The old chestnut of what came first, the savings or the loan, came up on the blog over the weekend.
I have argued for many years that it is, of course, the loan, and that the savings can only exist because a loan brought them into being. I had to work this out from first principles when I was in my twenties because I had always been taught the opposite. It took a long time to find others of similar persuasion. And it was some comfort to find the Bank of England finally agreed in 2014. One of the things they did when doing so was issue this video:
What they say is:
- Loans are made without any need for there to be deposits in a bank;
- Loans are quite emphatically not the recycling of depositors' money: all loans are made from newly created money;
- All savings are therefore created by lending, representing the unspent and so deposited part of funds created out of monies borrowed;
- There is, then, no such thing as fractional reserve banking and those thinking so; those economics text books that say there is; and those who based their economic thinking on this idea, are all wrong.
There are some things I should add I do not agree with in the video: the description of how QE works is just wishful thinking and not what has actually happened. It is also not true that QE has a cost: the interest paid on reserves is in real terms negative at present.
And there are things the video does not say. In particular it does not make clear that because of the argument made, savings do not serve a useful economic function as a source of funding for investment in the modern economy when that role has been supplanted by credit. Nor does it say that as a result the entire saving sector can in that case to some degree be seen as rent seeking and the whole edifice of the financial services industry that is built upon it a largely pointless activity that does not add value. But I won't develop that argument further here: my point at present is to reiterate that savings are not required to permit banks to make loans. This is a myth now known to be wholly untrue. Those who say otherwise are from the economic dark ages.
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To be clear (for me anyway) when you talk of ‘savings’ are you are referring to the money that is set aside to service debt which has the same effect as real savings on the economy as it reduces the amount of money for spending in that economy?
Other than that I totally agree with you – in fact I have for some time from a personal experience level – reflecting on how periods of debt – or even my mortgage reduces the amount of money I have available for things we need or want.
I saw this phenomenon when my wages were reduced and we were kicked of the tax credit system just after 2010 – my income went down but the mortgage stayed the same (it was a fixed rate).
Of course the main point is to illustrate the principles about the creation of money as it leads onto (or should at least lead onto) a debate as to what sort of money should be created for the economy. One based too much on fiat money issued as debt by banks is not ideal because of the money needed to service that debt.
I’m currently reading Michael Hudson’s ‘Killing the Host’ and he also explores this in great detail.
[…] it’s the cash that really interests me. These are savings. As I have explained, and as the Bank of England agrees, the economy does not need savings. They are not what funds […]
I have in the past referred to Investopedia as a one stop site for definitions. “What is money?” Investopedia’s explanation follows much of what you state http://www.investopedia.com/insights/what-is-money/?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186&lgl=rira-baseline-vertical I will read Ann Pettifor’s book next. And for Jerome et al I, for one, am not a “disciple”; I am an inquisitive sexagenarian student of life who can think for myself.
One of the many things that confuses me with regards to this is what the purpose of the banks reserves are if they are not part of the fractional reserve banking.
If they are just static pools of savings money then how could a run on the bank take place. Surely we would be able to just take out the money if it never leaves the bank.
The reserves exist to cover inter bank liabilities
And to impose monetary constraint if desired e.g. to demand reduced consumer lending
Interbank liabilities are many times larger than net reserves.
“And to impose monetary constraint if desired e.g. to demand reduced consumer lending”
Ah so now you admit there is a fractional reserve banking system?
No
There isn’t
But the bank can indicate the lending it wants
And does
What is bizarre is your continual denial
The does eventually lead to time wasting deletion
Ed note: Deleted for being repetitious
Why do the banks need to loan each other money if they can just lend money into existence?
There have been a lot of good links in the comments which I need to read. The more you learn…..
