Thursday, January 15, 2015

Creating Money Out of Thin Air and Trained Incapacity

Two days ago, I posted on DailyKos a summary of the very important article on money creation that Jon had featured. Jon asked me to also post my DailyKos summary here, which I am happy to do.

But I also want to draw your attention to some of the comments my DailyKos posting attracted, because they are a wonderful example of the "trained incapacity" Veblen analyzed in in his 1914 book, The Instinct of Workmanship and the Industrial Arts. As regular readers of this blog know, Jon and I have had more than one occasion to invoke "trained incapacity" in trying to understand the absurdity and inanity of political and economic positions, ideas, and arguments of people who otherwise appear to be smart. Jon has a number of posts on the subject of trained incapacity here - just scroll down until you see the phrase on the left.

There were at least three commenters to my DailyKos post who simply refused to accept the fact that banks create money out of nothing. They insisted that the banks would later have to meet reserve requirements, or that the borrower was the actual source of the money created because the borrower signs a pledge to pay back the money. One pointed to the Basel requirements regarding banks' T1 capital, a strong sign that that person is professionally involved in banking and finance. Yet another objected that it is the property pledged as security for the loan that is actually the money which I mistakenly believe (according to them) was created out of thin air. Another snidely argued that if banks can create money out of nothing, no bank would ever go bankrupt, so why "not lend to everyone under the sun, without expectation of repayment?" Then added, trying to dismiss the idea that banks create money out of nothing as the fantasy of some wild-eyed radical, "That may be in fact be what the diarist is driving at: what a wonderful world that would be to live in!" This person either did not see or deliberately failed to mention Jon's observation, which I quoted near the beginning of my posting, "don't create money will-nilly—only create money to pay for things that make the society richer."

When I asked a couple commenters, "Then please explain how the amount of money (measured as M2) grew from $1.28 billion in 1867, to $11,654.3 billion now. Where did the $11.653 trillion come from? Which accounts was it withdrawn from? Who created $11.653 trillion in money, and how, over the past 148 years?" one of my interlocutors could only reply, "economic growth." 

Now, I also want to point out that these people objecting to the idea that banks create money out of thin air, are supposedly "on our side." These are not knuckle-dragging conservatives or Republicans; they are liberals and progressives who regularly follow and contribute to one of the leading openly partisan Democratic Party websites on the tubez. With friends like these, who needs enemies?!? Are these people serious about addressing the problem of climate change? If they are, then I feel it is their duty to us, and to humanity in general, to explain what solutions they propose, and how to fund them. If they are not serious, I feel they should be candid and forthright, and express their rejection that climate change is the problem almost all scientists contend it is - a problem that threatens the very survival of our existence as a species.

Alternatively, they can be candid and forthright in informing us they are willing to allow the planet be burnt and rendered uninhabitable, rather than accept economic paradigms that are contrary to their beliefs of what reality is.

The other alternative, of course, is they are just being stupid by clinging to their belief of how money is created. In which case, we come back to Veblen's analysis of trained incapacity. As John Kenneth Galbraith once noted, "The process by which banks create money is so simple that the mind is repelled."

The thing to understand is that the real political fight in the USA, and the rest of the world, is not Democrat versus Republican, or liberal versus conservative, or left versus right. As Jon has pointed out numerous times, the real fight is the Producer Class versus the Predator Class (the Leisure Class as Veblen named it). What makes the prospect of a Hillary Clinton presidency so distasteful to many people who conservatives and Republicans stupidly believe are lefties and therefore Hillary's hardcore base? It is the fact that the Clintons sold out to, and became part of, the Predator Class many, many, many years ago, and the policies they support and espouse will do serious material harm to the members of the Producer Class. So go through the comments, and see for yourself the taint of the Predator Class within our own ranks.

As one of the Predator commenters wrote: "The real issue is that a faction here hates banks and wants to undermine the system somehow." That's exactly what we want to do, and that's what the Predator Class is terrified of.

He or she was exposed by another commenter.

