Banking yet again

Surely, the current banking crisis has exploded the myth about banks being able to create credit, i.e. money to lend out at interest, by a mere stroke of the pen but apparently not. Financial crises always spark interest in critics of the system. They see the problems of capitalism—like its vulnerability to crises—as primarily financial in origin. The whole point of production under capitalism is not the satisfaction of needs, but the accumulation of money. In other words, it’s impossible to separate the economic world into a good productive side and a bad financial side; the two are inseparable. The monetary surpluses generated in production—the profits of capitalist businesses—accumulate over time and demand some sort of outlet: bank deposits, bonds, stocks, whatever. It’s going to be that way until we replace capitalism with something radically different. What we need to ask is why people today tend to blame banks rather than capitalism as a whole.

No bank can lend more than it has, either as deposits or what it has itself borrowed. The idea that money is created through fractional reserve banking is more of a metaphor. Let's take a simple case.

I start a bank with a 10% fractional reserve. Alice deposits $1000 with my bank. I can then lend $900 to Bob, who wants to start a small business and pays the $900 to Charlie for equipment. Charlie deposits this money in my bank. I can now lend $810 to Debbie ...

Let's stop it there and see who has what. Alice "has" $1000 (which she doesn't), which is "in" my bank (though most of it isn't). Charlie has $900, which is also "in" my bank. And Debbie is holding $810 of actual money. (You might ask: what about the $190 reserve in my bank? But we've already counted that once, it belongs to Alice and Charlie.) So it looks almost as though I've turned Alice's original $1000 into $2710 just by moving it about and signing things. In that sense, whoopee, I've "created" money.

But note that there's still the same amount of actual cash. Debbie has $810 of it and I have $190 of it.

Furthermore, let's look at my balance sheet. I am holding $190. Bob owes me $900. Debbie owes me $810. I have assets of $1900.

But on the other hand, I owe Alice $1000 and I owe Charlie $900. I have liabilities of $1900.

Unless I charge interest, which I will, I'm not up on the deal. (Some argue that the only way that interest can be paid is by issuing more new loans. Presumably businesses borrow from banks to invest and expand. Higher profits from those expanded activities should more than cover the interest.)

Let's do one more sum. Alice has assets of $1000. Charlie has assets of $900. Debbie has assets of $810. I have assets of $1900. Total assets in the system: $4610. Whereas on the other side of the balance sheet, I have liabilities of $1900, Bob has liabilities of $900, and Debbie has liabilities of $810. Total liabilities in the system: $3610. Total assets minus total liabilities = $1000, which is what Alice started off with. So I'm only "creating" money by creating debt at the same time. Debt being, as it were, negative money.

Now, if this all still sounds suspicious to you, do the same math where Alice has $1000, she lends $900 directly to Bob who pays Charlie, Charlie lends $810 directly to Debbie, and everyone keeps their money under their mattresses.

The "creation" of money works out the same. Alice has $100 under her mattress and an IOU worth $900. Charlie has $90 under his mattress and an IOU worth $810. And Debbie has $810 in cash. Which makes $2710 --- again. It's the existence of lending and borrowing that "creates" the money: my bank has no special power to do so. What my bank did was to arrange the loans and act as a rather more secure substitute for the mattress. There's nothing particularly unreasonable (or profitable) about a bank doing this rather than people doing it for themselves.
Let's continue my story about Alice and Bob and the rest of the gang.

Suppose Alice, Charlie, and Debbie all decide to use their money to buy derivatives from Edward. Alice and Bob both write him checks, and Debbie pays cash.

And now between them they own $2710 worth of derivatives, even though the system of transactions is based on only $1000 of actual cash. And at this point I, the banker, still have net assets of $0 and hold only $190 in actual cash.

(Moreover, when Edward pays the checks he got from Alice and Bob and the cash he got from Debbie into his account at my bank, then I'll have $1000 in cash and liabilities (to Edward) of $2710, and can start looking around for someone who wants to borrow $729 ... quite possibly to buy some more derivatives.)

The money still isn't coming out of nowhere, it's coming from the obligation of people who borrow money to pay it back. And again, the bank as such is not "creating" the money, it's the fact that people are lending and borrowing that does that. The bank is just the middleman. What is never emphasised is that money is used and re-used and re-used again to create new and more deposits. One of the key features of capitalism is that money circulates. The banking system has not created any money out of nothing. It is still dependent on individual banks only being able to lend out what has been deposited with them or what they themselves have borrowed. The same coins and notes can be used for many different transactions including more than one bank deposit. These will have been generated by the mainly productive activities in which the series of loans can be assumed, in the real world. The banking system has created more “money” only if you regard “bank deposits” as money. If you don’t, all that has been shown is that currency has circulated in that the whole process depends on the initial deposit or injection of cash being recycled as further deposits by depositors (as opposed to by banks creating a credit line). So, neither an individual bank nor the whole banking system can lend more than has been deposited with it. All this assumes an expanding economy, since where is the money to repay the loans and the interest on them to come from without being assured of which the banks would not lend the money in the first place? So the banking system does not create money to lend out of thin air but can only lend out money deposited with it and then only when economic conditions permit it.