I think the answer is obvious in your question…
They can’t lend to themselves
Although it is suggested Barclays tried
Thank you for this blog post! It’s so important that we try to understand what money and debt really are-I would encourage people to read Richard Werner’s papers on how bank loans actually work. Pettifor’s books and Michael Hudson’s are superb as well as Steve Keen’s work if anyone is interested. As debt is the subject of my PhD I’ve spent a lot of time trying to convince academics I talk to that this is the way the system works-I was very grateful for the BoE 2014 report (and more recently the Bundesbank one).
Bundesbank link?
Thanks
Probably this:
https://www.bundesbank.de/Redaktion/EN/Topics/2017/2017_04_25_how_money_is_created.html
Thanks
As you rightly noted in the lengthy exchange between you and ‘Jerome’ on the earlier blog, it was scary that someone who has clearly worked in banking for a long time and was absolutely adamant that the BoE says the complete reverse to what it actually says (see the video you include) remains so ignorant of reality. Indeed, it was even scarier that he and at least one other commentor then cited various regulations as evidence that – in effect – deposits categorically must come before loans and our whole system is based on that ‘fact’. I do wonder, therefore, what ‘Jerome’ thought after he watched the BoE clip, and whether he went into work today and discussed this with colleagues. Or whether he chose to ignore reality and carry on regardless – as our government does every single day.
Anyway, on a related matter, this clip from a TedX Talk (Denmark)is good in that in the space of 15 minutes it also explains why allowing banks to create money from loans also drives inequality, economic instability and underscores the power relations that are so set on destroying the planet we inhabit for the purpose of short term gain.
https://www.youtube.com/watch?v=CvH66fz9nyU
Thanks Ivan
I will watch it later
It might well get posted
It’s also good in proposing a solution to the issues which I see you write about in other blogs today, Richard. I’m not entirely sure I agree with the proposal, but I do think his final points about why the privatisation of money creation (for that is what it is) is kept out of public discourse is extremely important.
I wonder if it may be appropriate to add a dimension of Central Bank activity into this discussion. I am thinking of the use (BofE) of “Operational Standing Facilities” (OSFs). It seems to me this is an important part of the mechanism; and being “operational” it possesses some contact with reality (the bit that interests me). The BofE website makes clear that
OSF) have two functions:
1) to provide an arbitrage mechanism in normal market conditions to prevent money market rates moving far away from Bank Rate.
2) to provide a means for Sterling Monetary Framework (SMF) participants to manage unexpected “frictional” payment shocks which may arise due to technical problems in their own systems or in the market-wide payments and settlement infrastructure.
The rates currently paid/charged on the facilities are shown below:
OSF – Lending Facility 0.5% (collaterised)
OSF – Deposit Facility 0% (uncollaterised)
The BofE uses operational standing facilities to SMF “participants” at 0% for uncollaterised requirements. I would really like to see a functionally operative definition of the term “frictionless” (remember, this is not physics); to say nothing of the term “shocks”. The BofE makes clear that the OSFs are “a vital part of implementing the Bank’s monetary policy”.
I would really like to see a piece here on OSFs in the SM Framework, and the following discussion. I know, you are really busy; but it is just a thought; och, its a request (there, I said it!).
I admit I would need to pull in expertise on this
@ Ivan
I thought that perhaps people like you and Richard Murphy should actually get some experience in how things actually work, rather than spouting whatever takes your fancy.
You simply cannot have a bank without a capital base (deposits) first. Then the bank creates broad money through loans. Deposits first, loans second. Those loans might create a lot more broad money than the initial deposits, but the very nature of the regulation on the fractional reserve banking system are designed to contain it.
But as I said in the other thread. Why bother with our treasury, balance sheet management, ALCO teams, or any of the accountants and the accounting standards when we don’t need to cover any loans we make, and all we need is double entry book-keeping. All we really need is a self-appointed expert tax accountant – preferably based in Ely.
Jerome
I wholly agree banks need working capital: they are businesses. I note you think depositors should bear that risk, underpinned by state guarantee, of course. Why? Why not shareholders?
