Creating money out of nothing
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OK I have a conundrum. There is a neat little argument to explain how banks can ‘create money’ that has been around for a while and needs answering. In my own view it is somewhat confused because what is being created, if anything, is credit, not money. But, nevertheless, it claims to explain how banks can advance money to borrowers that they don’t have. It’s a development of an old argument but with a neat little twist. It’s logically coherent and quite compelling in its own way (unless I’ve missed something obvious). Logical coherence of course does not demonstrate that it actually happens in the real world, but as it would be a neat little earner for the banks (if it were true) you would expect there to be some structural explanation of why it can’t happen, and frankly, I can’t think of one. (Well, I can think of a couple of explanations, but my thinking is not yet clear enough to give me confidence in them.)The argument goes like this. Banks can lend money out of nothing so long as all banks in the banking system do the sam. They can do it because every loan creates a deposit. (So far so good). What needs to happen though is that the deposits need in the long run to be distributed around the banks in the same proportion as the loans. At the end of the day the money each bank owes to each other bank is totted up and the balances are settled by interbank (BACS) payments. Now, the banks can keep this system in balance by checking their BACS payments every night. If they find that they are regularly paying more to other banks than they are getting back, then clearly they are lending more than is coming back in deposits (which are clearly going to their rivals). They can do two thing to put this right: they can either cut back on their lending: or, more commercially, they can try to increase the number of deposits (by marketing themselves more effectively). This argument is neat because it explains why banks must keep deposits coming in even though they are lending money out of nothing.So, if we say it doesn’t happen, why doesn’t it?If there is a weakness in the argument it probably lies in the competitive nature of the banks. I can get a broad sense of what might happen but I haven’t been able to put together a clear model. Any ideas.I’m putting this out into the ether in a spirit of rational enquiry. It would be nice to have a clear, structural explanation of why this couldn’t happen – if there is one. I’ve scoured our literature and I cannot find a direct counterargument against it. We should have one.And why suddenly will this damn thing not let me put in any paragraph breaks.
But, in your example, the banks are not creating loans “out of nothing” but out of deposits (real deposits by people with money, not “deposits” they open for borrowers). The process can only keep going if deposits do. (And every loan does not create a deposit: money loaned by one bank may find its way into another bank, but there’s no guarantee that all of it will).By co-incidence I’ve been having a e-mail exchange with someone who puts a far more subtle theory of banks creating money “out of nothing” which does have something in common with your scenario. Not the one we were entertained to at the meeting with Zeitgeist which claims that a single bank can create money to lend by a mere stroke of the pen, but one involving the whole banking system including the Bank of England. This is how he put it:
Quote:When the commercial bank makes an advance, it simultaneously creates a deposit: i.e.money is put in the borrower’s account. That deposit is then used by the recipient of the advance to buy things: it is money. Of course, when the recipient of the advance uses it to buy things from a customer of another bank, the bank that created the advance has to settle with the other bank by using with a claim on the central bank – that is how banks settle with one another. So it must either borrow from the central bank or own reserves at the bank (at present, the banks own vast reserves at the central bank, because of QE. But that’s not usual). Provided the commercial bank is deemed solvent (and often even when it is not), the central bank will always lend it the needed central bank money, at its official rate. So the central bank will provide the needed backing to the money created by the commercial bank. In this way, the money supply grows and normally net transfers of reserves between banks are very small, though that changes of course with a run on one of them.Now suppose the central bank thinks the money supply is growing too fast, then it will raise its interest rate. That will then become the rate charged by the bank on its loans (it doesn’t want to charge less than it pays the central bank on money it needs to borrow). That will reduce the number of willing borrowers from the bank and the growth of the money supply will slow.The answer then is that commercial banks can create money out of nothing, because the central bank will always lend a solvent bank the CB money it needs to convert its liabilities into CB money, at par. The commercial bank tail wags the CB dog, so to speak. They do not act on their own. They act in conjunction with the CB.Thus, all money in a fiat money system is created out of nothing. Nothing backs it. It is the joint product of the commercial banks and the central bank, acting together.Since nobody (not even us) denies that a central bank can create money “out of nothing” (that’s what “fiat money” is) this theory is not necessarily based on a silly fallacy. It does not claim that a single bank on its own can create money out of nothing. What it is saying is that a bank (in the system) can risk making a loan without first having the money because it knows that at the end of the day (literally, when balances between banks are cleared) it can get the money from the central bank. And of course it’s the central bank that’s doing the creating of any money out of nothing. Also, the commercial banks’ loans are in fact covered by something (a loan from the central bank).This said, this model is challenged by other economists, notably Paul Krugman who deny that this is the way the banking system works and that the commercial bank tail does or could wag the central bank dog. This is an argument about the best way to control banking lending (via interest rates or via central bank controls) which, as socialists, we needn’t get into. Personally, I’m inclined to agree that there are limits to the system working in the way described above.The other objection to this theory is the language in which it is expressed. By talking about “banks” being able to create money out of nothing this allows the real banking cranks to use this in support of their nonsensical theory that a single bank can do this on its own.
