, services or labour. In contrast, the counterparties of a loan, the two parties, have obligations to each other of which the lender’s are met as soon as the cash is spent, while the borrower’s remain outstanding until the loan is repaid. The creation of IOUs between counterparties is radically different to the creation of cash. With this in mind we can now sum up the conditions under which new bank IOUs come into existence and result in increased ‘broad money’ as it is termed (in the UK broad money is known as ‘M4’).

At the peak of the so-called ‘Great Moderation’ i.e. before the Credit Crunch, M4 growth was reaching as much as 10% per annum. Even then, 90% of loans by volume resulted in no new ‘money’ creation whatsoever. During steady-state or a recession that figure rises to 100%. Putting it another way, the increase in bank IOUs during periods of M4 growth is because new value is created in the economy allowing individuals to lend this value to banks which lend it to borrowers.

In 2008 M4 for the UK commercial banking sector stood at around £3 trillion. It is important to understand that, apart from cash, this £3 trillion was the sum lent by depositors to the banks, which the banks lent to borrowers, who spent it. In other words commercial banks hold negligible money but a mountain of IOUs. There is virtually no ‘money’ in the banks, and they certainly do not create it. They mediate IOUs between savers and borrowers, that is all.


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We can sum this up in a single key question that Positive Money needs to answer: If banks create money, why is it that they have to rent it from their depositors?

why Positive Money is wrong: the summary

Positive Money claims, for example, that private banks created £1 trillion of their own money between 2002 and 2009 by making loans, a profit technically known as ‘seigniorage’. If that were true then it would show as auditable bank profits and cause considerable inflation. Neither bank profits nor UK inflation is empirically observable on this scale. Also, if banks created money like counterfeiters, and this stood at £3 trillion in 2008, then their accounts should show this and an additional £3 trillion held by depositors. Nothing of the sort is empirically observable: there is only one lot of £3 trillion.

This and other errors that Positive Money appears to be making can be summed up:

  1. Positive Money says that profit (seigniorage) accrues to commercial banks on a large scale resulting from money-creation via lending. I say: Lending which results in new money creation is through increased economic activity, and the owners of the new money in the first instance are profitable depositors, not the banks. There is no seigniorage.
  2. Further to this Positive Money says that increased public debt and taxes, and decreased public services, arise from commercial bank lending through seigniorage foregone. I say: there is no seigniorage foregone.
  3. Positive Money insists that debt has to be created in order to facilitate economic transactions. I say: this confuses the netting (payment) system and the pooling (savings-loans) system. Only reserves (or cash, which is interchangeable with reserves) are needed for the payment system, a tiny sum in comparison to the total annual transactions in the economy (reserves are ~1/3000 – 1/7000 of broad money).
  4. Further to this Positive Money claims that increased savings reduces the percentage of money available as transactions. I say: reserves and transactions cannot diminish because of increased saving, but where reserves do become a smaller percentage of M4 over time it is because of increased efficiency in clearing.
  5. Positive Money claims that money, i.e. broad money or M4, is ‘rented’ from the banking system. I say: this confuses deposits which pay interest with loans that charge interest.
  6. Positive Money claims that commercial bank money ‘creation’ is responsible for house price rises. I say: the market has marked up house prices for many reasons, the most significant being the housing shortage.
  7. Positive Money believes that attempts to pay down debt lead to recessions. I say: causality runs the other way.
  8. Positive Money believes that an independent committee could better set the rate of money ‘creation’ than the commercial bank system. I say: the rate of money creation, or destruction, is not dictated by the commercial banks at all, but by the rate of growth or shrinkage of the economy.
  9. Further to this Positive Money believes that money ‘creation’ by commercial banks is undemocratic. I say: new money arises through increased economic activity and its level cannot be set by a committee, democratically accountable or otherwise.
  10. Positive Money believes in a concept called ‘debt-money’ as opposed to ‘debt-free money.’ I say: this distinction is vacuous. Money, whether held directly, or borrowed, is an obligation on the market to provide goods, services or labour. Unless that money is created ex nihilo by the state or a counterfeiter, it has arisen through prior provision of goods, services or labour.

We can sum this up in a single key question that Positive Money needs to answer: If banks create money, why is it that they have to rent it from their depositors?

Read the full paper: Why Positive Money is Wrong: An Obligations Analysis of Broad Money Growth (PDF).


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