Now for the last time say why the BoE is wrong or I will delete thereafter
Richard
@ Jerome, it isn’t what ‘takes my fancy’, far from it. Indeed, in many ways I’d much rather money creation was as you profess it to be – not least because it’d make many of the negative effects of the system we have (the promotion of inequality, economic instability and power relations – see here for how they arise: https://www.youtube.com/watch?v=CvH66fz9nyU) difficult, which would be a good thing in my book.
It takes my fancy because it is true, as the BoE clip Richard links to illustrates and explains, as are the outcomes that we see impacting on the world around us on a daily basis.
Furthermore, accepting that such a system exists does not necessarily negate the purpose/value of any/all of the processes and mechanisms you note here(and detail in another comment on a previous blog). What it would do, however, is make me reflect on why they exist, for what real purpose (as opposed to a claimed purpose), and how effective they are given that the system of money creation you believe in is no longer the system on which much of the economic and social activity of our planet is based on.
I would be grateful if you would simply respond to the Seth Carpenter and Selva Demiralp paper, “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?” (Federal Reserve Board, Washington D.C.,Finance and Economics Discussion Series, May 2010). This was presented, and the conclusions summarised on the other thread. I am interested in a rebuttal of their argument, and frankly nothing less; but so far there has been none; and we have all been entertained by a rather tiresome circular and endless debate.
The test is not theory, nor even what people think or claim is happening; but what is actually happening. This is what has marked out economics as a less robust science than physics (robust= makes accurate predictions).
I agree
But nothing has been offerd
Ed note: This comment deleted because it was purely repetitious
Ed note: deleted for being repetitious
I would have thought that the capital base does not include deposits.Are you saying that there is no distinction between shareholder provided capital and depositors funds?
After all a banks profits/ losses are based upon the management of interest receipts and payments, fees etc and are quite separate from the management of deposits and loans.
And talking of double entry book-keeping it would be interesting to know if the double entry on a loan written off is – credit asset account / debit loan account ( ie a reversal of the entry that created the broad money in the first place) – a transaction not affecting the P & L account of the bank apart from the loss of current and future interest received. Just as the creation of the loan (broad money) was not dependent upon anything other than a risk assessment I assume this is what you mean when you say “cover” the exposure.
Liquidity would not appear to be an issue when it comes to deposits and loans unless the bad loans are written off to the P & L account.
Bankers treat deposits as capital
And the reality is that pretty much they are
Which is a shock to most people who think they are safe when, barring givernment guarantee, they’re most definitely not
“Deposits first, loans second” (Jerome, 10.52am).
BofE Working Paper No. 529: Zoltan Jakab and Michael Kumhof, “Banks are not intermediaries of loanable funds – and why this matters” (2015). This has been referred to I think in both threads, but again it has not been taken up:
“….in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor. The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever. Third parties are only involved in that the borrower/depositor needs to be sure that others will accept his new deposit in payment for goods, services or assets. This is never in question, because bank deposits are any modern economy’s dominant medium of exchange.
Furthermore, if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does. To argue otherwise confuses the respective macroeconomic roles of resources (saving) and debt-based money (financing).” [quote from p.ii].
Jakab and Kumhof go on to conclude:
““Economic models that integrate banking with macroeconomics are clearly of the greatest practical relevance at the present time. The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist. Instead, banks create new funds in the act of lending, through matching loan and deposit entries, both in the name of the same customer, on their balance sheets. The financing through money creation (FMC) model reflects this, and therefore views banks as fundamentally monetary institutions.” [quote from p.38].
Currently I believe that between Gardner and Demilrap on the Multiplier and the implications of the research, and Jakab and Kumhof on Intermediation and the consequences of their analysis, they have the much more persuasive case. I am not sure what your case consists in, beyond an abstract description of a system that may not reflect the operational reality. In my opinion you require to answer their arguments, at length; clearly, precisely and directly. You need to prove your case. I wish to understand the nature of the economic reality. I am happy to discover that these papers (published by two major Central Banks) are complete eyewash. All you need to do is provide the evidence; so show us. As far as I am concerned, the floor is yours. Demonstrate that you are indeed the master of your brief.