Hi Adam
I’m rushing to get to work so have only skimmed your response, but the thing I’ve picked up is that in the scenario I have presented it is not necessary, in the normal course of business, for a bank to call on central bank reserves for this system to work. All that is required is that over time if bank A can ensure it owes bank B the same that bank B owes bank A etc (ie each bank manages to ensure a roughly equal number of deposits that arise from previous ‘loans’). In other words, over time the banks break even on the deal amongst themselves. And there is a mechanism to do this. By monitoring its BACS payments and adjusting its lending accordingly, or marketing itself better to increase deposits, the whole system can totter on. I can see various problems in managing this but I’m not sure they are necessarily insurmountable and therefore why this process cannot take place. If it can’t then there needs to be an immediate mechanism to prevent it – otherwise the banks would have exploited it. Alternatively, there needs to be a more fundamental explanation of why it can’t happen. Given my current state of knowledge/understanding I can’t work out what that is.I suppose your ideal system could work, but it assumes two things:1. Even if a bank does make a loan without having the money to cover it, it is expecting to get this by the end of the day. But this money would be coming out of payments due to it from other banks. So the loan would be being backed by funds the bank had (or got the same day).2. That, when it comes to settlements between banks at the end of the day, no bank finds itself in the red (surely this is highly unlikely except as an accident). So unlikely in fact that this is why the Bank of England is involved as a backstop in this process supplying any missing liquidity, as explained here on the Bank of England’s website:http://www.bankofengland.co.uk/markets/Pages/paymentsystems/default.aspxInsofar as any money is being created “out of nothing” it is being done by the Bank of England not the commercial bank.
Hud955 wrote:They can do it because every loan creates a deposit.In Walter Leaf’s ‘Banking’ there are some tables which disprove the empirical validity of this claim, how true this is in the present day I don’t know, but the data is certainly out there.
Quote:Thus, all money in a fiat money system is created out of nothing. Nothing backs it. It is the joint product of the commercial banks and the central bank, acting together.Isn’t state created money ultimately backed up by the fact that the state has never defaulted on gilt and bond payments? This is why board game money or hand written IOUs do not circulate as currency.To really understand what’s going on I think you need to be talking about assetts, liabilities, credit etc.
Hi both
Thanks Adam. I don’t think it would be necessary for banks to break even every night after BACS exchanges had been made for this to work. They would only have to achieve that in the medium term. That’s why they would need to monitor their BACS payments and adjust their lending/marketing accordingly. But they would do that anyway.
Your point that an individual bank is expecting to get a deposit at the end of the day to cover its previous loan is obviously true. It means that though there is a risk to an individual bank, it’s only a small one because it would get very rapid signals -and it could balance its books by adjusting its lending policy in the short term and its marketing in the long term. But collectively, it would still be the case that the banking system as a whole was issuing loans that were unbacked by previous deposits. The deposits they do receive would be covering previous loans and not any future ones, and like their loans, deposits of this kind are newly minted digits that have no backing in cash either from depositors, bank reserves or from a central bank.
Theoretically, the banking sector could go on doing this for as long as they liked, so long as individual banks reacted rapidly to the BACS payments and kept things in balance. Of course banks will not be trying to keep things in balance, they will be trying to outdo their competitors – making the greatest number of loans to guarantee them future interest payments and competing for the greatest market share of deposits, which would result in BACS in-payments from other banks. I guess, if anywhere, it is at this point of competition between banks that the system would break down. If a particular bank that was getting an average share of deposits stopped making loans, then it would not be getting much in the way of interest, but it would be getting a lot of BACS payments every night. That would force other banks to cut back on their own loans to prevent a drain on their cash, and so on.
One of the interesting aspects of a scenario like this is that If you follow through the logic of what would be happening, the digits ‘created’ only have a very temporary life, because, summoned up out of nothing, once paid back, the loan account they came from would also return to nothing. All that is happening here is that a debt has been created that will be paid back out of future earnings, and ultimately out of future production.
