This is a continuation of my attempt to explain the monetary system by describing how a (somewhat unusual) family would operate if it was similar to a country, with its parents issuing their own currency. To recap, the parents buy services from the children by issuing coupons which they can, in principle, create in any amount, and require tax to be paid in the same coupons, both to create demand for the coupons and to prevent too many coupons circulating amongst the children, which could cause inflation. The coupons are used by the children to trade amongst each other, enabling them to specialise in what they do best and/or enjoy most. The availability of coupons would limit the overall amount of trade possible, particularly if some of the children choose to save coupons instead of spending them immediately.
In this post I am going to explain how the banking system fits into the monetary system.
IF THE PARENTS BALANCE THEIR BUDGET ECONOMIC GROWTH IS RESTRICTED BECAUSE THERE IS INSUFFICIENT MONEY
Imagine the parents (the government) introduced a principle that they would always remove through taxes the same amount of coupons as they create through spending - i.e. they would 'balance their budget'. There is no fundamental need for this but it is nevertheless a widespread belief that this is a 'good thing'. Because this fixes the number of coupons in circulation it places a restriction on the amount of trade possible amongst the children. Much of the time they will be unable to buy from each other because they lack money. This situation is further aggravated by the fact that some children will choose to save their money rather that spend it, thus further reducing the money supply. Thus a shortage of money can prevent economic activity and reduce overall well-being.
BANKING HELPS TO MAINTAIN ECONOMIC ACTIVITY BY ENABLING SAVINGS TO BE BORROWED
At some stage one child, who has accumulated coupons through saving, has the idea of lending these to other children at interest. After a while he runs out of coupons and so starts to borrow surplus coupons from other children by offering to pay them interest. As long as this interest is lower than the interest he charges borrowers he can make a profit. The child is acting as a bank of sorts by intermediating between savers and borrowers. While this helps because coupons that had been hoarded are now being spent, economic activity is still artificially limited by the total number of coupons in circulation. As long as the parents 'balance their budget' economic growth is restricted by a shortage of coupons.
CREDIT CREATION BY BANKS ENABLES THE MONEY SUPPLY TO GROW
To make transactions more convenient the child acting as the bank develops a computer spreadsheet where he keeps track of all the deposits he has taken and all the loans he has made. He offers a service whereby instead of borrowers coming to him to get the coupons to spend, them spending them to purchase from sellers, and the sellers coming to the bank to deposit the coupons, he allows electronic transaction via his website, much like we spend and receive money today through electronic payments. When there is a transaction he just moves money around on his spreadsheet. This is far more convenient than dealing with physical coupons.
A major advantage of this new system, apart from convenience, is that the bank no longer needs actual coupons to lend money. This can be done by just marking up the balance of the borrower's account on their spreadsheet (and keeping a record of the loan). This means the bank can greatly increase the amount it lends and therefore increase its interest income. Since loans create deposits which can be spent by the borrowers this greatly increases the amount of money available for transactions, provided that they are all electronic. This is essentially how banks create most of our money supply.
CENTRAL BANKS PROVIDE THE CASH NEEDED BY BANKS AND MEDIATE PAYMENTS BETWEEN BANKS
Once this system is in place and most financial transactions are electronic it makes sense for the parents to issue coupons electronically. To do this the parents create a spreadsheet with an account for the bank. This is the bank's 'reserve account'. Now when parents spend by, for example, paying one of the children for washing the dishes, they mark up the child's bank's reserve account on their spreadsheet by the payment amount, and that bank then marks up the child's account on its own spreadsheet by the same amount. No coupons need to be issue. What if the child wanted some physical coupons? The parents provides the bank with coupons as and when children need it. When the coupons are issued to the bank the parents debit the bank's reserve account by the number of coupons issued. The parents are now acting as central bank. Only central banks issue coupons and create reserves. Reserves are money on their spreadsheet, which are interchangeable with coupons.
One of the other children, seeing the success of the bank, starts up a second bank. They also need to have an account on the parent's spreadsheet (a reserve account) to receive electronic payments. When a child A who keeps it money at bank A makes a payment to a child B with an account at the bank B the parents can settle the payment by transferring amounts between these banks' reserve accounts on its spreadsheet. They debit bank A's account and credit bank B's account. The parents, like a central bank, now settle payments between different banks by transfers between their reserve account. Now you understand what central bank reserves are and how the payments system works.
