Friday 1 August 2014

Private banks don’t exacerbate debts.





Positive Money, along with many others falls for the superficially plausible argument that private banks create a form of money which is “debt based”, thus the latter activity might seem to exacerbates indebtedness, ergo we should dispose of debt based money. There is actually a very good argument for doing the latter, i.e. disposing of debt based money (and more on that below). But the latter "superficially plausible" argument is not it. The flaw in the "superficial" argument is thus, and we’ll start with day to day transaction money as opposed to long term loans.
If you want £X of transaction money from a bank, the bank credits your account with £X which is an artificial debt owed BY THE BANK TO YOU. And you can force the bank to “owe” that money to someone else, using your cheque book or plastic card. Plus you undertake to eventually recoup the debt / money from the “someone elses’” and repay the £X to the bank. So initially there are two equal and opposite debts there. No net debt exists before you actually start to spend the money the bank credits to your account.
In fact there’s probably a THIRD debt: if you deposited collateral at the bank, the bank owes you that collateral when you repay the bank. So in that scenario, there is initially a net debt OWED BY THE BANK TO YOU!!!!! 
Spending starts.
Once you start spending your day to day transaction money, then your debt to the bank rises (or if you like, the bank’s debt to you falls). But let’s say everyone else in the economy has done the same as you: got themselves some transaction money which they spend. That money must end up somewhere, and some of it will end up in YOUR ACCOUNT, assuming like 99% of the population you have some sort of income (e.g. from work, benefits, etc). So on balance (to oversimplify the real world a little, but not by all that much) having private banks supply debt based transaction money does not result in increased debts.
Long term loans.
In contrast to day to day transaction money, there are LONG TERM LOANS, of which mortgages are the biggest example. Having got your long term loan from a bank and spent it, that money must again end up in someone else’s account.  But the someone else must be willing to leave it there for a longish period, and for the simple reason that if they didn’t, aggregate demand would rise as a result of you spending the money you borrowed. And if the economy is at capacity, a rise in AD is not permissible. (As to where the economy is NOT AT capacity, that’s dealt with below).
In short, private banks cannot create debt based money without willing savers. But in the absence of banks, those willing savers would still be there: they’d just lend direct to those wanting mortgages. Indeed that’s exactly what happens with collateralised debt (CDOs).
In short, disposing of debt based money does not in any DIRECT WAY reduce debts any more than ceasing to use gold coins as money means the World’s stock of gold declines. (There is actually a minor and INDIRECT way in which disposing of debt based money cuts debts, but I won’t go into that here).
As Keynes said, banks don’t do anything that wouldn’t happen anyway. All private banks do, so far as long term loans are concerned,  is to intermediate between savers and borrowers: i.e. assuming private banks work efficiently, they just make the lending / borrowing process more efficient.
Moreover, in the case of long term loans, those who have deposited money in banks for longish periods will tend to put the money on “term” or deposit accounts rather than in current or checking accounts. And normal practice round the world tends to be to not count as money sums deposited in term accounts.
Indeed Positive Money itself does not count as money sums placed in the investment accounts proposed by PM. Quite right.
The economy is not at capacity.
As to where the economy is NOT AT capacity, i.e. in a recession,  the fact of banks creating money out of thin air and lending it ABSENT THE EXISTENCE of willing savers, well the increased demand stemming from that wouldn’t matter. But it’s very doubtful as to what extent that  phenomenon actually takes place. That is, as Keynes pointed out, economies can get stuck in high unemployment equilibria. Put another way, private banks far from ameliorating booms and busts  EXACERBATE  them, if anything. Certainly prior to the recent crisis, banks in the UK were creating new money like there’s no tomorrow, then come the crunch, far from helping us escape the recesssion, they drastically CUT DOWN on their lending / money creation.
Conclusion.
In the case of transaction money, commercial banks do create money, but that does not give rise to debts. And in the case of long term loans, commercial banks just organise lending / debts that would exist anyway, but that tends not to result in money creation.
Ergo, contrary to PM’s claim in the above tweet, commercial bank money creation does not exacerbate indebtedness.
But that’s not to say there isn't a strong argument for disposing of debt based money and switching to a system that involves only debt free money (i.e. base money). The argument for doing the latter are not as suggested in the above tweet; it’s briefly as follows.
Money is a liability of a bank. Or to be more accurate, money appears on the liability side of banks’ balance sheets. (The extent to which that liability really is a liability in the case of central banks is debatable, but let’s gloss over that for the sake of simplicity.)
Next, money is fixed in value (inflation apart). That’s unlike the value of other assets like houses or shares which fluctuate in value. Ergo commercial banks have assets which can fall  in value and liabilities that are fixed in value, which is recepie for disaster. And indeed, regular as clockwork over the last few centuries, private banks have gone bust one after another. Ergo they have to be backed or subsidised by a host of different taxpayer funded subsidies: TBTF, depsot insurance, lender of last resort, etc. And subsidies misallocate resources: they reduce GDP.
Ergo commercial bank created money should be disposed of and replaced entirely by central bank or “debt free” money.
As to debts, there is no obvious reason why that switch to debt free money would greatly reduce debts.


