Understanding Money Creation as Debt

By Jon Crooks

Banks create new money whenever they make loans. 97% of the money in the economy today is created by banks, whilst just 3% is created by the government. So does this mean the banks are rolling in it whilst a large proportion of the population are suffering through austerity?

In early 2014, The Bank of England published a report explaining how money is created and how the flow of money is controlled. Contrary to popular belief money is not issued by The Bank of England, it is created when a private bank, like those on our high streets, makes a loan to a person or business.

But this doesn’t represent free money for the bank in question – and this is where your head explodes – because money is ‘destroyed’ when the loan or mortgage is repaid. And of course these are usually just numbers on a screen, not real money, as in cash, although the principle is the same.

The bank only gets to keep the money it makes in interest. That is the bank’s income, out of which it must pay running costs such as staff costs and property costs and of course the interest it pays you on your savings if you are lucky enough to have any.

All this of course is no doubt an eye-opener to those who believed the old theory still held true, that a bank lends money that already exists in the form of bank deposits or money borrowed from other banks.

This system of money creation as debt is how the modern economy works. The question is, should we be worried?

First, you need to get your head around the fact that money has to be produced all the time by someone. The analogy often used is that the economy is an engine and money is the oil that you put in it to keep all the moving parts working properly. Without it, the engine will seize up.

So does it matter who is creating the money in the first place?

The Green Party want to bring this process under state control. But arguably, how money is created and pumped into the economy is less important than how it is controlled and there are controls in place. Banks face limits on how much they can lend based on three main principles:

1) Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market and have to take steps to mitigate the risks with lending. For example, they must be careful who they lend to, how much they lend and under what circumstances; this is the fundamental principle of credit risk – the bank must be confident that they will nearly always be repaid in full to protect their profits. The regulators play a role here too in assessing whether individual banks have sufficient safeguards in place;

2) Money creation is also constrained by demand – households and businesses must want the money in the first place;

3) The ultimate constraint on money creation, in theory, is what we refer to as monetary policy.

Monetary Policy is how the state attempts to control the economy by manipulating interest rates.

If the money supply grows too fast, the rate of inflation will increase, products and services become too expensive, too quickly, wages can’t keep up and the currency loses its value, so the state increases interest rates. This encourages saving and discourages borrowing, hence less money is created by way of loans and mortgages, less money is spent and inflation reduces again – in theory.

In the UK, Gordon Brown as Chancellor handed over the power to set interest rates to the Monetary Policy Committee (MPC) of The Bank of England (BoE). Whilst the BoE has faced accusations of lack of transparency, the idea was that it removes political influence from the decision-making the process of setting interest rates, which in principle is a sound idea and should have got us away from ‘boom and bust’ by virtue of the fact that politicians wouldn’t play with interest rates in the run up to an election in order to win votes.

So what about the flip side, when the economy isn’t doing so well?

If the growth of money supply is slowed too much by banks reducing lending (as happened during and after the financial crisis of 2008), economic growth may slow (or the economy may even fall into recession) and deflation can also be a consequence, so interest rates are lowered to encourage borrowing. This is supposed to increase the money supply and get the economy going again. But following the financial downturn we had record low interest rates and yet the recovery was still very slow. This led to an additional measure known as Quantative Easing (QE).

As the banks were creating too little money to get the economy going again (and this could have been the banks being too risk averse in the new climate of heavier regulation and greater scrutiny – or people and businesses being too cautious to borrow – or a mixture of both), and as the BoE had already lowered interest rates as low as they could go (0.5% is considered to be the so-called effective lower bound), the BoE sought to provide further stimulus to the economy through QE. This is a process of buying non-bank assets such as pension fund or insurance company assets, through the creation of money. There is a common misconception here that this involved giving banks ‘free money’, whereas they only acted as go-betweens and didn’t benefit at all.

So how does this tie in with austerity? Does this throw the theoretical basis for austerity out the window?

Anthropologist David Graeber made this argument in a piece written for the Guardian in March 2014.

He made the point that the central bank could print as much money as it wishes (as it did through QE), but in reality of course it can’t print too much. This is why independent central banks exist in the first place. If governments could print money themselves, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Institutions such as the Bank of England and US Federal Reserve were created to carefully regulate the money supply to prevent inflation. This is why they are forbidden to directly fund the government, but instead fund private economic activity that the government merely taxes.

It is crucial to understand all this to understand why the government can’t simply create more money to pay off the national debt or build more hospitals.

In the modern economy, the government is just another borrower like you and me.

The crux of Graeber’s argument is this: The real limit on the amount of money in circulation is not how much the banks are willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. He argues that government spending is the main driver in all this.

This is true to an extent. Government borrowing, spent on public works, increases the flow of money, which increases economic activity, which leads to more tax revenue, which allows the government to pay down its debt and then borrow more and the cycle begins again. This is the basic principle of Keynesian Economics.

