World Economic Forum article claims private banks don’t create money.

The article is entitled “Do banks really create money out of thin air?” though the WEF do not officially endorse the arguments in the article.

The article starts with the hypothetical example of person S who sells a house to person B. “S” is obviously short for “seller” and “B” is obviously short for “buyer”.

The initial assumption is that B does not have any cash, so after the sale, B simply becomes indebted to S for the value of the house. And that, as the article rightly points out, is an arrangement which will not suit the vast majority of house sellers. Among other things, it involves S in collecting regular repayments and interest in respect of the debt from B for 20 years or so.

Next, the article explains that banks can help with the latter problem: a bank can open an account for B, credit the account with an amount of money equal to the value of the house (produced from thin air), which B then pays to S. S is now relieved of the inconvenience of collecting the debt from B, plus S has money with which to buy an alternative house.

But despite the obvious admission referred to in the latter paragraph that a bank has in fact created money from thin air, the article in the final paragraph then says:

“But this is only the prima facie appearance and not the truth of the matter because the outside observer has neglected to acknowledge that the deposit value records the value-for-value exchange conducted through an underlying transaction.”

Well the cognoscenti (which includes me needless to say) have always been aware that commercial bank created money nearly always RESULTS FROM the desire of people and firms to do business. I.e. if B did not have any need for a large amount of money, there’d be no point in B going along to a bank and asking for a loan, would there? But the fact that that money creation results from something or other does not stop that money creation being money creation, unless I’ve missed something.

The second flaw in the latter final paragraph, is that in fact banks will create money even where there is no immediate desire to do business. This is unusual, but if a particularly credit worthy bank customer went along to a bank and said “I have no immediate business deals in mind, but please lend me a million so that when a profitable looking deal comes my way I can pounce on it.”, the bank might well go along with that (and of course charge for the service provided). 

Private banks do not charge interest in respect of the money they issue.

There is a popular myth to the effect that the above is the case. The myth is promoted by among others, Positive Money, an organisation I actually support because PM gets many things right. Also Bryan Gould (former member of the UK Labour Party shadow cabinet) seems to lend credence to the myth.

The idea that private banks DO CHARGE interest in respect of the money they issue stems from the “loans create deposits” phenomenon: that is, when a bank makes a loan, it does not need to get the relevant money from depositors or from anywhere else. It can simply open an account for the borrower and credit $X to the account – the money comes from thin air. The bank then charges interest on the loan.

Thus banks do two things there: first, create money, and second, charge interest. Ergo, so it might seem, they charge interest on the money they have created.

The flaw in that argument is that banks either charge for the loan or for the money. They cannot charge for both. I.e. if a bank charges 5% interest, is that for the loan or is it the lucky recipient of the money who is charged?

Take the case of a loan for $X which is granted to Y, who then spends the money, which ends up in the bank account of Z. There is no doubt that Y pays interest to the bank. But Z, the recipient of the money doesn’t.!! If anything, Z charges his or her bank interest (or put another way, Z’s bank will pay interest to Z, particularly if the money is put into a term account.)

 
Double checking the argument.

By way of double checking the above points, consider an economy where there was no borrowing or lending, but people did (understandably) want a form of money. And let’s say that money is supplied by, or at least supplied almost exclusively by private banks.

Those banks would open their doors for business. Customers would ask to open accounts and would ask for some specific sum of money to be credited to those accounts to enable day to day transactions to be done. Banks would demand collateral as appropriate.

Certainly banks would charge for ADMINISTRATION  costs there (e.g. the cost of checking up on the value of collateral). But there would at that stage be no reason to charge INTEREST because no real resources would at that stage have been transferred by banks to customers.

Moreover, even after customers started spending their money, there would still be no very good reason for banks IN THE AGGREGATE to charge customers in the aggregate for interest. Reason is that money leaving one account must arrive in some other account. (To keep things simple, I’ll assume there is no physical cash – a not totally unrealistic assumption, given that it looks like physical cash will disappear in the near future.)

Of course where specific customers ran down their bank balances, and left them in a “run down” state for extended periods, banks would charge interest to those customers. But in that case, real resources would have been transferred to those customers for an extended period. That is, the only way for that “extended run down” to occur is for relevant customers to buy stuff off other customers and leave it at that. I.e. the latter “buyers” would in effect be borrowing from the latter sellers with banks acting as intermediary. Sellers, would understandably want interest, and that interest would be passed on to buyers.

 
Conclusion.

