Taken from the book What Went Wrong with Economics by Michael Reiss
This chapter will explain the basic money creation/destruction mechanism, both in theory and in practice.
“It’s a process that, even today, few bankers understand” – Milton Friedman – Nobel Prize winner in economics, 1976.
A few misconceptions about money and how much of it exists are worth considering. This is what most non-economists would assume:
“There’s a sum of money floating around in the economy, and people use it as a medium of exchange. The total amount of money out there is approximately fixed.”
Some people may have thought about inflation a little and may perhaps have a more sophisticated notion like:
“There’s a sum of money floating around in the economy, and people use it as a medium of exchange. The total amount of money out there would be constant except that the government regularly prints more of it, a few per cent extra per year, so the total amount of money in the economy only ever goes up.”
... and many people would be quite certain of this:
“Only the government has the power to increase the amount of money in the economy.”
None of these statements are true however, and without a good grasp of the truth about money creation and, very importantly, destruction, you have little chance of understanding economics. Having said that, it is remarkable that so many economists treat the money creation mechanism as a “technical detail” that is learned superficially and inaccurately at the start of an economics degree and then promptly forgotten about or disregarded forever more.
The creation and destruction mechanism is in fact rather strange and its widespread misunderstanding among the majority of economists is one of the main reasons that the economics profession has such a poor reputation among the sciences.
So let’s fix this right now and explain how money works:
The money system used throughout the world in modern times has evolved from something called fractional reserve banking. The way that this gets taught in most textbooks is significantly different to how the system works in practice but the textbook explanation is a perfectly good place to start. We shall explain this first and then point out the “real-world corrections” afterwards. Doing it this way will also give you an insight into how many economists are mistaken in their understanding of money.
Fractional reserve banking (as told in the textbooks)
When people “store” their money in banks, they know full well that the banks may use some of it to lend out to other people. This immediately begs the question: “What happens if I want to take all my money out again at short notice?” The answer is that the banks never lend out all your money, they keep some in reserve. So if you want to take it all out then the bank can give you back that fraction of your money that they didn’t lend out, with the remainder made up from the pool of un-lent-out parts of everyone else’s accounts. This then begs another question: “What happens if all (or a large fraction) of the customers come to take out all their money at the same time?” This possibility is known as a bank run. The answer is that the bank then has a big problem. It will not have enough money to pay out to all its customers. This is a serious situation, and to make this unlikely, governments over the years have tried a variety of schemes, the exact choice of which has profound implications for the whole economy. One way of doing this is for the government to make rules about exactly what fraction of people’s savings the banks must keep in reserve. The larger the fraction the less likely that the bank will ever be in a position where it does not have enough money in store to give to customers asking to withdraw their money. This fraction is known as the reserve requirement.
In our modern society, most of the money that we have to our names is not stored as a pile of cash under the mattress; instead almost all of it is in the bank. If someone handed you $100,000 in cash in the street, then (after you’d got over the surprise of being handed $100,000!) you’d probably feel very nervous carrying so much cash and be very keen to get that money to the bank as soon as possible in case you got mugged. You’d feel much more comfortable knowing that you had that money in the bank but that you were armed with a cheque book (or credit/debit card – a more modern equivalent) that enabled you to spend your money in dribs and drabs as and when you needed it. Keep this in mind as we consider the following:
Let’s say that the reserve requirement is 10% (a fraction often quoted in economics textbooks). Let’s also imagine that the world’s first ever bank has just opened up and their very first customer (Man A) comes in with $1,000 cash to deposit for safe-keeping. The bank would give him a cheque book and make a note on its computers that he can spend up to $1,000 with his cheques. Note that Man A can now spend up to $1,000 with his cheques.
Then a second customer (Man B) comes in wanting to borrow $900 (the maximum the reserve requirement allows the bank to lend out) in order for him to buy a used car. The borrower typically does not take out any cash; instead the bank just gives the borrower a cheque book and makes a note on its computers of the fact that the borrower is allowed to spend up to $900 with his cheques. Note that the bank still has the original $1,000 cash in its vaults.
Man A can spend up to $1,000 with his cheques
Man B can spend up to $900 with his cheques.
The “spending power” of the community at large has grown by $900.
Now the borrower goes to buy his car from Man C. He writes out a cheque for $900 and hands it over. Man B no longer has any money to spend. Indeed over the coming months or years he will gradually have to pay back the loan plus interest in instalments, but at the moment we are just considering the short term. Man C can now go to the bank and start up a new account. He stores (deposits) his $900 cheque and walks out with his own cheque book, the bank having noted that he is allowed to spend up to $900.
Man A can spend up to $1,000 with his cheques
Man C can spend up to $900 with his cheques.
