Monday, 8 September 2014

Fractional reserve banking causes house price increases?

I support Positive Money because PM backs full reserve banking, but some of PM’s other ideas a bit strange, in particular the idea that the existing banking system is responsible for elevated house prices in the UK, a claim PM makes here. There are four problems with that idea as follows.

1. Other countries.
Other countries have EXACTLY THE SAME banking system as the UK, yet while house prices trebled between 1970 and 2002 in the UK in real terms, there was no increase at all in Germany and Switzerland! At least that’s the case according to the chart below which comes from a Policy Exchange study. Incidentally I suspect that “treble” figure is too much, but that doesn’t detract from the basic point which is that if house price increases have been substantially more in the UK that other countries with the same banking system, then it’s a near certainty that it’s not the banking system that explains the relatively large house price increase in the UK.

2. History.
Second, the existing or “fractional reserve” banking system has been going for SEVERAL CENTURIES! There is thus no obvious reason why that banking system has had any more of an effect on house prices in the last ten, twenty or thirty years than the last 110, 120 or 130 years.

3. Supply and demand.
If the banking system DOES PROUDCE a bigger demand for houses than would otherwise be the case, that won’t result in higher house prices if the supply of stuff needed to build houses (land in particular) is elastic. But of course the supply of land is not elastic, as the Policy Exchange article makes clear. Quite the contrary: in the UK the price of land for building is very restricted. So that’s the main explanation for house price increases in the UK. 

4. Money creation.
Third, PM claims “A major cause of the rise was that banks have the ability to create money every time they make a loan.” Now the problem with that argument is that there is no sharp dividing line between money and non-money. In particular, it is widely accepted around the world that so called money in term accounts does not constitute money where the “term” is more than about two months. That is, if it takes the depositor longer than about two months to access to their so called money, then what they possess is not really money. And indeed that is a policy which PM itself goes along with in that it does not count so called money in its investment accounts money where the “term” is sufficiently long.
Now as I explained in section 1.12 here and as others have explained, a bank cannot increase its loans unless there is a corresponding increase in people willing to lend, i.e. unless the number of savers increases. And a mortgage is a LONG TERM loan, thus that loan will TEND TO BE balanced by a LONG TERM DEPOSIT. That of course is not entirely true in that banks engage in maturity transformation, but there is certainly SOME TRUTH in the claim that long term bank loans are balanced by long term deposits. And if those deposits are “term” accounts, then that’s not money for reasons given above, thus  . . . roll of drums . . . it is not entirely true to say that when a bank extends a loan of £X that £X of new money is created. That is, the EXACT AMOUNT of new money created is very debatable.
But it really doesn’t matter how much new money is created. That is, if a bank grants a loan of £Y, and recipients of that new money decide to put the whole lot in two month plus term accounts, the effect  on house prices will be exactly the same as if the savers put their money into current or checking accounts and didn’t spend it. Thus the whole “money creation” point is irrelevant. It has no bearing on the house price boosting effect.

1 comment:

  1. If we looked at house prices from a population perspective, what would we see?

    If the house numbers remained constant but population increased, we would expect to see house prices increase. Bank lending to support this house-price-increase would be visible in the bank loan volume reports, and should show an increase in loan activity.

    Sellers of house property should see an increased ability to buy other products but this should be balanced by a decreased ability to buy other products for those paying the higher house prices.

    Now for our lessons from this creative example: House prices are up, bank lending is up, so should we conclude that bank lending CAUSED the price increase? I think not.

    Should we conclude that banks ENABLED the price increase? They probably made it LARGER because it would easier to convince a banker to lend than to convince a house owner to sell on time payments. But I can not conclude that banks by themselves ENABLED the price increase.

    Could banks by themselves cause a housing price increase? The answer here is clearly YES! We could take away the population increase, allow banks to make more loans on easier loan criteria than in the past, and watch the housing prices increase.

    To conclude, it seems to me that rather than noticing that countries have a similar fractional reserve banking system and then drawing conclusions, we should rule out population changes as the cause of housing price increases. Once we have established that populations have commonly remained constant, we can look for other fundamental reasons for the housing price change.


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