Creating money out of thin air can now be said with confidence for the first time – possibly in the 5000 years' history of banking - that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air. The implications are far-reaching.
That's the conclusion of a December 2014 article, by Richard A. Werner, in the scholarly journal International Review of Financial Analysis, entitled Can banks individually create money out of nothing? — The theories and the empirical evidence. I don't know what I can write to convince you how important this article is. The implications for economic and financial policies of government the world over are staggering - and in a good way. A very good way. Because anyone who looks at the simple evidence presented in this scholarly paper can reach no other conclusion than
  • we really don't need banks,
  • we don't need bankers,
  • we don't have to borrow money to fund government programs,
  • we don't have to cut social programs to balance government budgets,
A big tip of the hat is due to Jon Larson, at Real Economics, for highlighting Dr. Werner's article at RE. This is important material, because the cost of stopping climate change has been pegged by experts at $100 trillion, as I wrote a few weeks ago. And, as Larson explains:
...if guys like Tony and I are going to run around telling folks that their only hope for survival lies in spending $100 trillion for infrastructure upgrades, we owe it to them to explain where all that money will come from.
Actually, the source of that money is blindingly obvious—we will get those funds the same way modern society always gets those funds. We will create them out of thin air. But, scream the monetary Puritans, if you just create money willy-nilly out of thin air, what will stop us from becoming Zimbabwe with runaway inflation? Again the answer is obvious—don't create money will-nilly—only create money to pay for things that make the society richer.
There are three basic hypotheses of money creation that professional economists recognize. First, and probably the most widely accepted among professional economists today, is the financial intermediation theory of banking. This idea is that banks are merely intermediaries between savers and borrowers: the banks take in deposits, then when someone needs a loan, the banks lend them some of the money they have collected as deposits. Thus banks do not really create money, they just aggregate it and distribute it. Moreover, since any other institution can do pretty much the same thing - General Motors Acceptance Corp, for example, or General Electric's GE Capital, or even your local chain of grocery stores, then banks are really not that special, and all those fancy models of how the economy works can pretty safely ignore the existence of banks. Uh huh. Well, that's their theory, and they're sticking to it, even though it has, cough, cough, some difficulty in explaining why what happened in 2007-2008, uh, happened.

The second basic hypothesis is the fractional reserve theory of banking. This was the predominant hypothesis in economics from the 1930s to the late 1960s. In this view, banks are financial intermediaries, just like in the first view, but the banks as an aggregate system can create money by lending out some fraction above and beyond what they actually hold in deposits. For example, say a bank has $100 million in deposits. It can lend out $90 million and hold a reserve of $10 million. The borrower of the $90 million then deposits it in another bank, which in turn can now lend out $81 million while holding a reserve of $9 million. The borrower of the $81 million then deposits it in yet another bank, which, in turn, can now lend out $71.9 million while holding $8.1 million in reserve. And so on and so on, to the final iteration. In this way, the banking system as a whole can create new money, while any one individual bank cannot. Bank regulators can adjust the "reserve requirement" to either increase or decrease the amount of new money the banking system as a whole can create and lend out.

