One of the root causes of the global financial crisis is that mainstream economists do not understand how banks work. Like most people they believe that banks act as convenient financial intermediaries, receiving deposits from savers and lending this money onto others. While this seems intuitively sensible it is wrong. When banks extend credit they simply increase the borrowers current account balance by the loan amount. They do not "get" this money from anywhere. It is literally created out of thin air. Instead of deposits being required for loans, loans actually create bank deposits.
This can be a difficult concept to grasp so here is an analogy to help explain it. Imagine that the landlord at your local pub allows you to buy drinks and food on credit, i.e. run up a tab. Now imagine that he extends credit to you before you spend it. To do this he tells you that you have £10 to spend in his pub which you have to repay at a future date. This is equivalent to having £10 in your 'account' with him. Imagine that he allows you to use this credit to pay £5 to another of his customers, who also has a tab or 'account'. To make the payment the landlord decreases your 'account' by £5 and increase the other customer's 'account' by the same amount. Of course the £10 loan has to be paid eventually but meanwhile you are able to use the credit that this loan created as money. The landlord is now acting like a bank. Indeed, anyone can make these types of arrangements and so act as a bank of sort. All that is needed is a reliable and mutually acceptable way of keeping track of these debt obligations or IOUs, which usually achieved by recording them in writing. There is evidence that these obligations or IOUs were the first form of money and recording them was one of the first uses of writing.
The main difference between all of us and a bank is that the £10 of credit that banks create when making a loan can be spent almost anywhere and converted into cash, whereas the £10 credit that the landlord extends to you can only be spent in the pub or transferred to another person to spend in the same pub. Why is bank money accepted everywhere? The short answer is possession of a banking license. The long answer requires an explanation of the payment clearing system that only licensed banks can use. If you spend money loaned to you and thus created by a bank the money is transferred through this payment system. All licensed banks have accounts at the central bank called reserve accounts. Payments between parties are settled by transfers between these reserve accounts. For example, if I use my debit card to pay for a meal at a restaurant the money is transferred as follows. My bank reduces my current account balance by the amount of the payment. It simultaneously transfers the same amount from its account at the reserve bank to the restaurant's bank's reserve bank account. The restaurant's bank then increases the amount in the restaurant's bank account, less any charges.
Instead of making a transfer between reserve bank accounts for every individual payment the Bank of England keeps a record of all gross transactions between all banks over a 24 hr period and only transfers the net amounts. Transfer between any two banks will occur in both directions and will mostly cancel each other out. It is only necessary to transfer the difference between these amounts - the net amount - between the two bank reserve accounts, which will be a tiny fraction of the gross transactions.
Central banks can create reserves in unlimited amounts and so can and will always ensure that interbank payments will clear. They will also convert bank reserves into cash. This enables customers to convert the money created by banks into cash.
In summary, the central bank provides a clearance system which ensures that bank money can be used to make any payment and convertible into cash.
So when banks make a loan to you they create spendable money out of nothing. In return you acquire a debt of the same value, which you have to pay interest on.
Almost all new money is created this way. At the moment 97% of the money supply in the UK is this kind of bank money. As a result, increases in the supply of money are accompanied by equivalent increases in the amount of debt, on which interest is paid. In effect, we rent our money supply from commercial banks.
Importantly, banks have few constraints on how much new money they can create by extending loans. The main factor that determines whether they extend a loan is whether the person that they are lending the money to can pay back them back and meet the interest payments. That is why they prefer to make loans towards the purchase of an asset such as a house, which can be held as security in case the borrower defaults. Even this limit can be removed if banks can sell the loan onto someone else. This is known as debt securitisation.
Most economists unfamiliar with the intricate details of the payments system think that central banks control the amount of bank lending by, for example, changing the amount of reserves held by banks and/or by requiring banks to holding a minimum amount of reserves that is a certain fraction of their deposits. The reality is that most central banks either do not have this requirement (eg Canada) or allow commercial banks to increase their reserves after they have created the new deposits, by borrowing either from other banks who have surplus reserves or from the central bank itself. Banks create money first and acquire the necessary reserves later, and these reserves are always available. At worst they have to be borrowed from the central bank at the base rate set by central banks.
There is another constraint on lending which is called the Capital Adequacy Ratio (CAR). This is a requirement for the banks to ensure that their assets (e.g. loans) exceed their liabilities (e.g. bank deposits) by a certain minimum margin. However, the CAR does not act as a restraint as long as banks make a profit. If the CAR is 5% then retained profits of £5 billion enable a bank to make £95 billion of new loans.
In conclusion, commercial banks create almost all new money, through credit creation. We rent our money supply from banks. This explains why economic growth has been been accompanied by huge, unsustainable increases in private sector debt and asset price bubbles, why the global financial crisis was inevitable, why the recovery has been so weak, and what needs to be done to restore growth and reduce private sector debt. The failure of mainstream economists to understand the role of banks explains their failure to predict the GFC, and their inability to come up with effective solutions.
