A free ebook for your weekend perusal. The 7 Deadly Innocent Frauds of Economic Policy by Warren Mosler, a very experienced hedge fund manager who is one of the founders and proponents of the Post Keynsian Modern Monetary Theory school.
An excellent talk by Bill Mitchell, Professor of Economics at the University of Newcastle, New South Wales, Australia and a Post Keynsian specifically one of the founders and proponents of Modern Monetary Theory school. He gave the talk as the 3rd Joan Muysken Lecture at the Maastricht University School of Business and Economics.
As I noted last Friday, my posts on Friday are for weekend reading. This week I am highly recommending David Graeber‘s Debt – Updated and Expanded: The First 5,000 Years.
No time for a review but the publisher’s overview does present a very good idea about the issues covered in the book:
Here anthropologist David Graeber presents a stunning reversal of conventional wisdom: he shows that before there was money, there was debt. For more than 5,000 years, since the beginnings of the first agrarian empires, humans have used elaborate credit systems to buy and sell goods—that is, long before the invention of coins or cash. It is in this era, Graeber argues, that we also first encounter a society divided into debtors and creditors.
Graeber shows that arguments about debt and debt forgiveness have been at the center of political debates from Italy to China, as well as sparking innumerable insurrections. He also brilliantly demonstrates that the language of the ancient works of law and religion (words like “guilt,” “sin,” and “redemption”) derive in large part from ancient debates about debt, and shape even our most basic ideas of right and wrong. We are still fighting these battles today without knowing it
All the key themes I wish to explore on this blog, specifically over money and debt, are presented with anthropological evidence in support. You may or may not agree with his overarching model of virtual versus physical money eras and I too am undecided about that. Regardless the evidence over the origins and evolution of money and debt is very still very relevant.
 There is also an earlier edition freely available online, although I am not sure as to whether this is with the permission of the author or publisher – I will let you decide and search for that.
In yesterday’s post Do Banks Loan Deposits we very briefly looked at the conventional and popular understanding of how banks provide loans and stated that this is not how they actually work. So how, in fact, do they provide loans?
Sticking, momentarily, to a 10% fractional reserve requirement (FRR) and a £1000 deposit, the more likely scenario (still not quite correct but we will get there) is as follows.
The bank receives a £1000 deposit. It uses 10% of that – £100 – as the reserve against that deposit and uses the remaining £900 as the 10% reserve against a £9,000 loan! How can it do that? Where is the actual money, yesterday we saw how a £1000 deposit could be multiplied by 10 (given a 10% FRR) but this was through a deposit-loan-redeposit recycling process that reused the same money, in each case there were transfers of FRR reduced existing money.
We need to look at this from a balance sheet perspective in terms of assets and liabilities.
When you take out a loan, you strike a loan agreement with your bank, this is actually a promissory note – agreeing to terms of payment and in return the bank puts the loan in your current (or demand) account.
From your perspective the loan document payment schedule is your liability and the newly loaned amount in your account is your asset.
From the banks perspective, it is the other way around, the loan document is their asset and added to their assets (technically this is a debit to their assets but we will ignore subtle issues of double entry accounting for now) and the loan amount is their liability added (credited) to the liability side of their balance sheet. (Also this new asset should be worth more than their liability in Net Present Value or Discounted Cash Flow terms, otherwise they would be making no profit from the transaction but we can ignore that too for now).
Most importantly the bank loan department, having set up the loan, now hands over the adminstration of both interest and principal payments from you and loan payments from them over to the relevant accounts department. You will see an increase in your current account of the loan amount but until you use it is, from the bank perspective, an account payable but not yet paid! Yes, you are just a creditor of the bank, like all the other creditors providing utilities, services, goods or demanding salaries, taxes, bond coupons payments and so on. That is there is no actual transfer of money into your account!
How can this be? Is this an accounting trick? (Some did and still do regard this as quite dubious but we need to understand the operational issues first).
We need to see what happens when you make a payment from your account regardless of whether it is either from cash deposited or from the new loan added to it. Say you are paying all your loan from Bank A to an account holder in Bank B to purchase a car.