In 1931 the MacMillan Committee Report into Finance and Industry was written in large part by John Maynard Keynes and gave credence to the myth but you may be interested to know that a significant minority of the Committee at the time opposed the view promoted by Keynes and several of those who went along with it did not understand or realise the implications of what they had signed up to. Keynes in The General Theory of Employment, Interest and Money (1936) effectively abandoned the view he had promoted on the MacMillan Committee just a few years previously. What the simplistic model used in the Report had assumed was that banks kept a certain 'cash ratio' back for customers to access as a proportion of whatever is deposited with the bank (10 percent was assumed at the time though these days this would be far less). They then assumed that the whole of a new deposit by a customer could be held in cash to underpin the creation of credit nine times its value (i.e. operating with a 10 percent cash reserve an initial $1,000 deposit would enable the creation of $9,000 worth of credit). It also then assumed that this cash was never called upon in practice. In other words, for the model to hold, they correctly assumed that banks kept cash in reserve for customer use, but then assumed that nobody ever withdrew any of it. Samuelson and others reject the approach used by the MacMillan Committee in favour of a multi-bank model. However, this model does not demonstrate anything more than that currency circulates around the banking system and can be used more than once in the process of customers' creating bank deposits - as opposed to banks somehow creating multiples of credit from these deposits.

Everybody accepts that hard cash - currency - is money. The first point to be clear on is the definition of "money". Up to WW2 there was more or less agreement that money was "currency" (notes and coins). Since then "bank loans" have been regarded as money. This is okay as long as the same definition is kept to throughout the analysis. But it should be noted that, even today, conventional economics has felt the need to distinguish between M0 (mostly currency) and M1 (which is M0 + bank loans) (M2, M3 and M4 are M1 plus various other types of loan). people say "banks create money" this is true (by definition) if money is defined as M1. But it wouldn't mean that banks create all money, as M0 is created by governments and/or central banks. Having said this, it is true that only 3% of M1 is currency and 97% bank loans. The case against regarding both bank loans and currency as money is that they come into being and behave differently. Currency circulates. Bank loans don't. In fact, although M0 is only only about 3% of M1 it can be used to make payments, etc (including bank deposits and bank loans) of many times its face value.

Some might be prepared to include cash deposited in banks as well. Others though widen the definition to just deposits by people of the money they already possess but any account for which the holder has a cheque card (transactional accounts hence no or little interest or in fact a users fee imposed), i.e. including credit lines granted to those who banks have lent money to “debt money”. “Money creation” is now about “bank deposit” creation"! Fractional reserve banking leads to the creation of more “money” in the sense of more bank deposits for banks have learned that when cash has been deposited with them they only need to keep a part (a “fraction”) of it as cash as a “reserve” to deal with likely cash withdrawals; the rest they can lend out.

If $10,000 is deposited in the banking system, initially say in one bank, that bank can make loans (create credit line bank deposits) of $9000. When it is spent this $9000 will be re-deposited in other banks which can then lend out 90 percent of this, or $8100; which in turn will be re-deposited in banks, allowing a further $7290 to be lent out, and so on, until in the end and over the period, a total of $90,000 new loans will have been made. This shows how the Fed can practise “fractional reserve banking” to control the amount of “money” (currency plus bank deposits) in the economy. The Fed, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in US government securities. In today’s world of computerized financial transactions, the Fed pays for the securities with an ‘electronic’ cheque drawn on itself. The Fed has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances.The bank from which the Treasury bills were purchased now has reserves above the 10 percent limit and so can turn the $10,000 into loans, which starts the process described above rolling, leading to an extra $90,000 bank lending. The one bank that can create money out of thin air and that is the government-owned or controlled central bank. It does so by mere decision, by creating more "fiat" ("let it be") money and introduces it into circulation by using it to buy government bonds off commercial banks ("quantitative easing" is a variety of this)

Banks don’t just borrow from individual depositors, or “retail”. They also borrow “wholesale” from the money market. It is in fact the difficulties they have experienced here with the inter-bank lending that has revealed that they cannot create credit out of nothing. Banks are reluctant to lend on the money market for fear that the borrowing bank might turn out to be insolvent. Which meant that one source of money for the banks to re-lend to their customers had shrunk. So, deprived of this source of money, the banks had less to lend out themselves. Which, of course, wouldn’t have been a problem if they really did have the power to create money to lend out of nothing.

The on-going banking crisis problems arose because they wished to lend out more than had been deposited with them and to do this they had to borrow 'short' on the money markets to finance their long-term loans and mortgages. The game was up - and no-one could just tell them to go away and create some more multiples of credit from their deposits! There is no easy way out of this crisis for banks by attracting some more extra deposits and then creating vast multiples of credit from them to magically cover their losses.

It seems to be rather that because money so dominates people's lives and that they associate money with banks that people's resentment at their money problems is aimed at banks. Of course no banking or monetary reform is going to stop money dominating people's lives.

"I think that people have learned that money is not made in banks. It is made by real people working hard at real jobs. Actually, deep down we knew that all along. We just have to learn it again." Asbjorn Jonsson, an Icelandic fisherman, in a week when Iceland was effectively a bankrupt state. Its banks owed the world an astonishing £35billion - 12 times the size of Iceland’s gross domestic product and £116,000 for every man, woman and child.