Wednesday, 6 January 2016

Banks do intermediate.

Richard Murphy, affectionately known in some quarters as “Murphaloon”, wrote an article recently in which he gives advice to the economics Nobel laureate, Joseph Stigligz, on the question as to whether banks intermediate between savers and borrowers. This should be interesting. (I use the word “interesting” advisedly.)

Basically Murphaloon has fallen hook line and sinker for flavor of the month, which is that commercial banks when they lend, create the relevant  money out of thin air RATHER THAN acquire such money from savers. As he puts it, “The reality is that banks technically do not need any deposits to make a loan.”

If that were the case, one has to ask why banks have dished out hundreds of billions over the decades in the form of sweetners designed to attract the money of savers (i.e. shareholders, bond-holders, depositors etc). When I say “sweetners” I mean dividends for shareholders and interest for bond-holders and depositors.

The reality is that commercial banks engage in BOTH ACTIVITIES. That is, it’s beyond dispute that they create a certain amount of new money most years (apart from in the middle of severe recessions). That stares you in the face from the money supply figures. But at the same time, they DO INTERMEDIATE.

In support of his ideas, Murphy cites a recent Bank of England publication. As he puts it, “As the Bank of England conceded in April 2014, the idea that banks act as intermediaries between savers and investors is just wrong.” Well if you word search for “intermediate” in the BoE work you won’t find anything about the intermediation idea being “wrong”.

What the BoE publication DOES SAY (in the summary of its second section) is “…banks do not act simply as intermediaries, lending out deposits that savers place with them…”.

That’s correct. I.e., as I said above, commercial banks do intermediate, but that’s not all they do: in addition they create a finite amount of new money most years.

The intermediation process.

The reason why commercial banks must obtain a certain amount of savers’ money before lending is thus.

Additional loans means additional spending: people borrow specifically so as to spend the money on something. Assuming the economy is at or near capacity or “full employment”, additional loans / spending must be matched by a CUT IN SPENDING elsewhere. That cut could take the form for example of a cut in public spending, but assuming “all else equal” (including public spending), additional loans / spending must be matched by additional “abstinence from spending” somewhere, i.e. additional saving.

It could well be argued that when there’s additional lending, the free market does not raise interest rates by enough to cause an equivalent amount of extra saving. And if that’s the case, the central bank has to step in and boost any naturally occurring rise in interest rates by an artificial rise in interest rates.

But the fact remains that given additional loans, and assuming all else equal, and assuming full employment, there has to be additional saving.

Put another way, given EXCESS unemployment (i.e. plenty of spare capacity), additional loans can indeed be made with no corresponding saving. But unfortunately that point is of limited relevance because given a recession, the one thing that commercial banks DO NOT DO is the save the day by granting more loans. That is, commercial banks act in a pro-cyclical rather than anti-cyclical manner.


  1. You say that at full employment "when there’s additional lending...there has to be additional saving"

    Not so.
    (a) There is no obvious reason for savings to increase if incomes are unchanged and the government keeps interest rates constant.
    (b) Extra saving by the private domestic sector is just one possibility, and probably the least likely. Other more likely outcomes are extra imports, reduced investment (other than investments financed by bank loans), reduced exports, higher taxes or reduced government expenditures.
    (c) If there were any extra savings, only a small fraction would be kept in bank deposits. Most would be invested in equities, housing etc.
    (d) As you note, banks do indeed compete with each other for deposits. However, such inter-bank competition does not imply that banks are seeking funds in order to make loans.
    Banks compete because there are profits for an individual bank resulting from economies of scale etc. This does not increase overall bank deposits, while overall bank profits are likely to be reduced by such competition. Inter-bank competition does not imply that banks intermediate between borrowers and savers.

  2. a) But if loans rise, then (all else equal) spending and incomes WILL RISE. Borrowers borrow specifically so as to spend on something or other.

    b) If the extra spending / demand caused by extra loans is met by imports, then I agree: there’d be no need for extra saving – at least for a while. But there’s a problem, which is that assuming one starts from a balancing external position (exports = imports), then those extra imports will cause a fall in the value of the currency relative to other currencies. That in turn cuts imports and increases exports sooner or later. Thus in the long run the effect is the same: the above extra demand has to be met by suppliers WITHIN the relevant country.

    c) By “saving” I meant “hoarding of cash” so to speak, rather than making some sort of physical or other investment. I should have made that clear. Keynes incidentally used the word saving in the same sense in his “paradox of thrift” point. That is, thrift in the sense of hoarding cash causes a problem: a rise in unemployment. In contrast, thrift in the sense of making some sort of physical investment like buying a new car or building an extension on your home does not cause unemployment.

    d) I don’t fully understand your point. You say that banks DO COMPETE for savers’ money, but that that money does not make it easier for them to lend. The question that arises from that point is: why then bother to compete for savers’ money? My answer is that if a bank JUST funds loans (which is where profits are made) out of freshly created money, the relevant bank runs out of reserves.

  3. Just a thought,do banks need deposits to suffocate the opposition so to speak.The more bankimg customers they have the less money they have to transfer to other banks,which saves them having to find the reserves.If you dominate the market the money flows to you,or at least stays with you.I have read that the best system would be where all banks expand loans or contract at the same rate,so that no bank becomes overextended.Of course they can also sell life insurance,savings plans,PPI,mortgages to these customers, so that must be an attraction too.

    1. Yes, if bank X can attract deposits, bondholders etc away from banks Y,Z, etc, that helps bank X to "suffocate the opposition" so to speak.

  4. The New Economics foundation explain the need for deposits.They say it is mainy for "account balance" purposes,to match assets to liabilties,they also say that deposits are cheap borrowing for the banks,better than the inetrbank rates in any case.

    See from 17 mins on this video


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