Bank A and Bank B have their own accounts at the Central Bank and need to work out the net transfer between them over a specified period, say a day and this transfer will happen in their central bank accounts.
Bank A sums up all the account demands on Bank B accounts and provides these to Bank B to approve (or bounce) those demands determining the net amount that Bank B owes Bank A. Similarly and in parallel Bank B provides the demands on Bank A in order to determine the net amount that Bank A owes to Bank B. It is the difference between these that is then transferred. The central bank acts as the clearing house for the banks to settle their balances.
The transfer of your new loan to pay for a car is just a minute part of this daily clearing and settlement process between banks.So thats how this credit can be created without your bank lacking resources to fulfill its obligation to you.
All these payments are managed in the money we already know as reserves. However, as customers of a bank, we cannot access reserves directly, we can only access bank credit. We can convert this credit to cash in, say, an atm, and a bank can convert deposited cash into reserves but we do not directly use nor access reserves at all.
So how much reserves are required in these banks accounts at the central bank? Surely at least 10% of credit outstanding? Well no. In the UK there is no fractional reserve requirement! And this applies in various degrees to many other central banks where the government has its own sovereign currency. So revisiting our momentary example posited at the beginning of this post, no reserves are required and so no deposit is required to create the loan. In other words, loans create deposits!
So the causality of loans and deposits is quite reversed. It is not deposit create loans but the loans create deposits. There is no Money Multiplier. This is the Credit Creation Theory of Bank Loans. The Fractional Reserve Theory of Bank Loans is a fiction. The Loanable Funds doctrine is false.
Now there are a number of important implications of this, all of which will be discussed in future posts.
There are times when a bank does not have sufficient reserves to settle its account with other banks but then there are various means to borrow those reserves such as borrowing from other banks with surplus reserves. We will discuss that shortly.
It would be overreaching to say that banks do not need deposits at all for credit creation, banks need a supply of reserves and typically the cheapest source for them has been deposits. Again this is a theme I will expand upon shortly.
If we are just a creditor what are our rights when a bank becomes insolvent? If there is no fractional reserve requirement, how does this affect bank liquidity and the threat of bank runs? If banks are not constrained by the money multiplier and deposits, what is to stop them lending an infinite amount of money (and creating inflation)?
If this is how banks work, why do most if not all mainstream macro economists still insist upon the Loanable Funds doctrine. And how does the Credit Creation Theory of Bank Loans affect their macroeconomic models?
If people want to reform banking and they do not understand how it work, should we listen to them? (There are plenty who argue for reform based on the correct understanding, this question, obviously, does not apply to them!)
Finally, I did say I did not want to reinvent the wheel and there is some very good literature on this topic. Still the themes just mentioned above I do need to specifically explore. The next post will include some decent references to back the claims made in this post.
A very simple question that to most people is obviously true. But is it?
The story in most introductory economics textbooks goes something as follows:
- Bank A receives a deposit of £1000
- With a reserve requirement of 10%, the bank keeps £100 in its reserves and can lend out £900.
- This can be used to pay an account in Bank B and the same process occurs.
A quick spreadsheet for an initial deposit of £1000 with a 10% reserve requirement and a minimum loan size of £100 shows the total loans:
Now a bank can aggregate deposits from different accounts and so carry on the loan process even with a minimum loan set to £100. The end result is that the original £1000 ends up in the banks (taken together) reserve accounts at the Central Bank and that £10,000 has been loaned out. This is the Money Multiplier – with a 10% reserve requirement money has been multiplied by 10.
It is important to note that no new money is created, rather it is the same money that has been circulating from deposit to loan with each bank retaining 10% of that deposit each time. (Of course, any bank could be involved in the deposit loan process multiple times, indeed it could even always be the same bank).
The argument is meant to be a demonstration of what is known as the Loanable Funds Doctrine within neo-classical mainstream macroeconomics, which implies that bank are just financial intermediaries, banks lend deposits, merely matching patient savers with impatient borrowers and, as such, can be left out of their models of the macro economy – the study of the economics of nations. They might be added in as a friction – the cost of doing business – as this service has transaction costs to the loans process (otherwise how would the banks generate profits), but they are not intrinsic to their models.
