Deposits create loans or the other way round?

The “loans create money” brigade have got all excited over the last two weeks or so as a result of this Bank of England publication which says that loans create deposits / money.

Actually the cause effect relationship runs both ways. That is, the commercial bank system cannot lend an extra £X unless someone or a collection of people are prepared to deposit approximately £X in the commercial bank system. That is, the relationship between depositors and borrowers is a bit like the relationship between apple growers and apple consumers: the market price for apples is not determined exclusively by buyers or sellers.

Or as Nick Rowe put it, “And commercial banks, neither individually nor collectively, can create loans, unless they can persuade people to hold their deposits and not hold central bank money instead.”

At least the latter point by Nick is right if the economy is at capacity. That is, in the latter scenario, if commercial banks did simply credit the accounts of borrowers without bothering to see if they had enough depositor money, the result would be increased aggregate demand. That is, the fact of failing to “persuade people to hold their deposits” would mean that those depositors would try to spend away their increased stock of money, thus demand would rise, which would be inflationary, which the central bank / government would counter, e.g. by raising interest rates or increased taxes. Result: no extra borrowing.

In contrast, if the economy is BELOW capacity, lending money into existence with the resulting depositors trying to spend away their new stock of money would increase demand. But that wouldn’t matter to the extent that extra demand was called for.

Central bank money creation renders commercial bank money creation superfluous.

A system in which there are commercial banks but no central bank would work without any big problems, far as I can see. Obviously there’d need to be some generally agreed money unit, e.g. a gram of gold, to start with. But once the system was up and running, the relevant country could abandon the “gold standard”.

As to settling up between themselves, commercial banks would not have the convenience of using central bank money. But that wouldn’t matter too much. First, they’d just let inter-bank debts stand for longer in the hope that those debts were eventually wiped out by countervailing debts. Indeed, even under the existing system, i.e. where there IS A CENTRAL BANK, commercial banks don’t always settle up inter-bank debts immediately. Second, there is no limit to the number of assets that can be used to settle up: shares, bonds, property, etc.

It’s possible that in a “commercial bank only” system, and absent a gold standard, banks would lend too much and bring hyperinflation, but that’s not what I want to concentrate on here.

Rather, the point I want to make is that money creation by commercial banks is inherently expensive, compared to central bank money creation. That is, to monetise an asset, a commercial bank has to check up on the value of the asset, and that involves significant costs. Plus there is the risk that something goes wrong, e.g. the person depositing the asset / collateral might be a fraudster and doesn’t actually own the asset. The bank has to insure against that risk.

In contrast, once a central bank is established, and everyone accepts that it issues money in a reasonably responsible way, the cost of creating and spending that money into the economy is next to nothing. And even when government is an IRRESPONSIBLE issuer of money, as used to be the case with Robert Mugabe, people will still use the government’s money until levels of inflation become totally absurd, at which point (as was the case in Zimbabwe) people will start using some other currency (US dollars and South African Rands in the case of Zimbabwe).

___________

P.S. (31^st March 2014). My above claim that central bank money creation is more efficient that commercial bank money creation begs the question as to why commercial banks manage to compete with central banks. That is, how come commercial banks manage to create money at all?

One answer is that central banks create an inadequate amount of money, which leaves room for the “counterfeiters” so to speak. A classic example of this is taking place right now in the UK. That is, politicians and half the economics profession cling to the daft notion that a deficit leads to increased national debt, and thus that we have to be ultra cautious with deficits. As I’ve pointed out a trillion times before on this blog, Keynes stated quite rightly that a deficit can be funded either by debt or new money. But the latter ignoramuses immediately start changing “inflation” as soon as the words “print” and “money” appear in the same sentence. But for some bizarre reason they think that private bank lending / money creation WON’T BE inflationary.

The latter delusion is in overdrive mode just at the moment in the UK in that politicians and economically illiterate economists are having a nervous breakdown about the deficit, while doing all they can to encourage excessive private bank lending: “funding for lending”, “help to buy”, etc.

 

National debt should be called “private sector savings”.

At last – a letter in the Financial Times spells out what advocates of Modern Monetary Theory have been saying for years, namely that government debts might as well be called “private sector savings”.