Banks charge interest on loans. They also charge for administration costs when supplying customers with day to day transaction money. But it would not make any sense for banks to charge interest simply for supplying all and sundry with day to day transaction money.

Random charts XX.

Text in pink on the charts below was added by me.

Steve Keen and Mish make a fallacy of composition error?

I agree with Steve Keen and Mike Shedlock (“Mish” for short) about 90% of the time. But they’ve slipped up on the subject of bank reserves, unless I’ve missed something. I’ll use the word “bank” to refer to commercial banks (as distinct from central banks)

Mish challenges the conventional wisdom on interest on reserves (IOR), which is that IOR is an incentive for banks not to lend. The conventional wisdom is that if a bank gets say 5% on its reserves, and given that lending $X means the bank loses about $X of reserves, it won’t lend unless it gets at least 5% after expenses from the potential borrower.

Mish challenges that by pointing out that the decision by an individual bank (or indeed the bank industry as a whole) to lend more has no effect on the industry’s stock of reserves. He concludes from that that interest on reserves does not provide banks with an incentive not to lend.

Well it’s true that the decision by a bank or the bank industry as a whole to lend more has no effect on the industry’s stock of reserves. However, the flaw in the latter “Mish” argument is that “incentives” as seen by an INDIVIDUAL bank are not the same as “incentives” as seen by the commercial bank system as a whole. That is, if an individual bank (to repeat and over-simplify a bit) gets say 5% on its reserves, it has no incentive to lend unless it gets MORE THAN 5% from the potential borrower after expenses.

The fact that IF IT DID LEND, there would be no effect on the TOTAL AMOUNT the bank industry gets by way of interest on reserves is irrelevant because banks just don’t collude when it comes to the decision by an INDIVIDUAL bank to lend – they couldn’t collude if they tried. To illustrate…

Suppose that bank A is contemplating a loan of $Y to a customer, and suppose that in the event of the loan taking place, relevant monies will be deposited at bank B. It is plain impossible for both banks to get together and work out the effect on their combined incomes as a result of making that loan: reason is that each bank will be making thousands of loans per day. Moreover, in the latter example, relevant monies will not necessarily be deposited at just one bank (i.e. bank B): chances are they’ll be deposited at several banks. And worse still: relevant monies will not stay at recipient banks for long. Those monies will be re-spent and deposited at yet another set of banks.

Thus the idea that banks can somehow collude with a view to working out the effect on their total income as a result of one bank making a loan is wholly, completely and totally unrealistic.

Random charts IXX.

Text in pink is added by me to the original charts.

Do Job Guarantee enthusiasts want the entire workforce raking leaves rather than doing something useful?

Reason I ask is that it’s not entirely clear where JG enthusiasts stand on this one. For example Pavlina Tcherneva is one of the more vociferous advocates of JG, but in the opening paragraphs of an article of hers (Levy Economics Institute Policy Note 2012/2) she criticises conventional stimulus and sings the praises of JG type employment.

So how far does she want to take that point: abolish all forms of conventional employment, and instead have the entire workforce raking leaves, planting trees and doing the other assortment of jobs normally given as examples of what JG / make work scheme employees can do?

Strikes me as pretty obvious that the optimum policy here is to boost demand as far as possible, and get as much of the workforce as possible into conventional types of employment (public and private), and then use JG to deal with the remaining and unemployed members of the workforce. But there is no hint in her article of the latter idea.

More evidence of the dim view she takes of conventional forms of employment comes in this tweet of hers where she castigates dangerous car factories. Well the solution to that is proper and properly enforced health and safety laws, not closing down every car factory in the country and putting redundant employees onto raking leaves and planting trees.

Amazing that it is even necessary to explain this, isn't it?

Factories that produce cars and other items produce what people actually want and are prepared to pay for (shock horror). JG work is inevitably less productive because if a given JG job really was more productive than the less productive regular jobs, market forces would bring the former into existence and dispense with the latter, all else equal, i.e. assuming a constant level of aggregate employment.

Moreover, it’s not as if there is a total absence of injury and death on JG projects: a significant proportion of the JG scheme which operated in the 1930s, namely the WPA, involved constructing buildings, roads, bridges and so on. That sort of work is inevitably quite dangerous.

In contrast to today’s deluded JG advocates who will get precisely nowhere under the current Republican administration, the JG ideas I was advocating about 20 years ago have actually been put into effect, albeit in a small way.  One idea I advocated was that JG type work should be with EXISTING employers rather than on specially set up projects, as per WPA. Second I advocated that there should be no preference for public sector employers as compared to private sector employers (or vice-versa).