11 comments:

  1. OK got it working.

    I don't understand this, clearly a large amount of money creation took place re mortgage lending, how does this fit with banks just being intermediaries?

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    1. Actually I’m trying to argue that money creation tends NOT TO TAKE PLACE when it comes to mortgages. Reason is that mortgages are LONG TERM loans, and they tend to matched by relatively long term deposits: i.e. term deposits or similar. And the latter tend not to be counted as money.

      And even if they’re matched by excessive amounts left for long periods in current or checking accounts, while that is OFFICIALLY counted as money, it’s actually more in the nature of a long term loan to a bank.

      I.e. I’m arguing that in the case of mortgages, banks just act as intermediaries rather than create money.

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    2. That interesting, but it's contrary to the narrative as I've come to understand it. Here is how I've come to understand it, Banks make loans with a view to making a profit. The restriction on them are capital adequacy and how they risk weight assets.

      Within those restrictions they can create money for loans to make a profit as they see fit.

      It's within this framework credit bubbles can occur since their assessment of risk and capital can enter a feedback mechanism when their lending is against assets like housing.

      From what your saying it would seem that a house price bubble has to develop from the misallocation of existing savings rather than the misalocation of created credit.

      If so at what part of the process does expansion of private sector money/credit take place?

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  2. I think the internal contradictions in your argument can be resolved if we better distinguish between "base money" and money.

    To most economist,, "base money" is a small block of money that underlays the system. It may be gold in a gold based currency or it may be that money created directly by a central bank.

    In contrast, I believe that "base money", in addition to gold and central bank created money, also includes all money received by the economy from the government. The idea here is simple--government DOES NOT pay in counterfeit money. Therefore, all money received by people (and then deposited into banks) must be legitimate.

    The fact that government may have borrowed the money-it-pays-out does not prevent the money from becoming NEW "base money". It works this way: all the recipients of government payments count the money as theirs so long as the money exists. (Agreed, it will not stay in one persons hand, but will constantly(?) move between economic participants.)

    Now that "base money" is more generally defined, we take a look at money by using a different standard. We agree that banks can create the illusion of more money supply because for every dollar loaned by a bank, there becomes TWO claims on the base money. Therefore, we can add all the bank deposits and find that they increase when banks make new loans.

    If bank deposits increase, everyone feels richer, including the banks making the loans. This rich-feeling can lead to even more bank loans and soon loans from banks will be made using not "base money" but money as measured by the amount of deposits in banks. Once this happens, the system is ripe for occurrence of "bank runs" which is a lack of "base money".

    Now to encapsulate and close: We need to carefully distinguish between money supply measured by "base money" and money supply measured by bank deposits. The money supply measured by bank deposits will be larger than the money supply measured by "base money". A severe danger point comes when bank deposits are greater than twice the "base money" supply because further bank-money-supply-expansion would be based on bank-loan generated "base money".