BANK LENDING BY CREDIT CREATION EXPANDS THE MONEY SUPPLY AND DEBT AT THE SAME TIME
Since bank loans create electronic money the supply of money increases with the amount of lending. This provides a mechanism for the amount of money available to children to increase independently of the amount of coupons introduced into the economy by the parents. Even if the parents introduce NO new coupons the economy can grow the money supply and thus economic activity can increase. The key difference is that money created by bank lending is always accompanied by an equal debt. Because interest has to be paid on this debt there is a limit as to how high this debt can go relative to the level of economic activity. If it is too high the debt will be too expensive to service. This is analogous to limiting the size of one's mortgage relative to one's salary.
EXCESSIVE CREDIT CREATION BY BANKS CAUSED THE GLOBAL FINANCIAL CRISIS
We are now in the position to understand the causes of the current financial crisis, and the possible solution. It is very tempting for the child acting as bank to increase the amount of loans it makes as that increases its revenue (interest payments). Its main consideration when making the loans is whether the borrower will be able to meet the interest payments and pay the capital back. To reduce the risk they would usually only lend large amounts if the loan was backed ('secured') by an asset such as a house, which could be repossessed if repayments were not made. When asset prices go up banks are more willing to make loans to purchase them as they are confident they will get their money back. The problem is that this increases the amount of money available to purchase assets causing prices to go up further. This is a self-perpetuating cycle called an asset price bubble which all credit-based banking systems are prone to. As the bubble inflates the amount of debt increases along with the amount of bank money and asset prices. In the decade preceding 2007 bank-created money and private sector debt increase far more rapidly (~10% pa) that the rate of economic growth (~3% pa). Private sector debt approached 450% of GDP, far higher than ever before in history. Clearly this cannot continue forever and, as always happens eventually with such bubbles, it burst when asset prices stopped increasing and started to fall. When this happens the debt starts to be repaid more quickly than new loans are extended. Since repayment eliminates both the money and the debt the money supply contract, causing a decrease in the overall level of economic activity. This decrease in economic activity causes more distress as those with loans have difficulty paying the interest on them as their incomes drop or they lose their jobs. The banker is now much less likely to lend money because asset prices and economic activity is dropping.
During this process the spending by the parents may have been maintained but their tax revenues, if they are based on sales and income taxes, will decrease along with sales and income. The budget is therefore no longer balanced - there is now a 'deficit'. It is important to note that this increase in the 'deficit' is the inevitable result of economic contraction and has NOTHING to do with 'loose spending' by the parents.
Economic activity is low because the children are trying to repay their debts and the banks are reluctant to lend, causing the money supply to shrink. As a result many of the children are inactive and getting hungry.
DEFICIT SPENDING IS NEEDED TO INCREASE DEMAND AND ENABLE THE NON-GOVERNMENT SECTOR TO REDUCE ITS DEBTS
How do we resolve the problem? If you have understood the above you will realise that origin of the problem is in excessive credit creation by the banks and that the obvious solution is for the parents to increase their spending into the economy and/or reduce taxation rates so that more money enters the economy, demand increases, and those that are un- or under-employed can get back to work. Of course this will further increase the 'deficit' and the 'government debt' but this is irrelevant since the deficit is simply a measure of net spending and the debt just represents the net financial assets of the children as a result of deficit spending. Once the economy is recovering and functioning at full capacity the amount of spending can be reduced and/or the level of taxation increase to prevent demand exceeding supply, which could cause inflation.
Instead what is being advocated is policies to increase bank lending/private borrowing while parents/government cut their spending and increase taxes in an attempt to reduce the deficit and stop the 'government debt' increasing. If you have followed my explanation so far it should be obvious that this approach, cutting spending and/or increasing taxation to reduce the 'deficit', will only make things worse. It is precisely the wrong thing to do. Indeed, as expected, wherever this austerity based approach has been tried it has made things much worse.
What is amazing is that despite this evidence so many people, many highly educated, still cling to the belief that the primary problem is the government deficit and debt, and that tackling that is urgently needed. This is arguably the most tragic example of collective blindness and/or stupidity that the world has ever known. It is a problem that is remarkably easy to solve, but you have to understand the problem in the first place. Unfortunately those that do are outside the economic mainstream and have to deal with two generations of economic brainwashing.
