John Kenneth Galbraith
I can still remember small details of the room where I was sitting when someone explained the mysteries and glories of fractional banking to me. I did NOT believe him. I was in seventh grade and had already thoroughly absorbed the idea that banks attracted deposits by paying a low rate of interest, found worthy borrowers willing to pay a higher rate of interest, and made their living off that spread. It had to be true or else why would Milburn Drysdale put up with so much to keep Jed Clampett from moving his money out of Drydale's bank in the Beverly Hillbillies. Thankfully, by the time I was ready to write my chapter on Money in Elegant Technology, I had been overwhelmed by the evidence that the fractional banking story was true and the Beverly Hillbillies version was not.
Unfortunately, most people still believe the fairytale about the importance of depositors, big and small, to the banking business. I understand their skepticism because I was once one of them (in the seventh grade.) Even so, it is a bit unnerving to discover the true believers can be full-grown and aging adults. And their childish beliefs are even less understandable these days after the Bank of England (of all institutions) has decided to come clean on the facts of fractional banking (in March 2014).
The Proof That Banks Create Money
More than 97% of all the money in the economy exists as bank deposits – and banks create these deposits simply by making loans. When people first hear this, they often find it hard to believe. But we don’t want you to take our word for it. In March 2014 the Bank of England has released official papers and a video explaining that money is created by commercial banks:
Money in the modern economy: an introduction (531KB)
Money creation in the modern economy (111KB)
Where does money come from? In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money. This description of how money is created differs from the story found in some economics textbooks.
“Loans create deposits not the other way round.”
Find out more here
In this video Dirk Bezemer, Associate Professor at the University of Groningen and Michael Kumhof, an IMF Economist explain where money comes from in less than 2 minutes:
Below you can read many more quotes from central bankers, finance journalists, and commentators on the subject.
When banks extend loans to their customers, they create money by crediting their customers’ accounts.
Sir Mervyn King, Speech to the South Wales Chamber of Commerce at The Millenium Centre, Cardiff on 23rd October 2012
“The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.”
Martin Wolf, Financial Times, 9th November 2010
The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money.
Lord Adair Turner, former chairman of the Finacial Services Authority, Speech to the South African Reserve Bank, 2nd November 2012
Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower’s money account.
Lord Adair Turner, former chairman of the Finacial Services Authority, Speech Credit, Money and Leverage, 12th September 2013
By far the largest role in creating broad money is played by the banking sector… When banks make loans they create additional deposits for those that have borrowed the money.
Bank of England, Interpreting movements in broad money, p.377
Even before the crisis banks enjoyed various kinds of state support, including the effective right to create money.
Independent Commission on Banking Report
So when you take out a loan from the bank, the ‘money’ is just typed into your account and created effectively out of nothing. Here’s further proof from Paul Tucker, Deputy Governor of the Bank of England and Member of the Monetary Policy Committee (the term ‘extend credit’ is a synonym for ‘make loans’):
Banks extend credit by simply increasing the borrowing customer’s current account … That is, banks extend credit [i.e. make loans] by creating money
Paul Tucker, Deputy Governor for Financial Stability
“Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation” – credit is created literally out of thin air (or with the stroke of a keyboard).”
Paul Sheard, Chief Global Economic & Head of Global Economics and Research, Standard and Poors
more
"…More than 97% of all the money in the economy exists as bank deposits…"
ReplyDeleteFirst of all, glad to see you getting on this bandwagon. Your blog posts have more relevance to real-world economics thought than most blogs by far and it is tailored to layman readers which is the most important cohort to win over. I've been reading your Russia posts with great interest.
As to the quoted part above, I'm pretty sure (for the U.S.) the 97% figure ignores bonds (Treasuries, i.e. public debt) since private credit outstanding in the US is about $47T and there is approximately 1.5T in currency and coins in existence. The ratio for other sovereign currency issuers is probably comparable.
The point is that bonds are money, for example Apple's cash hoard is commonly cited as $150B+…90%± of that is in bonds. Bonds are money…they're dollars that earn interest.
So this framing is part and parcel of the neoliberal paradigm that is promoted even in this article which admits (finally) that loans create deposits (grudgingly, because they simultaneously promote more myths at the end, essentially trying to backtrack). That''s a step in the right direction but we have to push back against their erroneous framing which steers us towards the neoliberal rut.
Reality is quite a bit different than the quote above…
Since WWII public spending has totaled about $68T dollars…you can verify this and any other numbers I've presented here by looking at FRED data…
Over the same period private debt outstanding grew by about $46T…
Both money-creation sources create new dollars in the system and contribute to spending which contributes to income so both are taxed…proportionately I presume because the tax man can't know where the income came from.