This can be a difficult concept to grasp so here is an analogy to help explain it. Imagine that the landlord at your local pub allows you to buy drinks and food on credit, i.e. run up a tab. Now imagine that he extends credit to you before you spend it. To do this he tells you that you have £10 to spend in his pub which you have to repay at a future date. This is equivalent to having £10 in your 'account' with him. Imagine that he allows you to use this credit to pay £5 to another of his customers, who also has a tab or 'account'. To make the payment the landlord decreases your 'account' by £5 and increase the other customer's 'account' by the same amount. Of course the £10 loan has to be paid eventually but meanwhile you are able to use the credit that this loan created as money. The landlord is now acting like a bank. Indeed, anyone can make these types of arrangements and so act as a bank of sort. All that is needed is a reliable and mutually acceptable way of keeping track of these debt obligations or IOUs, which usually achieved by recording them in writing. There is evidence that these obligations or IOUs were the first form of money and recording them was one of the first uses of writing.
The main difference between all of us and a bank is that the £10 of credit that banks create when making a loan can be spent almost anywhere and converted into cash, whereas the £10 credit that the landlord extends to you can only be spent in the pub or transferred to another person to spend in the same pub. Why is bank money accepted everywhere? The short answer is possession of a banking license. The long answer requires an explanation of the payment clearing system that only licensed banks can use. If you spend money loaned to you and thus created by a bank the money is transferred through this payment system. All licensed banks have accounts at the central bank called reserve accounts. Payments between parties are settled by transfers between these reserve accounts. For example, if I use my debit card to pay for a meal at a restaurant the money is transferred as follows. My bank reduces my current account balance by the amount of the payment. It simultaneously transfers the same amount from its account at the reserve bank to the restaurant's bank's reserve bank account. The restaurant's bank then increases the amount in the restaurant's bank account, less any charges.
Instead of making a transfer between reserve bank accounts for every individual payment the Bank of England keeps a record of all gross transactions between all banks over a 24 hr period and only transfers the net amounts. Transfer between any two banks will occur in both directions and will mostly cancel each other out. It is only necessary to transfer the difference between these amounts - the net amount - between the two bank reserve accounts, which will be a tiny fraction of the gross transactions.
Central banks can create reserves in unlimited amounts and so can and will always ensure that interbank payments will clear. They will also convert bank reserves into cash. This enables customers to convert the money created by banks into cash.
In summary, the central bank provides a clearance system which ensures that bank money can be used to make any payment and convertible into cash.
So when banks make a loan to you they create spendable money out of nothing. In return you acquire a debt of the same value, which you have to pay interest on.
Almost all new money is created this way. At the moment 97% of the money supply in the UK is this kind of bank money. As a result, increases in the supply of money are accompanied by equivalent increases in the amount of debt, on which interest is paid. In effect, we rent our money supply from commercial banks.
Importantly, banks have few constraints on how much new money they can create by extending loans. The main factor that determines whether they extend a loan is whether the person that they are lending the money to can pay back them back and meet the interest payments. That is why they prefer to make loans towards the purchase of an asset such as a house, which can be held as security in case the borrower defaults. Even this limit can be removed if banks can sell the loan onto someone else. This is known as debt securitisation.
Most economists unfamiliar with the intricate details of the payments system think that central banks control the amount of bank lending by, for example, changing the amount of reserves held by banks and/or by requiring banks to holding a minimum amount of reserves that is a certain fraction of their deposits. The reality is that most central banks either do not have this requirement (eg Canada) or allow commercial banks to increase their reserves after they have created the new deposits, by borrowing either from other banks who have surplus reserves or from the central bank itself. Banks create money first and acquire the necessary reserves later, and these reserves are always available. At worst they have to be borrowed from the central bank at the base rate set by central banks.
There is another constraint on lending which is called the Capital Adequacy Ratio (CAR). This is a requirement for the banks to ensure that their assets (e.g. loans) exceed their liabilities (e.g. bank deposits) by a certain minimum margin. However, the CAR does not act as a restraint as long as banks make a profit. If the CAR is 5% then retained profits of £5 billion enable a bank to make £95 billion of new loans.
In conclusion, commercial banks create almost all new money, through credit creation. We rent our money supply from banks. This explains why economic growth has been been accompanied by huge, unsustainable increases in private sector debt and asset price bubbles, why the global financial crisis was inevitable, why the recovery has been so weak, and what needs to be done to restore growth and reduce private sector debt. The failure of mainstream economists to understand the role of banks explains their failure to predict the GFC, and their inability to come up with effective solutions.
No comments:
Post a Comment