Now this is where the craziness starts… The bank is then allowed to treat that $900 cheque as a new deposit and is allowed to lend out 90% (or $810) of that. The bank may lend it to Man D…
Man A can spend up to $1,000 with his cheques
Man C can spend up to $900 with his cheques
Man D can spend up to $810 with his cheques.
This process can repeat itself over and over, starting with a loan of $900 then $810 then $729 then $656.10 and so on and so on in an ever decreasing sequence. This can all happen because, with the use of cheques, the original $1,000 cash does not need to be touched; it can just sit there in the bank. The original $1,000 has been transformed into a series of cheques that can be used as a medium of exchange. These cheques behave as, and indeed are, real money. The sum total of this series of cheques turns out to be $10,000. This may seem like a strangely round number, but that’s just the way the maths turns out.
Figure 1‑1 The effects of fractional reserve banking.
As you can now see, fractional reserve banking is a system in which $10,000 of “money” can be created from a starting base of $1,000.
The story told so far has left out all sorts of complications, like there being more than one bank, interest being charged on loans and many other factors, but none of these complications alters the essential conclusion: The total amount of money (cash + cheques + other “electronic money”) available for society to spend can be a large multiple of the total amount of “real” money the system starts with.
Some people when first shown a description of fractional reserve banking assume it must be some mathematical sleight of hand, or perhaps some kind of conspiracy theory that the mainstream economists would dispute. But what has been described so far is not at all contentious, it is simply not widely known among the general public, or most politicians for that matter.
Some definitions: The $1,000 in the above story is part of what is known as the monetary base while the $10,000 is part of what is called the money supply. The “money” that can be spent with checks is sometimes referred to as cheque book money. The type of bank account described in this story is known as a demand deposit.
Fractional reserve banking is used all around the world today, but it doesn’t work quite as described in the textbooks. The textbooks tell a story which implies that the reserve ratio puts a hard limit on the total amount of money that can be lent out. The key error in the textbooks is the idea that money cannot be lent out if it would break the reserve requirement limits even for a second. The truth in the real world, however, is that the “limits” are intended to be enforced on average over an extended period, often a couple of weeks. The result is that loans can be made which break the limits temporarily and then the banks can seek out the money to comply with requirements later. The process of making the loans produces more money than is required for the reserves. So when the borrower spends the money it will come back to the banking sector, guaranteeing that some institutions will be in possession of excess reserves. This means that any banks that are short can seek out others with an excess and borrow the money in order to comply. The result of this process is that the reserve requirements are not a restriction on money creation at all. Remarkably few economists are aware of this leak in the system but it most certainly does exist and some very senior people right at the heart of the banking system are indeed aware of it.
Another factor usually unreported in the textbooks is that the reserve requirements have been diminishing over the years. Often they vary according to the types of loan, with some types having zero requirement. Many countries have simply abandoned statutory reserve requirements altogether and just leave it to the banks to decide for themselves how much to hold in reserve.
The supposed “restrictions” on money creation are now controlled by a new system called the capital adequacy ratio. This is a requirement that a bank is the owner of a certain collection of assets (known as the equity capital reserve) as a fraction of its loans. The composition of the types of asset that a bank is required to possess and the methods prescribed for determining their value are subject to a whole raft of ever-changing rules and regulations.
Given the fact that the old reserve ratio system did not limit lending in any way, you may be wondering whether capital adequacy fairs any better? Sadly the answer is no. For a start, banks can sidestep their rules with some accounting trickery.
Professor Charles Goodhart, a former member of the Monetary Policy Committee for the Bank of England, said in a recent television interview: “A lot of very clever people [who] were hired by banks with very large salaries worked for months to try and find very clever and ingenious and legal ways to get around the regulations.” The accounting tricks they came up with have been documented in many other books so we won’t go into any detail here, but the gist of the most common trick involved a process known as securitisation which works as follows:
Bank X makes a loan of $500,000 to Miss Jones for her to buy a house, thereby creating $500,000 of new money. Imagine that after having made this loan the bank is now right on the limits of how much it is allowed to lend out according to the capital adequacy rules. Now the bank is barred from making any more loans unless it purchases some more assets. But now it can “sell” the loan. The idea of selling a loan may seem a little strange, but remember that the loan is effectively an IOU from Miss Jones stating that she will pay back $500,000 plus interest over some period. This IOU is valuable and can be sold on to someone else. If some third party comes along and purchases the loan from Bank X then Bank X can claim that the loan has effectively (according to the strict letter of the capital adequacy rules) been “repaid” and so it is now free to make another loan without having to purchase any more capital. Notice that the $500,000 of new money has leaked out into the system. The capital adequacy rules have not placed any limit on money creation.