So the point here is that the problem isn’t the way in which money supply works; that’s just a means to an end. Yes, there are other ways to do this, which are explored more below. Actually, the real problem is the government’s ideological reluctance to borrow to spend and then to tax to recoup. Instead, George Osborne insists on cutting borrowing, cutting spending and cutting taxes on the assumption that lower taxes will drive greater activity in the private sector and boost the economy that way.

In Osborne’s mind everybody then benefits from increased prosperity, or so the theory goes. This is ‘trickle down economics’. A theory that has been utterly discredited by the growing inequality seen the world over the past few decades; ever since this brand of economics, now commonly referred to as neo-liberalism, took precedence.

This failure of government policy should be the focus, not how cash is pumped into the economy.

Blaming the Banks

The commercial banks as a group increased the money supply by 2.5 times between 1997 and 2007 by lending it into existence, and created a housing price bubble in the process as much of the money went into providing cheap mortgages to anybody and everybody.

When the bubble burst, a recession followed because people and governments were trying to pay down their debts, and so taking money out of the economy. Quantitive Easing was seen as a way of maintaining the money supply, otherwise the recession would probably have been a lot worse.

Of course, in this respect the banks were directly to blame for the financial crisis, but it is a bit like blaming a child for eating too many sweets when left alone in a sweet shop. Banks are private enterprises, motivated by profit, and if insufficiently regulated, they will run a mock

The real culprit once again is neo-liberalism. The deregulation of the financial sector in the 80s and 90s is widely recognised as having lead to the excessive risk taking by the banks that preceded and led to the crash.

We need to improve that regulation again and that is happening – though we need to make sure full banking reform is implemented, with no half measures. Given half a chance, Osborne will start to backtrack, just like he has with the bank levy.

Positive Money

Others seek a more radical approach to reforming the banking system. Following a campaign by an organisation called Positive Money, The Green Party adopted some of its principles. One of these is that…

“all national currency (both in cash and electronic form) would be created, free of any associated debt, by a National Monetary Authority (NMA) that is accountable to Parliament.”

The Greens worry that the size of our money supply – the total amount of money in circulation – is dependent upon millions of separate commercial lending decisions by banks. Although this view is a little jaundiced because for a bank to make a loan there has to be demand for that loan from a customer. As such, the money supply is dependent on millions of customers and businesses all acting independently.

The Positive Money and The Green Party approach is based on the fact the we need more money and less debt. They believe that the Bank of England should only be directing loans to productive activity.

Capital Constraints

Still with me? I’m amazed! I’m boring myself now, but hang on in there if you can. Capital constraints are another way to control how much banks lend. Under the present system bank lending is capital constrained, not reserve constrained. How much credit a bank can create is governed by the ratio of shareholders’ funds and retained earnings.

Each new loan drains an amount of capital proportionate to its risk weighted amount. Banks can only lend within their capital ratios. In the run up to the financial crash the capital ratios were much lower than they are now and were widely ignored anyway. Now capital requirements are much higher, which limits lending, and hopefully regulators are being tougher about enforcing them.

Regulators are also trying to move towards constraining leverage as well, which is the ratio of capital to deposits. As each loan creates an equal deposit, forcing banks to restrict their leverage would also have the effect of limiting lending.

Positive Money and The Green Party would like to change this. In effect their proposal is to introduce reserve constraints on lending: they want banks to obtain reserves in advance of lending and only lend up to the limit of those reserves. They also want to force all banks to obtain reserves only from term deposits or from central bank liquidity: current accounts would be excluded, and banks would not be allowed to lend to each other. The MPC or MPA would be tasked with making sure the Bank of England created enough money to fund lending without increasing inflation.

Conversely, the Independent Commission on Banking (ICB)’s proposal for bank reform envisages significantly increasing capital requirements, particularly for systemically-important banks with retail operations. The ICB rejected Positive Money’s proposals for bank reform on the grounds that they would be unnecessarily restrictive of credit. Instead, they proposed capital ratios for large banks that would go beyond the levels previously recommended by regulators.

Predictably, the banks objected to the amount of capital they have been asked to raise, on the grounds that it would hinder economic recovery.

These tighter regulations no doubt have reduced the appetite or ability of the banks to lend post crash and during the recession (as Vince Cable and The Daily Mail kept reminding us), but tighter regulations were necessary to ensure we don’t have a repeat of the financial crisis.

There is no doubt that bank reform was and continues to be necessary. There is also no doubt that it is and will continue to be painful, not only for banks themselves but also for their customers, both borrowers and savers. Savers are receiving poor returns on their investments. Borrowers are finding it harder to get credit and are facing higher interest rate margins and charges.

Is the Positive Money ‘s alternative banking system too radical?

There are other policies we can introduce in the meantime:

  • Banks tend to take on too much risk? Insist upon higher capital or liquidity requirements. This is already happening.
  • There’s too much “speculative” mortgage lending? Impose quantitative limits.
  • House prices are too high? Build more houses (especially affordable homes) and impose Loan To Value and affordability restrictions and rent controls
  • “Productive” firms are starved of finance? Create a state investment bank.

 

First posted on http://www.thebeardyguy.com on 9 July 2015