In this post I continue to discuss elements of macroeconomics that are beyond dispute. One of these is our monetary system. While this is complicated it was designed by humans so should be readily understood. What is remarkable is that not only do very few ordinary people understand the monetary system, most of those working in or writing about the financial sector do not appear to fully understand it. This is a consequence of the highly misleading fact way that it is taught at University and described by economists.
The first important fact to appreciate is that most of the electronic money that is used by the private sector is created by private banks, NOT by the central bank or government. This money, which experts call bank money, is created when a bank makes a loan. When it does this it adds a number to your bank account using a computer. At the same time it gets you to sign a contract requiring you to pay that money back by some future date. When this loan is paid back the money disappears. This is analogous to how matter is created out of nothing but has a counterpart anti-matter. When the two come together nothing remains.
Central banks also create electronic money but this money, called bank reserves, is present at far lower amounts than commercial bank money. The relationship between central bank reserves and bank money is not well understood. Central bank reserves never actually leave the central bank account system. Instead they move between those who have accounts at the central bank, namely the government and licensed banks. Their primary role is to settle payments between private banks, and between the government and private banks.
When customers with accounts at the same bank exchange money all that happens is their accounts recording their bank money go up and down accordingly. No central bank reserves are involved. However when customers with accounts at different banks exchange money then the banks transfer central bank reserves between their respective accounts at the central bank to effect these payments. In essence banks have reserves to enable them to settle payments between their respective customers. They also use reserves when they issue notes and coins to customers. When they obtain cash from the central bank their reserve account is marked down by that amount, and vica versa.
Only central banks can create bank reserves, and they can do this unlimited amounts. The amount of money in reserve accounts bears little relationship to the amount of spendable money in the economy. Some central banks require banks to hold a minimum amount of reserves, equivalent for example to 10% of the value of bank deposits that they hold. Students are usually taught that this requirement enables the central bank to indirectly control the total amount of money in the economy just by changing the amount of reserves. This is wrong. In practice central banks always lend banks whatever reserves they need to meet these reserve requirements (if they exist) or to make payments between each other. They do this because failure to do so would cause the payment system and hence the economy to collapse. What central banks do try to control is the interest that banks have to pay to borrow more reserves. When a bank makes a loan of BANK money it is possible that, if that money is transferred to a customer at another bank it will need to borrow reserves to settle the transaction. Therefore the interest rate that banks set for that loan will be influenced by and always be higher than the interest rate that it would have to pay to borrow reserves.
The fact that almost all the money that is spent in the economy is bank money created by banks out of nothing when they make loans has important implications.
1. We effectively rent most of our money from private banks.
2. The amount of money circulating in the economy is determined by the balance between the rate that banks make new loans and the rate that old loans are repaid. If people take out fewer loans or increase the rate at which they repay existing loans then the money supply shrinks which reduces economic activity. This is why the government has been trying so hard to persuade people to take out more loans.
3. Increasing the amount of central bank reserves does increase the amount of money in the economy but changes in bank lending have much bigger effect on the amount of money. Since 2008 central banks have been increasing reserves by huge amounts but this has barely compensated for the reduction in the amount of bank money as people stop taking out new loans and continue to pay back existing ones.
4. As the economy grows the level of private debt grows since all bank money created to support growth has a corresponding debt. In fact in the past 40 years the level of private debt has grown much faster than the growth in economies. It should be obvious that it is not sustainable for private sector debt to grow faster than the economy as measured by GDP because the interest costs of this debt are paid for out of total income or GDP. Nevertheless policymakers allowed this to happen, and only a tiny handful of economists pointed out the fact that this would end in tears. By 2007 this debt level reached over 300% of GDP before, as predicted by economists outside the mainstream, the credit bubble collapsed.
5. Growth collapsed largely because the private sector switched from increasing their borrowing year by year, which they had done for up to 40 years non-stop, to paying down their debts. Unfortunately because of the fact that most money is created through bank lending, this resulted in a decrease in the money supply and has suppressed economic growth. That is why government are desperately trying to reverse this and encourage borrowing.