So when the Queen asked economists how they missed the Global Financial Crisis (GFC), part of the answer is because of believing the above, justified them in not modelling a key part of the financial markets and so they missed the signficant effect these had on the real economy.
In the next post I will show this is not how banks make loans and how they do.
Some concluding remarks on issues that should be discussed if the above were true but are rarely if ever discussed.
Clearly it takes time for the deposit-loan-redeposit process to occur. The above process was shown 34 times to get from an initial deposit of £1000 down to £100. Even allowing for aggregation across accounts, the velocity of this process needs to taken into account in deriving the money multiplier but I never see such a point being made. That point also leads to the Monetarist’s favourite Quantity of Money theory, but there they assume that this velocity is constant and quite low. (I will not explore this theme more for now, I have bigger fish to fry).
Another point that follows from the velocity issue is that the fractional reserve could be a policy parameter available to the Central Bank. For example, changing the reserve requirement from 10% to 5% could be a form of private sector stimulation, as the available loans at each stage would be 5% larger and so available sooner in having an effect on demand in the economy. Again I do not see this being discussed in such a way. (Of course, the original argument for a reserve requirement was to ensure banks were liquid enough to avoid bank runs but there are, as we shall see, other means of managing liquidity).
Thats all for now.
 I would be grateful anyone has any references to textbooks that don’t commit this error to add these in the comments, I have not yet found any within the mainstream economics approach.
This title is an inversion of what I mistakenly recalled as a very ancient line of poetry from the Roman poet Virgil, but turns out to be by the 19th century English romanticism poet William Wordsworth in his most famous piece of philosophical poetry – The Prelude – and it was about Isaac Newton:
Of moon or favouring stars, I could behold The antechapel where the statue stood
Of Newton with his prism and silent face,
The marble index of a mind forever
Voyaging through strange seas of thought, alone.
My inversion is meant to capture the problem that is a main issue that I plan to blog about and against. This being that most everyone of significance involved in the political and economic debate, over how to organise the macroeconomics of a country, is operating within the ideology of neoliberalism, that the debate is framed and constrained by the neoliberal mindset, to the degree that the questionable assumptions that form it, are not even explicit but so tacitly presumed and presupposed as to render the conception of alternatives, let alone the objective consideration and evaluation of those versus the mainstream, nearly impossible. TINA – There is No Alternative. It is too easy to operate and debate within this groupthink and I think it is also dangerous and harmful to our society to do so. It may well be the some proposals and policies within this framework are preferable to alternatives, but unless one has a more objective and scientific framework to evaluate them all, you have a biased and distorting set of spectacles that can lead you astray or worse. Time to throw these glasses away and get a better prescription!
Luckily we do not need a Newton to overturn and challenge this dominant paradigm. There are many – but not enough – researchers with a range of methods to challenge and overturn this paradigm and to present better alternatives, including showing what “better” means. These, as I mentioned in my introduction, are primarily from the Post Keynesian tradition and present, what I think, is a basis for a true science of economics, getting beyond, what I, deliberately and, yes, pejoratively call, the rational alchemist tradition of neoclassical macroeconomics, that provides the pseudo-scientific backbone of neoliberal politics.
So this is still early days in this blog and these thoughts have led me to update the tagline of this blog from “A UK focused sceptical take on economics, politics, science, ethics etc.” to “working towards a science of economics”. However this blog will still have a UK focus.
Now this is a very significant week in UK politics and economics as Parliament clears the way for Brexit talks. Even with the tagline change, I remain focused on UK issues and this is probably the most important one to discuss the next few years. However to get there I need to outline, in my own words, what the issues with neoliberalism are, in order to develop an explicit framework within which to discuss these issues. Whilst there has been much talk about banks, money and debt, especially since the Global Financial Crisis, wearing neoliberal spectacles makes it very hard to see what is really going on. So my… ahem…focus, for the next few posts, will be to look at the truths and fictions behind banks, money and debt.