This means that roughly 40% of all money creation came from banks and the rest came from public spending. So in real terms the 97% number is (at least to me) highly misleading. It waves away bonds as money but bonds are simply savings accounts for the rich, unencumbered by the $250k FDIC limit, and it assumes that taxes only accrue against income derived from public spending, ignoring income derived from borrowers spending loans. Nonsense in my view.
One only has to note the non-growth of private debt (see CMDEBT) over the past 5 years coupled with the increased deficits to see that public spending has created nearly 100% of the new money in the system.
It's just another shell game. an obvious head-fake, because the neo-liberal march is mainly about giving banks and corporations a position at the top of the hierarchy above governments. Lincoln had to contend with the same erroneous ideas so this is nothing new…it's the bankers game plan and has been so since banking was invented.
Keep up the great work. We need many more like you.
Paul, the comparison of "public spending" and "growth of private debt" is not really appropriate. You should compare "spending - taxing"= "growth in public debt" to "growth of private debt". Or "public spending" to "private spending" (=~ "growth of private debt" + "private debt repaid").
DeleteBoth money-creation sources create new dollars in the system and contribute to spending which contributes to income so both are taxed…proportionately I presume because the tax man can't know where the income came from. Misleading at best. Private debt does not create new government-dollars in the system, which are the only ones that the tax man accepts.The tax man (the US gov) does know where the income he is interested in ultimately comes from - himself!
I disagree with the statement "private debt does not create new government dollars in the system, which are the only ones that the tax man accepts." Loans create deposits which , if necessary, create reserves. Bank credit becomes government dollars which is why I would accept a dollar from you even if you merely borrowed it from your bank.
DeleteCalgacus, spending results from both public spending and spending of loan proceeds, which fill the "container" together. Taxes accrue against the total income created, so why would you only subtract taxes from the public spending? Income is income.
ReplyDeleteI agree with Paul Meli that the 97% figure is nonsense, but not for the reasons Meli gives. Far as I know, the much repeated 97% figure comes from Positive Money. Their (flawed) argument is that 3% of money is physical cash, ergo the rest (97%) must be commercial bank created money. That of course leaves out a large chunk of money: non physical central bank created money. And the latter chunk of money is HUGE just at the moment thanks to QE. In fact about 20% of money in the US consists of central bank non physical money according to the chart here:
ReplyDeletehttp://ralphanomics.blogspot.co.uk/2014/01/the-us-is-awash-with-positive-money.html
That 20% equates to Meli’s “public spending” money roughly speaking.
As for Meli’s claim that “bonds are money”, that’s just nonsense. Of course, as anyone who has worked their way thru an introductory economics text books knows, there is no sharp dividing line between money and non-money. I.e. bonds CAN BE and indeed are used as money sometimes. Come to that, you can use a bottle of whiskey as money.
But certainly bonds are never included in any conventional definition of the word “money”.
The above article claims “whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money.” Not true, and for the simple reason that a deposit is not necessarily money: in particular relatively long term deposit or “term” accounts are not included in the money supply in most countries.
ReplyDeleteIndeed, the money deposited in so called “investment accounts” which Positive Money advocates is far from being instant access, and for that reason, that so called money is not counted by PM is money.
And quite apart from PM, suppose the economy is at capacity and a bank extends a loan. That will boost demand, which will be inflationary, which the central bank or government will counter in some way, e.g. by raising interest rates, which in turn CUTS BORROWING!!!! Ergo private banks just cannot increase lending unless there’s someone out there willing deposit money at said banks for a longish period. I.e. the conventional story about banks intermediating between lenders and borrowers is correct.
But that’s not to say private banks never create money. If someone simply wants TRANSACTION or day to day spending money rather than a LONG TERM LOAN, and they do not intend being overdrawn for any length of time, a private bank will supply that money.
I.e. there’s an important distinction between a long term loan, and on the other hand, supplying the population with day to day transaction money.
Ralph-
ReplyDeleteI've asked this question to you numerous times and you've always ignored it. I presume you keep ignoring it because you are wrong and you don't wish to admit as much. So I will try again.
What evidence do you have for this statement?:
"That will boost demand, which will be inflationary, which the central bank or government will counter in some way, e.g. by raising interest rates, which in turn CUTS BORROWING!!!!"
Any cursory glance at FRED charts showing FFR and non-financial domestic debt clearly shows that you're statement is erroneous. It doesn't matter if you do it in YOY, nominal or real.
Paul-
ReplyDeleteYour way of accounting for the money supply is wrong. Under normal conditions (non-QE), all Govt spending results in a NET ZERO change in the # of bank deposits. All Govt spending (including deficit spending) is offset by a bank deposit reduction method (Taxes or bond issuance).
Total private debt = $42T
Total Govt bonds = $17T
If we include all CB balances (reserves and securities) in our definition of the money supply, than the private sector is responsible for about 75% of the money and the Govt for 25%.