6. Given this scenario described above, and the fact that private sector debt levels are still so high, it seems foolish to try to restore growth by encouraging the private sector to once again increase its debt levels, especially when economies are shrinking because of cuts in government spending.
The first important fact to appreciate is that most of the electronic money that is used by the private sector is created by private banks, NOT by the central bank or government. This money, which experts call bank money, is created when a bank makes a loan. When it does this it adds a number to your bank account using a computer. At the same time it gets you to sign a contract requiring you to pay that money back by some future date. When this loan is paid back the money disappears. This is analogous to how matter is created out of nothing but has a counterpart anti-matter. When the two come together nothing remains.
Central banks also create electronic money but this money, called bank reserves, is present at far lower amounts than commercial bank money. The relationship between central bank reserves and bank money is not well understood. Central bank reserves never actually leave the central bank account system. Instead they move between those who have accounts at the central bank, namely the government and licensed banks. Their primary role is to settle payments between private banks, and between the government and private banks.
When customers with accounts at the same bank exchange money all that happens is their accounts recording their bank money go up and down accordingly. No central bank reserves are involved. However when customers with accounts at different banks exchange money then the banks transfer central bank reserves between their respective accounts at the central bank to effect these payments. In essence banks have reserves to enable them to settle payments between their respective customers. They also use reserves when they issue notes and coins to customers. When they obtain cash from the central bank their reserve account is marked down by that amount, and vica versa.
Only central banks can create bank reserves, and they can do this unlimited amounts. The amount of money in reserve accounts bears little relationship to the amount of spendable money in the economy. Some central banks require banks to hold a minimum amount of reserves, equivalent for example to 10% of the value of bank deposits that they hold. Students are usually taught that this requirement enables the central bank to indirectly control the total amount of money in the economy just by changing the amount of reserves. This is wrong. In practice central banks always lend banks whatever reserves they need to meet these reserve requirements (if they exist) or to make payments between each other. They do this because failure to do so would cause the payment system and hence the economy to collapse. What central banks do try to control is the interest that banks have to pay to borrow more reserves. When a bank makes a loan of BANK money it is possible that, if that money is transferred to a customer at another bank it will need to borrow reserves to settle the transaction. Therefore the interest rate that banks set for that loan will be influenced by and always be higher than the interest rate that it would have to pay to borrow reserves.
The fact that almost all the money that is spent in the economy is bank money created by banks out of nothing when they make loans has important implications.
1. We effectively rent most of our money from private banks.
2. The amount of money circulating in the economy is determined by the balance between the rate that banks make new loans and the rate that old loans are repaid. If people take out fewer loans or increase the rate at which they repay existing loans then the money supply shrinks which reduces economic activity. This is why the government has been trying so hard to persuade people to take out more loans.
3. Increasing the amount of central bank reserves does increase the amount of money in the economy but changes in bank lending have much bigger effect on the amount of money. Since 2008 central banks have been increasing reserves by huge amounts but this has barely compensated for the reduction in the amount of bank money as people stop taking out new loans and continue to pay back existing ones.
4. As the economy grows the level of private debt grows since all bank money created to support growth has a corresponding debt. In fact in the past 40 years the level of private debt has grown much faster than the growth in economies. It should be obvious that it is not sustainable for private sector debt to grow faster than the economy as measured by GDP because the interest costs of this debt are paid for out of total income or GDP. Nevertheless policymakers allowed this to happen, and only a tiny handful of economists pointed out the fact that this would end in tears. By 2007 this debt level reached over 300% of GDP before, as predicted by economists outside the mainstream, the credit bubble collapsed.
5. Growth collapsed largely because the private sector switched from increasing their borrowing year by year, which they had done for up to 40 years non-stop, to paying down their debts. Unfortunately because of the fact that most money is created through bank lending, this resulted in a decrease in the money supply and has suppressed economic growth. That is why government are desperately trying to reverse this and encourage borrowing.
6. Given this scenario described above, and the fact that private sector debt levels are still so high, it seems foolish to try to restore growth by encouraging the private sector to once again increase its debt levels, especially when economies are shrinking because of cuts in government spending.
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