I think this is nevertheless a troublesome argument because we frequently make the case that the reason banks constantly tout for new depositors is that they need deposits before they can lend. But as this scenario shows, that’s not necessarily the case. Banks may need deposits because they can’t lend without them, but euqually, they would need them to prevent a drain on their cash through BACS payments to other banks? It also offers an alternative interpretation of empirical evidence showing that banks do not, on the whole, have more money in their loan accounts than they do in their deposit accounts and cash reserves.
Ho Hum! Am I missing something? I’m acutely aware that I’m making a logical argument here and don’t have much practical understanding of the banking system. But this is bugging me.
Hi Darren, that’s a useful reminder from Walter Leaf. Thanks for that. I’ve been so carried away trying to puzzle this one out that I had forgotten that loans don’t always result in a deposit (obviously true) and haven’t yet considered what its implications might be. I would imagine, though, that it is less true today in the age of credit and debit cards and digital money than it was in Walter Leaf’s time.
I’m not so sure about the language of assets and liabilities and credit, though. I’ve tried to think the same scenario through using that terminology, and though it’s useful, I also find it becomes easier to make category errors.OK, it seems like I’m the only person on here that is bothered by this. My problem is that if I were faced with this argument, I would not know how to meet it – at least, confidently. I don’t even know whether there is any evidence or form of reasoning that is sufficient to meet it. As I’ve never thought that just putting a counter-argument or merely asserting the argument’s contradictory was very ‘scientific’ ( especially when the same evidence can be used to support both views) this leaves me feeling rattled. I’m feeling rattled, not convinced that this whole silly argument is correct because there are broad indications that suggest there is, indeed, something wrong with it. But I can’t work out the detail.
So, this is a frustrated moan that nobody is prepared to give me an argument on this to test the bloody thing out.
Robin? You out there?
Normally I would be game but right now and for the next few weeks I’m having to write “The link between wages and productivity – an econometric comparison of different industries” set to be a bestseller for sure!
LOL. Thanks for the offer, D. Appreciated. Good luck with the essay/dis? If the answer isn’t 42, let us know. Could be… Well, Good luck!
You keep saying that the scheme you are thinking about (where banks all extend credit at the same rate) has nothing in common with what happens today but I think it has. See if you can spot the error in this explanation by Positive Money of why Northern Rock went bust. According to them, it was because it extended credit too much and too quickly and so ended up with a continuing negative balance when the clearings with the other banks were over.
ALB wrote:See if you can spot the error in this explanation by Positive Money of why Northern Rock went bust. According to them, it was because it extended credit too much and too quickly and so ended up with a continuing negative balance when the clearings with the other banks were over.Well, I’m not knowledgeable enough to spot the error but the discussion is interesting and the explanations given by one Frances Coppola seem pausible enough…
I think the simplest way to approach this is to ask: why are banks different from any other firm?You can do the “Bank creating money” story for any sort of business. A retailer could extend credit to customers (and buy its stock on credit, or even future options on not-yet existent stock), but this simply wouldn’t be creating money. Thus: I have £100 (of my own capital). I’m a good salesperson, I buy £90 worth of stock and sell it all (on credit) and keep £10 cash in till. I then buy another £90 worth of stock, on tick, which I then sell on credit for £90. I then sell another £90 worth and then place the order with my wholesaler (and arrange credit for myself). By this point I’m owed £270, so can extend my order to the retailer by another £90; but I’d better start getting some cash in soon or I’m in trouble. The only qualitative difference is that banks are hooked up, ultimately, to a mint.
Hud955 wrote:They can do it because every loan creates a deposit. (So far so good).And herein, like says law, is the Achilles heal. Why does a loan create a deposit? What if I draw my loan out as cash? A certain percentage of loans will go out into cash and will not come back into the banks but will continue to circulate.
ALB wrote:You keep saying that the scheme you are thinking about (where banks all extend credit at the same rate) has nothing in common with what happens today but I think it has. See if you can spot the error in this explanation by Positive Money of why Northern Rock went bust. According to them, it was because it extended credit too much and too quickly and so ended up with a continuing negative balance when the clearings with the other banks were over.Hi Adam. Thanks for this but I can’t open the link. Have you got an address?
Hud955 wrote:Hi Adam. Thanks for this but I can’t open the link. Have you got an address?http://www.positivemoney.org.uk/2012/07/if-banks-can-create-money-how-come-northern-rock-went-bust/
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