Those two ideas are in fact inherent to the only JG type scheme up and running in the UK, i.e. the Work Programme.

For my latest ideas on this subject, which have not changed substantially from 20 years ago, see my recent paper in the journal below. This is an exercise in tidying up and bringing things up to date.

Random charts XVIII

Text in pink is added to original charts by me.

Nonsense from the World Economic Forum.

A recent World Economic Forum publication claims everyone in any given country would have to “contribute” something if that country’s national debt was to be paid off. Er – no they wouldn’t because (to over-simplify a bit) for every dollar of so called debt, there is someone with a dollar of a financial asset called “government bond” or similar. (“Treasury” in the case of the US or “Gilt” in the case of the UK for example).

Thus in the simple case of where a country’s national debt is held entirely by residents of the relevant country, the national debt could be wiped out by for example by simply having government announce it no longer owed anything to anyone. Debt holders would lose $X, while others would be relieved of the obligation to repay $X to debt holders, thus the average “contribution” per citizen would be zero.

A more subtle and less dramatic way of doing the same thing would be some sort of tax on debt holders combined with tax cuts and/or increased social security payments for the less well off. But the end result would be the same: a zero net “contribution” per citizen.

Of course in the real world, most countries’ debts are to some extent held by foreigners. But that makes little difference if the amount of country A’s debt held by citizens of country B is balanced by the amount of country B’s debt held by country A.

And so far as the World as a whole goes, the same applies as in the above example of where all of a country’s debt is held by natives of that country: that is, debts and financial assets in the form of government bonds net to nothing for the World as a whole.

In contrast to the above sort of “net to nothing” scenarios, a country can of course be left in debt to other countries after all the above “netting off” has been done. Such a country clearly has a problem, maybe a serious problem, maybe not: depends on the size of the debt.


 
 Kenneth Rogoff.

This is all reminiscent of the nonsense spouted by Kenneth Rogoff, Carmen Reinhart and other economists at Harvard luniversity. According to Rogoff, what he calls “financial repression” has to be endured for a country to pay off its national debt. And “financial repression” according to Rogoff is bad, bad, bad and horrible.

In fact, as MMTers have pointed out ad nausiam, a country which issues its own currency has total and complete control of the rate of interest it pays on its debt. Thus it can perfectly well organise things so that the REAL or “inflation adjusted” rate of interest on its debt is zero or even negative. In the latter scenario, national debt is not any sort of burden: in fact in that scenario, if anything, it’s the debtor who rips off the creditor rather than vice-versa.

But that does not mean it’s a good idea to let debts rise for ever (relative to GDP). The time to cut the debt is when the economy has a fit of Alan Greenspan’s “exuberance” and inflation looks like getting uppity. In that scenario, taxes can be raised and some of the debt can be paid off. But note that that DOES NOT constitute any sort of Rogoff type “standard of living reducing repression”: the object of the exercise is simply to control inflation – there is no effect on GDP or average incomes.

Indeed, given that excess inflation imposes various real costs on the country, a rise in tax (given excess inflation) far from being any sort of “repression” equals an all-round benefit for the country.

Kenneth Rogoff’s “financial repression” is pure, unadulterated bullshit.
And the final important point to understand about national debts (as pointed out over and over by MMTers) is that national debts are self limiting. That is, debt (to repeat) is a financial asset as viewed by the private sector, and the more such assets the private sector holds, the more it will spend, all else equal. If someone gave the average household a million dollars worth of debt, what would the average household do? It wouldn’t just sit on it! Doubtless it would save or “sit on” some of it. But at the same time it would try to sell and spend away a significant proportion.

Bank capital ratios - the incompetent critics of Modigliani Miller.

The Modigliani Miller (MM) theory is defined by Wikipedia as the idea that “the value of a firm is unaffected by how that firm is financed”.  So as regards bank capital ratios, MM says that changing the capital ratio has no effect on the cost of funding a bank and hence no effect on the cost of loans it offers or on total profits. And that is clearly good news for those who want to raise bank capital ratios.

By the same token it is not good news for the pro-bankster “let’s get back to business as usual” brigade. Thus the latter brigade devotes considerable efforts to criticizing MM. Unfortunately some of their efforts are not too clever, to put it politely.