I also advocated the change of name here a year or two ago.

I particularly like this passage from the letter: “A frequent question is: “Look at the size of the debt – how on earth are they going to finance it?” One could just as easily ask: “Look at all those savings in Japan – where on earth are they going to invest that?”

The letter also advocates what it calls “sectoral flow of funds analysis”: another tool that MMTers are keen on.

In fact money deposited at the UK’s “National Savings and Investments”, which is a sort of publicly owned savings bank, is all invested in government debt. Now if you ask people if a rise in sums deposited at NSI is beneficial, all else equal, they tend to answer “yes”. I know, because I’ve asked several people.

But if you ask them whether a rise in government debt is beneficial, all else equal, they almost invariably say “no”.

Tee-hee.

Douglas J Elliot’s flawed Brookings Institution article.

As an advocate of much higher bank capital ratios (and preferably a 100% ratio) I’m always much encouraged by the incompetence of those who argue against higher capital ratios.

Douglas J.Elliot tries to argue in this Brookings Institution article that improved bank capital ratios would come at a cost.

His first argument is that “interest payments on debt are tax-deductible while dividend payments on common stock are not.” Thus if banks had to have more capital, that would raise their costs. Well the flaw in that argument should be obvious: tax is an ENTIRELY ARTIFICIAL imposition. It has precisely and exactly nothing to do with underlying REAL COSTS.

I shouldn’t have to illustrate that point because it should be obvious, but evidently I’ll have to, so here’s a nice simple illustration that even those who write for the Brookings Institution will hopefully understand.

If government taxed red cars more heavily that blue cars,that would raise the retail price of red cars. But that would not be evidence that the REAL COST of producing red cars was any more than the cost of blue cars. Hope that’s clear now.

But I’ve got good news for Douglas J.Elliot: I’ve come across more than one other so called “economist” who doesn’t get the point that the change in price brought about by a tax is an entirely ARTIFICIAL change in price.

Point No.2: TBTF.

Elliot’s second point makes the same mistake as above first point. That is, he argues that where a bank is funded by debt, the bank is not charged as much as it should be for that debt since the relevant creditors know or suspect they are protected by the Too Big To Fail subsidy. So to that extent, having banks funded by capital rather than debt would raise bank costs.

Well of course! But there again, the TBTF subsidy is ENTIRELY ARTIFICIAL. It does not reflect REAL UNDERLYING costs.

Bizarrely, Elliot actually concedes the point that TBTF and other bank subsidies are an entirely artificial contrivance. He says “Advocates of higher capital correctly point out that these subsidies represent policy distortions and ought to be done away with..” But for some reason he still clings to his claim that deposits are an inherently cheaper method of funding a bank than capital.

Third: asymmetric information.

Elliot then claims that since management knows more about a bank than potential purchasers of its shares, and because management is likely to be overoptimistic about the bank’s prospects, potential share buyers will want a discount when a new issue of shares is offered. Thus, so he argues, having depositors fund a bank is an inherently cheaper method of funding.

Well the first answer to that is that is “bonds”. Bonds are a sort of compromise between shares and deposits. That is, like deposits, a bank’s liability is fixed in dollar terms in the case of a bond. But like shareholders, bond holders are not the most senior type of creditor. And when a bank issues bonds, exactly the same “assymetric” point applies: that is, potential bond holders want a discount.

As to depositors, one important reason they don’t demand a discount when supplying a bank with funds is that most depositors are protected by taxpayer funded guarantees: again an entirely ARTIFICIAL contrivance.

A second reason depositors don’t demand a discount is that they are senior creditors. But of course it’s nonsense to deduce from that that funding a bank almost entirely via depositors is therefore an inherent cheaper method of funding. Reason is that the higher the proportion of a bank’s creditors that are made up of depositors, the less the significance of the word “senior”. To illustrate, if 99.9% of a bank’s creditors are depositors and 0.1% are shareholders, then the word “senior” is almost meaningless. Who are depositors senior to? Almost nobody!!

Conclusion.

Given the poor quality of Elliot’s first three arguments against higher capital ratios, I can think of better things to do than examine his fourth, fifth and sixth reasons.