The conclusion from looking at the way reserve ratios and capital adequacy work in practice is that there is no limit at all on the amount of money that banks can create other than their ability to find people they can lend to and make a profit from.
Some may be thinking that perhaps the current monetary system is just too complicated for it to be worth putting in the effort to understand it unless you are training to be a banker. Surely it’s just a collection of boring technical details. Surely real-world, day-to-day economics can be understood perfectly well without paying attention to the monetary system. Unfortunately this is not the case. The millions of people who have lost their jobs around the world following the 2007/8 crash have lost their jobs very largely because of politicians’, and even central bankers’, failure to understand the behaviour of their own monetary system. This chapter will not go into the complex details of the rules and regulations (that could fill a large book by itself) but instead will try to convey simply the important characteristics of the system:
You will notice that in the description of fractional reserve banking, additional money gets created by the banks when they lend to people. The converse is also true, i.e. when people pay back their loans the money disappears.
Indeed in the lending and relending scenario described at the start of this chapter, if nobody else borrowed any more money and all that happened was that the borrowers gradually paid back their loans, the total amount of money in the system would shrink back down from $10,000 to $1,000. The idea of the total amount of money in an economy reducing may seem a little odd, but it does certainly happen. All that is required is for there to be a mass reluctance to borrow and the money supply will decrease as the existing loans are paid back.
The most dramatic example of a shrinking money supply was possibly that which occurred during the Great Depression. During that period the money supply in the US diminished by around one third. Unfortunately there are unpleasant consequences of a shrinking money supply and governments may take actions to try to avoid it. So historically big reductions are relatively rare. Sadly the actions that governments may take to prevent these reductions can also have bad effects as we shall see later.
Ballooning and shrinking
Hopefully you can see now that this potential ballooning and possible shrinking of the total amount of money in the economy by a very large factor could have a dramatic effect on how economies work. Indeed it is the ballooning and shrinking of the money supply that has dominated all the major financial crises since fractional reserve banking was invented. This issue shall be examined again in later chapters.
You might imagine that the reserve ratio and other regulatory requirements are well understood by virtually anyone that calls themselves an economist. Unfortunately this could not be further from the truth. It would be more accurate to say that the reserve ratio and the other rules governing bank lending are a ramshackle, arcane, ever-changing collection of regulations that get tweaked, botched and fiddled with as the banking industry limps from crisis to crisis.
The information about how it all works is very hard to come by. Any description of the system you find in economic textbooks is almost certainly out of date and was probably incorrect and/or woefully incomplete at the time of its printing. Just as one example, the 848-page Principles of Economics by N. Gregory Mankiw (third edition), one of the most popular standard economics textbooks sold in the world today, has a section on “The Monetary System” which makes no mention of the fact that the reserve requirements vary depending on the type of account, and makes no mention of the capital adequacy ratio at all. It does have a short section entitled “Problems in Controlling the Money Supply” which contains the following sentences:
Yet, if the Fed is vigilant, these problems need not be large. The Fed collects data on the deposits and reserves from the banks every week, so it is quickly aware of any changes in depositor or banker behaviour. It can, therefore, respond to these changes and keep the money supply close to whatever it chooses.
These soothing words give the impression that everything is under control. Any student reading this book is hardly likely to take any special interest in the money supply when it appears to be such a boring, stable beast. This attitude appears to be the orthodoxy in economics teaching. The textbooks may as well write: “The control of the money supply is a boring technical issue, please ignore.”
Now contrast this sentiment with the sight of Hank Paulson (the US treasury secretary at the time) metaphorically putting a gun to the head of Congress on the weekend of the 27/28 September 2008 and saying if you don’t create $700 billion of new money to give to the banking sector by Monday morning then the US economy will collapse. The behaviour, side-effects and control of the money supply are perhaps the most important things any economist could possibly study and it is about time standard economic textbooks reflected this fact.
You would expect that information on the current rules and regulations about money creation would all be public knowledge. You may think there would be websites that explain it all in plain English, but there are no such things. There are some web pages on the sites of some banks, but as with the economics textbooks, the information is woefully inadequate and/or out of date; usually both.The following sections have been omitted...
But what about the interest?
How old is our monetary system?
Can you have a fixed money supply system?
Demand and time deposits in a 100% reserve system
A mistake you may see in textbooks
Why don’t we use a fixed money supply system?
The precise rules and regulations covering money creation and destruction have been changing continuously, but for at least the period 1971 to the present we can make the following observations:
· Most new money gets created when it is lent out by banks.
· Money disappears when loans are paid back or defaulted on.
· The total money supply grows or shrinks according to the net balance between the following factors:
Table 1‑1 Factors that alter the money supply.