In the next post I will explain how the parents can set up rules make it appear that they have to obtain the coupons that they spend from the children through taxes and borrowing. Similar self-imposed and easily-changed rules are in place in all countries. This has created the confusion which supports the dangerous myth that it is important for governments to 'balance their budget' and keep their 'debt' levels low.
In this post I am going to explain how the banking system fits into the monetary system.
IF THE PARENTS BALANCE THEIR BUDGET ECONOMIC GROWTH IS RESTRICTED BECAUSE THERE IS INSUFFICIENT MONEY
Imagine the parents (the government) introduced a principle that they would always remove through taxes the same amount of coupons as they create through spending - i.e. they would 'balance their budget'. There is no fundamental need for this but it is nevertheless a widespread belief that this is a 'good thing'. Because this fixes the number of coupons in circulation it places a restriction on the amount of trade possible amongst the children. Much of the time they will be unable to buy from each other because they lack money. This situation is further aggravated by the fact that some children will choose to save their money rather that spend it, thus further reducing the money supply. Thus a shortage of money can prevent economic activity and reduce overall well-being.
BANKING HELPS TO MAINTAIN ECONOMIC ACTIVITY BY ENABLING SAVINGS TO BE BORROWED
At some stage one child, who has accumulated coupons through saving, has the idea of lending these to other children at interest. After a while he runs out of coupons and so starts to borrow surplus coupons from other children by offering to pay them interest. As long as this interest is lower than the interest he charges borrowers he can make a profit. The child is acting as a bank of sorts by intermediating between savers and borrowers. While this helps because coupons that had been hoarded are now being spent, economic activity is still artificially limited by the total number of coupons in circulation. As long as the parents 'balance their budget' economic growth is restricted by a shortage of coupons.
CREDIT CREATION BY BANKS ENABLES THE MONEY SUPPLY TO GROW
To make transactions more convenient the child acting as the bank develops a computer spreadsheet where he keeps track of all the deposits he has taken and all the loans he has made. He offers a service whereby instead of borrowers coming to him to get the coupons to spend, them spending them to purchase from sellers, and the sellers coming to the bank to deposit the coupons, he allows electronic transaction via his website, much like we spend and receive money today through electronic payments. When there is a transaction he just moves money around on his spreadsheet. This is far more convenient than dealing with physical coupons.
A major advantage of this new system, apart from convenience, is that the bank no longer needs actual coupons to lend money. This can be done by just marking up the balance of the borrower's account on their spreadsheet (and keeping a record of the loan). This means the bank can greatly increase the amount it lends and therefore increase its interest income. Since loans create deposits which can be spent by the borrowers this greatly increases the amount of money available for transactions, provided that they are all electronic. This is essentially how banks create most of our money supply.
CENTRAL BANKS PROVIDE THE CASH NEEDED BY BANKS AND MEDIATE PAYMENTS BETWEEN BANKS
Once this system is in place and most financial transactions are electronic it makes sense for the parents to issue coupons electronically. To do this the parents create a spreadsheet with an account for the bank. This is the bank's 'reserve account'. Now when parents spend by, for example, paying one of the children for washing the dishes, they mark up the child's bank's reserve account on their spreadsheet by the payment amount, and that bank then marks up the child's account on its own spreadsheet by the same amount. No coupons need to be issue. What if the child wanted some physical coupons? The parents provides the bank with coupons as and when children need it. When the coupons are issued to the bank the parents debit the bank's reserve account by the number of coupons issued. The parents are now acting as central bank. Only central banks issue coupons and create reserves. Reserves are money on their spreadsheet, which are interchangeable with coupons.
One of the other children, seeing the success of the bank, starts up a second bank. They also need to have an account on the parent's spreadsheet (a reserve account) to receive electronic payments. When a child A who keeps it money at bank A makes a payment to a child B with an account at the bank B the parents can settle the payment by transferring amounts between these banks' reserve accounts on its spreadsheet. They debit bank A's account and credit bank B's account. The parents, like a central bank, now settle payments between different banks by transfers between their reserve account. Now you understand what central bank reserves are and how the payments system works.