The third basic hypothesis of money creation is the credit creation theory of banking, and it holds that banks create money out of nothing when they grant a loan. The key to understanding why all this arcane banking stuff is so important is to realize that if the credit creation theory of banking is correct, then why does it necessarily have to be banks that do the creating? Why can't it be governments also? Interestingly, most professional economists - including Keynes - dismiss the credit creation theory of banking as the work of a lunatic fringe. But the credit creation theory of banking has been gaining adherents since the financial crashes of 2007-2008, as people like you and me have turned our attention to these matters that were previously the lonely province of professional economists. Or as Dr, Werner puts it:
Since the American and European banking crisis of 2007–8, the role of banks in the economy has increasingly attracted interest within and outside the disciplines of banking, finance and economics.
As the credit creation theory of banking has fought for acceptance, the debate has been rather furious at times: recall the controversy a few years ago over the idea of the U.S. national government erasing its budget deficit by minting a special coin with a face value of $1 trillion, and depositing it with the Federal Reserve. The thing is, as Dr. Werner dryly notes in his paper:
Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories.
So what Dr. Werner, a German-born economist at the University of Southampton in Britain, and some colleagues set out to do was to borrow a large sum of money from a bank, and track what actually happens in the bank's internal accounting and management systems.
The simplest possible test design is to examine a bank's internal accounting during the process of granting a bank loan. When all the necessary bank credit procedures have been undertaken (starting from ‘know-your-customer’ and anti-money laundering regulations to credit analysis, risk rating to the negotiation of the details of the loan contract) and signatures are exchanged on the bank loan, the borrower's current account will be credited with the amount of the loan. The key question is whether as a prerequisite of this accounting operation of booking the borrower's loan principal into their bank account the bank actually withdraws this amount from another account, resulting in a reduction of equal value in the balance of another entity — either drawing down reserves (as the fractional reserve theory maintains) or other funds (as the financial intermediation theory maintains). Should it be found that the bank is able to credit the borrower's account with the loan principal without having withdrawn money from any other internal or external account, or without transferring the money from any other source internally or externally, this would constitute prima facie evidence that the bank was able to create the loan principal out of nothing. In that case, the credit creation theory would be supported and the theory that the individual bank acts as an intermediary that needs to obtain savings or funds first, before being able to extend credit (whether in conformity with the fractional reserve theory or the financial intermediation theory), would be rejected.
Dr. Werner and his colleagues approached a number of banks in Europe, but all the big banks they asked declined to be involved in the experiment. All the big banks gave two basic reasons for their refusal: they were unwilling to risk compromising their internal management and IT systems, and the amount of money the team wanted to borrow - 200,000 Euros - was too small. I quote: "... the transactions volumes of the banks were so large that the planned test would be very difficult to conduct..." OK, then.
It was therefore decided to approach smaller banks, of which there are many in Germany (there are approximately 1700 local, mostly small banks in Germany). Each owns a full banking license and engages in universal banking, offering all major banking services, including stock trading and currencies, to the general public. A local bank with a balance sheet of approximately €3 billion was approached, as well as a bank with a balance sheet of about €700 million. Both declined on the same grounds as the larger banks, but one suggested that a much smaller bank might be able to oblige, pointing out the advantage that there would be fewer transactions booked during the day, allowing a clearer identification of the empirical test transaction. At the same time the empirical information value would not diminish with bank size, since all banks in the EU conform to identical European bank regulations.
Thus an introduction to Raiffeisenbank Wildenberg e.G., located in a small town in the district of Lower Bavaria was made....
It was agreed that the researcher would personally borrow €200,000 from the bank. The transaction was undertaken on 7 August 2013 in the offices of the bank in Wildenberg in Bavaria. Apart from the two (sole) directors, also the head (and sole staff) of the credit department, Mr. Ludwig Keil was present. The directors were bystanders not engaging in any action. Mr. Keil was the only bank representative involved in processing the loan from the start of the customer documentation, to the signing of the loan contract and finally paying out the loan into the borrower's account. The entire transaction, including the manual entries made by Mr. Keil, was filmed. The screens of the bank's internal IT terminal were also photographed. Moreover, a team from the BBC was present and filmed the central part of the empirical bank credit experiment (Reporter Alistair Fee and a cameraman).
Dr. Werner presents the full results in his article, including
  • a numbered sequence of the steps the bank took in reviewing and granting the loan, then crediting the loan amount to the researcher's account;
  • the bank's balance sheet the day before the loan was made, and the balance sheet the day after the loan;
  • the key asset positions of the bank the day before the loan, and the key asset positions the day after;
  • the key liability positions for the same periods;
  • the account summary table for the new account of the borrower;
  • a standard T-account of the transaction from the borrower's perspective.
The critical question is: where did Raiffeisenbank Wildenberg e.G. obtain the funds from that the borrower (researcher) was credited with?
Well, you can probably guess the result of this very, very interesting experiment. It turns out that the bank neither took the €200,000 from the funds it already had as deposits, nor did it obtain €200,000 from a regional or national banking authority, or from the European Central Bank. The €200,000 was simply credited to the borrower's account. Period. The €200,000, in other words, was, created out of thin air. I will close by quoting from the U.S. Constitution.
Article I, Section 8, Clause 5: The Congress shall have Power…To coin Money, [and] regulate the Value thereof...
Aargh... if only the Framers had used the word "create" instead of "coin"! Then it would be much more difficult for the oligarchs who now control the creation and allocation of money and credit, to convince the chowderheads on the right that "government has to live within its means" is our big problem, instead of what our big problem really is: the creation and allocation of money and credit is being misused and abused by oligarchs who speculate and arbitrage with that new money and credit, instead of using it for something economically productive.

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