One of the most popular criticisms of MM (in fact THE most popular, far as I can see) is the idea that the tax treatment of dividends is different from the tax treatment of interest, ergo MM does not work out in the real world as per theory. That different tax treatment seems to be relevant for the big “bank capital ratio” argument, since banks are funded in part by dividend earners (holders of bank capital) and in contrast, depositors and bond holders (who earn interest, not dividends).

Astute readers will have spotted the flaw in the latter “tax” argument. But for the benefit of those who have not, the flaw is that tax is an ENTIRELY ARTIFICIAL imposition on corporations: it has nothing to do with the validity or otherwise of MM.

To illustrate, suppose my great new seminal theory states that the cost of making blue cars is the same as the cost of making red cars. Then suppose government imposes a much heavier tax on red cars than blue cars. Would that prove there was something wrong with my “red and blue car” theory? Clearly not.

But the highly qualified academics who cite the above tax point against MM would presumably claim that, by the same token, there was something wrong with the “red and blue car” theory. How dumb can you get?

Just to expand on that, if the red cars were taxed more heavily than blue cars, then on the face of it (i.e. from the point of view of car buyers) red cars would be more expensive than blue cars. But of course from the point of view of the country as a whole, there is no difference between the cost of red and blue cars.

To illustrate, if people switched from blue to red cars, that would mean consumers would be worse off. But it would mean more income for government, which means government could for example cut income tax. Thus consumer / tax payers would be back where they started.

And of course when it comes to bank capital ratios, the important consideration is costs for the country as a whole, not costs for bank customers.


If government has introduced a distortionary tax regime, the best solution is to get rid of the distortion. The distortion is not a brilliant argument for protecting or boosting forms of economic activity that benefit from the distortion.

If you want a list of the so called “professional” economists who cite that tax argument against higher bank capital ratios, i.e. economists who apparently do not understand the latter “red and blue car” point, here they are. At least these are the ones I’ve come across. Doubtless there are several more.

Note that for one of the economists below, the tax criticism of MM is the only one cited, so it’s presumably the only one the relevant author can think of. And for another, only two criticisms are cited, one of which is the tax criticism. So all in all, the tax argument is an important one for the critics of MM.

Birchler, U. & Jackson, P. (2012).  ‘The Future of Bank Capital.’

Elliot, D.J.  (2013).  ‘Higher Bank Capital Requirements Would Come at a Price’. Brookings Institution.

Independent Commission on Banking Final Report, section 3.45.

Kashyap, A.K., Stein, J.C. & Hanson, S. (2010). ‘An Analysis of the Impact of “Substantially Heightened” CapitalRequirements on Large Financial Institutions’. (The tax point is the only criticism cited by Kashyap & Co).

Miles, D., Yang J., and Marcheggiano G. (2011). ‘Optimal Bank Capital’. Bank of England External MPC Unit Discussion paper No.31. Note: the version of this paper referred to here is the April 2011 version, not the January 2011 version.

Ratnovski, L. (2013). ‘How much Capital Should Banks Have?’ Voxeu. (The tax point was one of two criticisms of MM cited by Ratnovski).

So the economics profession never promoted austerity?

Simon Wren-Lewis claims the economics profession was pretty much innocent of promoting austerity during the recent recession. He claims surveys of economists opinions on the subject would show a large majority favoured stimulus rather than austerity.

I agree that gauging the exact extent to which the economics profession was guilty / innocent of promoting austerity during the recent recession is difficult. Surveys of the type he suggests would help. But what also needs to be taken into account is the clout of relevant economists. And the fact is that powerful voices in the profession were calling for austerity (politely known as “consolidation”).

One powerful voice was the OECD. Another was the IMF.

For more on the IMF and OECD’s enthusiasm for consolidation / austerity, Google “consolidation” “IMF” “OECD” “billyblog”.

As for Rogoff and Reinhart, the two Harvard economists who argued loud and clear for holding back on stimulus, my impression is that they were making huge efforts to promote their pro-austerity views to judge by the amount they had published on the subject.

R&R are essentially a pair of simpletons who have fallen for the understandable mistake made by the general public and by some newspaper economics commentators (who should know better), that national debts are just like other debts and have to be paid back by “future generations”.

The reality (as MMTers keep pointing out) is that a country which issues its own currency can pay any rate of interest it likes on its debt: if it wants to reduce it, it just has to print money and buy back debt, then raise taxes so as to deal with any excess inflationary effect of the latter printing.

For more detail on the latter point, Google "national debt ralphonomics", though there is plenty of equally good material produced by other MMTers.