BANK LENDING BY CREDIT CREATION EXPANDS THE MONEY SUPPLY AND DEBT AT THE SAME TIME
Since bank loans create electronic money the supply of money increases with the amount of lending. This provides a mechanism for the amount of money available to children to increase independently of the amount of coupons introduced into the economy by the parents. Even if the parents introduce NO new coupons the economy can grow the money supply and thus economic activity can increase. The key difference is that money created by bank lending is always accompanied by an equal debt. Because interest has to be paid on this debt there is a limit as to how high this debt can go relative to the level of economic activity. If it is too high the debt will be too expensive to service. This is analogous to limiting the size of one's mortgage relative to one's salary.
EXCESSIVE CREDIT CREATION BY BANKS CAUSED THE GLOBAL FINANCIAL CRISIS
We are now in the position to understand the causes of the current financial crisis, and the possible solution. It is very tempting for the child acting as bank to increase the amount of loans it makes as that increases its revenue (interest payments). Its main consideration when making the loans is whether the borrower will be able to meet the interest payments and pay the capital back. To reduce the risk they would usually only lend large amounts if the loan was backed ('secured') by an asset such as a house, which could be repossessed if repayments were not made. When asset prices go up banks are more willing to make loans to purchase them as they are confident they will get their money back. The problem is that this increases the amount of money available to purchase assets causing prices to go up further. This is a self-perpetuating cycle called an asset price bubble which all credit-based banking systems are prone to. As the bubble inflates the amount of debt increases along with the amount of bank money and asset prices. In the decade preceding 2007 bank-created money and private sector debt increase far more rapidly (~10% pa) that the rate of economic growth (~3% pa). Private sector debt approached 450% of GDP, far higher than ever before in history. Clearly this cannot continue forever and, as always happens eventually with such bubbles, it burst when asset prices stopped increasing and started to fall. When this happens the debt starts to be repaid more quickly than new loans are extended. Since repayment eliminates both the money and the debt the money supply contract, causing a decrease in the overall level of economic activity. This decrease in economic activity causes more distress as those with loans have difficulty paying the interest on them as their incomes drop or they lose their jobs. The banker is now much less likely to lend money because asset prices and economic activity is dropping.
During this process the spending by the parents may have been maintained but their tax revenues, if they are based on sales and income taxes, will decrease along with sales and income. The budget is therefore no longer balanced - there is now a 'deficit'. It is important to note that this increase in the 'deficit' is the inevitable result of economic contraction and has NOTHING to do with 'loose spending' by the parents.
Economic activity is low because the children are trying to repay their debts and the banks are reluctant to lend, causing the money supply to shrink. As a result many of the children are inactive and getting hungry.
DEFICIT SPENDING IS NEEDED TO INCREASE DEMAND AND ENABLE THE NON-GOVERNMENT SECTOR TO REDUCE ITS DEBTS
How do we resolve the problem? If you have understood the above you will realise that origin of the problem is in excessive credit creation by the banks and that the obvious solution is for the parents to increase their spending into the economy and/or reduce taxation rates so that more money enters the economy, demand increases, and those that are un- or under-employed can get back to work. Of course this will further increase the 'deficit' and the 'government debt' but this is irrelevant since the deficit is simply a measure of net spending and the debt just represents the net financial assets of the children as a result of deficit spending. Once the economy is recovering and functioning at full capacity the amount of spending can be reduced and/or the level of taxation increase to prevent demand exceeding supply, which could cause inflation.
Instead what is being advocated is policies to increase bank lending/private borrowing while parents/government cut their spending and increase taxes in an attempt to reduce the deficit and stop the 'government debt' increasing. If you have followed my explanation so far it should be obvious that this approach, cutting spending and/or increasing taxation to reduce the 'deficit', will only make things worse. It is precisely the wrong thing to do. Indeed, as expected, wherever this austerity based approach has been tried it has made things much worse.
What is amazing is that despite this evidence so many people, many highly educated, still cling to the belief that the primary problem is the government deficit and debt, and that tackling that is urgently needed. This is arguably the most tragic example of collective blindness and/or stupidity that the world has ever known. It is a problem that is remarkably easy to solve, but you have to understand the problem in the first place. Unfortunately those that do are outside the economic mainstream and have to deal with two generations of economic brainwashing.
In the next post I will explain how the parents can set up rules make it appear that they have to obtain the coupons that they spend from the children through taxes and borrowing. Similar self-imposed and easily-changed rules are in place in all countries. This has created the confusion which supports the dangerous myth that it is important for governments to 'balance their budget' and keep their 'debt' levels low.
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