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    1. Roger, I agree with what you say up to “If bank deposits increase, everyone feels richer…”. When commercial bank deposits increase, assuming that is not caused by an increased supply of base money, there is no change to the net assets of the private sector non-bank sector. That is because, as is widely accepted, commercial bank money nets to nothing: i.e. for every dollar of money created by commercial banks, there is a dollar of debt. (I’m using the word money in a broad sense there, i.e. to include sums in term accounts). Thus when the stock of commercial bank money rises, there won’t be any “feeling richer” effect.

      Also I don’t agree that “A severe danger point comes when bank deposits are greater than twice the "base money" supply…”. Bank reserves, i.e. their stock of base money, average roughly one twentieth their assets / liabilites. Though that varies from country to country and other factors. E.g. a 10% reserve requirement is imposed on large US banks I think. Also the stock of base money has risen dramatically in several countries as a result of QE. But it’s still nowhere near half the total amount of commercial bank created money.

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  3. Thanks for considering my comments. The issues you raise are very important to the basics of banking; It would certainly be nice if everyone could agree on these effects.

    On the "richness point", there is certainly agreement that an instrument of debt is issued for each loan. I would think that the person who accepted the debt would feel less rich as you suggest.

    As I wrote my comment, my suggestion of a generally richer feeling was meant to apply to all the many people who were the later beneficiaries of the debt as the money was spent. Yes, the one person who signed for the debt would feel less wealthy but as he spent this borrowed wealth, he would make many others feel MORE wealthy. Each of these many others would have enhanced bank deposits which would be in place until the debtor repaid the loan. The feeling of enhanced richness would disappear when the loan was finally repaid.

    On the next subject of a base money danger point, I think you are speaking of base money in the conventional way and you are certainly correct in that context. My suggestion of a danger point flows from the broader concept that base money also flows from government spending, not just central banks.The base money you describe then becomes the remaining broad based money supply that the central bank deems necessary to have in the system at any point in time. Base-Money-in-the-conventional-sense is then just a result of central bank management, not the result of some mysterious process of base money generation.

    Clearly, the concept that "government spending is also a source of base money" is an "out of the box" idea. It is interesting to me that it ties in so well with the money flows of our economy.

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    1. I think your "government spending is also a source of base money" point is correct.

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  4. Comment from POK.

    This blog system has gone wrong: it won’t publish comments (other than mine). So I’m publishing a comment from POK manually plus my answer.

    POK’s comment is this:

    That interesting, but it's contrary to the narrative as I've come to understand it. Here is how I've come to understand it, Banks make loans with a view to making a profit. The restriction on them are capital adequacy and how they risk weight assets.
    Within those restrictions they can create money for loans to make a profit as they see fit.

    It's within this framework credit bubbles can occur since their assessment of risk and capital can enter a feedback mechanism when their lending is against assets like housing.

    From what your saying it would seem that a house price bubble has to develop from the misallocation of existing savings rather than the misalocation of created credit.

    If so at what part of the process does expansion of private sector money/credit take place?

    My answer to POK:

    Your final two sentences rather suggest that “expansion of private sector money/credit” can be separated from “existing savings”. I don’t agree: they’re joined at the hip.

    Ignoring base money, there is no way the commercial bank system can create savings without first creating loans. That has lead many to conclude that loans CAUSE savings. I beg to differ. I claim above that the relationship between borrowers and savers is a standard supply / demand relationship.

    It’s like growing and eating apples. Apples must be grown before they’re eaten. But that doesn’t mean the fact of growing apples causes them to be eaten. If anything, the cause effect relationship runs the other way, that is, it’s the desire to eat apples that causes them to be grown.


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    1. hmm, I don't really understand this, particularly the causal direction. Could you point me to something that fleshes out this narrative?

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    2. Can’t think of anything particularly inspiring to point you to. But if you Google the phrase “loans create deposits” you’ll find plenty of material which debates the point I’m on about. I noticed in the last 48 hours that Nick Rowe of Worthwhile Canadian Initiative made the same point as me, namley that commercial banks cannot lend unless there are willing savers, but I’ve lost the link.

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    3. OK thanks for the replies I'll have a look around. Cheers.

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