Wednesday, 18 July 2012

Tim Worstall does not understand money or banking.

Tim Worstall is normally clued up on economics. But not, so it seems, on the subject of money and banks. He says, “No, banks do not create money. The banking system as a whole creates credit. But individual banks do not create money. They just don’t.”

He needs to look up the definition of the word money in a dictionary. It is defined as something like, “Anything widely accepted in payment for goods or serves or in settlement of a debt.”

Now the fact of the matter is that when someone gets a loan from a private bank, the latter does not need to get the relevant money from anywhere: it can just credit the borrower’s account with a book keeping entry – or if you like, it can credit the borrower’s account with money ex nihilo.

And when the borrower draws a cheque on that account or does a credit or debit card transaction based on the account, the cheque or card transaction will be “widely accepted” in payment for goods and services. Ergo the bank has created money.

Here are some quotes on the subject.

"Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created -- brand new money." - Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

"When a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower."

- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

Northern Rock.

Worstall then claims that if private banks can create money “then Northern Rock would not have gone bust, would it?”

The answer to that is that there are an infinite number of grades or types of money: in particular, “Northern Rock money” is not as good as central bank money.

Indeed it was common in the 1800s and before for WEALTHY INDIVIDUALS AND FIRMS to issue a form of money: bills of exchange. The latter were simply I.O.U.s or promises to pay a certain sum on a particular future date. And they were passed from hand to hand in settlement of debts or in payment for goods and services. Ergo bills of exchange were a form of money. And issuers of bills of exchange who conducted their affairs in a competent manner had no problems, while the incompetents ended up doing a “Northern Rock”: going bust.

To summarise, private banks cannot issue a form of money which is as good as gold. They cannot produce a form of money which is as good as central bank money. But they can nevertheless issue a form of money.

Wholesale borrowing.

In the paragraph starting “What Rock actually did…” Worstall claims that Northern Rock funded itself via the wholesale money market: i.e. borrowing from other banks or other institutions.

True: to a large extent it did. But that does not prove that Northern Rock did not in addition create money. In fact for those of us who understand banks, it is obvious that a bank which DOES NOT expand faster than other banks will NOT NEED to borrow from the wholesale markets. While banks that ARE EXPANDING faster than others WILL NEED to borrow. Reason is thus.

When a bank “lends money into existence” as the saying goes, most of that money will be deposited at other banks. And the latter will want central bank money from the former bank in exchange for the former bank’s “funny money”: that’s done at the end of each working day in the books of the central bank. Now if a bank is expanding faster than other banks, it will need to borrow to cover what it owes other banks.

However, if every other bank is expanding at the same rate, the amount of money deposited at the first bank will be about equal to the amount of the first bank’s money deposited at OTHER BANKS. I.e. it all nets out, roughly speaking.

Conclusion: the fact that Northern Rock was borrowing significant amounts wholesale does not prove (a la Worstall) that Northern Rock was not creating money. It is just evidence that that Northern Rock was expanding faster than other banks, which indeed it was.



  1. "Now the fact of the matter is that when someone gets a loan from a private bank, the latter does not need to get the relevant money from anywhere: it can just credit the borrower’s account with a book keeping entry – or if you like, it can credit the borrower’s account with money ex nihilo."

    This is absolutely true. Right up until 3.30 pm on the day the loan is issued.

    For all banks must balance their books at that time. Liabilities must equal assets plus capital. Which is where the interbank market, and bonds etc come in.

    Northern Rock issues a mortgage at noon? Sure, they've just created credit and they've done so entirely by pressing a few keys on the computer.

    But at 3.30 they must find a way to fund that loan. Because, as I say, all banks must balance their books at that time each and every day.

    And as I say, this fact that Crock fell over shows exactly that banks cannot simply create money willy nilly. For if they could then Crock would not have fallen over. But it did fall over: it fell over because it had to, but could not, fund the loans it had already made.

    Ergo, banks must fund the loans they make, not simply create the money, because if they don't fund them then they are bankrupt. And Crock is the proof of this contention.

    1. Re the mortgage that Northern Rock grants at noon, it won’t owe anything to other banks, as I explained above, if the latter are expanding the amount they lend at the same rate as Northern Rock. Reason is that the amount of money loaned into existence by other banks and deposited at the Northern Rock will over a week or so equal money loaned into existence by Northern Rock and deposited at other banks. Thus Northern Rock won’t need to “fund the loan”.

      In contrast, where a bank expands its lending FASTER than other banks, which is what Northern Rock was doing, it WILL need to fund its loans (to the EXTENT that it is expanding faster than other banks). And if the latter funding dries up, it’s curtains.

  2. They don't have a week. They've got 3.5 hours.

    1. To recap, if £X created by Lloyds is deposited at Barclays and within 3 hours £X created by Barclays is deposited at Lloyds, there is no need for the two banks to settle up or borrow anything.

      As to where Barclays does not create its £X for another week or so, the ultimate effect is just the same. Lloyds will need to borrow reserves (assuming it does not have enough). Let’s say to keep things simple there are just two commercial banks, so Lloyds will borrow from Barclays. But at the end of the week, Lloyds will be able to repay Barclays. Net result: the commercial bank system has created money, and no individual bank has had to borrow on a long term basis to do it.

      There is actually a chart showing the extent to which commercial bank money expanded faster than central bank money (monetary base) prior to the crunch. Scroll half way down here:

  3. Excellent, so we agree. Individual banks do not create money but the banking system as a whole creates credit.

    Which is what I said at the start, isn't it?

  4. I agree that there differences between what central banks create and what commercial banks create. For every pound of money/credit that commercial banks produce, there is a corresponding pound of debt owed by some private sector entity.

    In contrast, private sector debts do not rise when the government / central bank machine creates and spends more money into the economy.

    So if your definition of money is something like “net financial assets in the hands of the non-bank private sector”, then commercial banks do not create money, as you say. But I’m sticking to the traditional definition of money, which is something like “anything widely accepted in payment for goods and services”. And commercial banks do produce something “widely accepted…” I.e. assuming I’ve identified the difference between us, then the difference is semantic.

    Incidentally most advocates of Modern Monetary Theory have a good grasp of the above distinction between central bank and commercial bank money, which is one reason I support MMT.

  5. I picked up on this discussion, and found it interesting and important enough to write something on it. The post is at
    Essentially you're both right - and both wrong!


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