Thanks
For a day when I have technically been on holiday I have done a lot of blogging…..
And did not pursue this through
I am grateful
I agree with this speaker that banks can drive inequality, instability and can be anti-democratic but I do not agree with his solution.
We need private banks like we need supermarkets because they provide a service and competition works. But they need to be regulated and must not become too big to fail. Large banks need to be broken up, do not listen to the bankers who say they regulation will be bad for consumers. The local German sparkasse work just fine for consumers.
As I think Richard will agree the solution to the instability of money creation is taxation and fiscal policy.
I will get to the video
I agree we need banks
And your conclusion is 100% right
What they say is:
“Banks create additional broad money whenever they make a loan. It is sometimes overlooked as the main way in which money is created”.
Now you have taken this to mean Banks don’t need deposits. Good luck getting that one past the regulators – all banks need a certain amount of Tier 1 capital (including deposits) before they can make a loan.
You are also creating a straw man. I never said that Bank’s ONLY lend out their deposits.
What I did say is that when we do lend, we have to cover that long term loan with short term cash – the maturity transformation – on the money markets.
It might be worth you looking up what fractional reserve banking actually is – given the whole world’s banking system runs on it.
And the BoE specifically say there is no such think as fractional reserve banking or the money multiplier, which of course refers to that system
Now stop wasting my time with your continued wilful ignorance. More will be deleted
1) What precisely do you mean by “covering” the loan with short-term cash? Presumably you are not saying that the cash “covers” the loan on a 1-to-1 basis? Follow the textbook formulae on fractions? Lend long, borrow short. That has worked well in the banking system. It works so well, it has perfectly reflected reality; always. What could go wrong?
2) I see no evidence that you have actually replied to the Gardner and Demiralp research. You just keep repeating the same obvious line. Until you address the issue as fairly stated, and sources provided; and addressed the matter directly, with rigour and clarity I consider that you are offering no more than generalised waffle.
You are generous in your assessment
Each deposit brings ith it an obligation to repay, a balance sheet debit is offset with a balance sheet credit – the net equity or accumulated fund of the bank is not increased.The “base” capital is not increased.
Tier 1 capital – why call it capital? It really represents the funds available to meet the trading pressures of the bank and should include a note on “depositors funds deemed available to meet the realised and contingent liabilities of the bank”.
So if banks don’t need deposits, why do bank runs ever happen?
Because they are insolvent or illiquid or both
But if they don’t need deposits, how would they ever become illiquid?
You are saying they can just make new loans, which make new deposits?
Jerome was arguing above that banks need liquidity, but you said they didn’t? But now you are saying they do?
So which is it?
They can only make loans if their promise to pay is accepted
It is caoutal that should underpin that
And it is capital that should provide liquidity
“Banks do not need any deposits to make loans”
Clearly, there never was a run on Northern Rock.
Perhaps you’re not aware of the reason for that
Northern Rock was insolvent because of bad lending in excess of security
That is a wholly different issue
Jonathan,
If nothing else your comment is a near perfect non-sequitur.
Most (including you) are not aware of this but Northern Rock had already colllapsed BEFORE the run by depositors. Here:
‘Reflections on Modern Bank Runs: A case study of Northern Rock’
http://www.princeton.edu/~hsshin/www/nr.pdf
Marco
Might you repost the link as that one does not work?
Thanks
Richard
‘Reflections on Modern Bank Runs: A case study of Northern Rock’
I have it as Hyun Song Shin, Princeton University (August 2008):
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.534.1387&rep=rep1&type=pdf
From the Abstract:
In spite of the television images of long lines of depositors outside its branch offices, the run on Northern Rock was unlike the textbook retail depositor run caused by coordination failure. Also, contrary to received wisdom, its reliance on securitization was not an immediate factor in its failure. Rather, its problems stemmed from its high leverage coupled with reliance on institutional investors for short- term funding. When the de-leveraging in the credit markets began in August 2007, it was uniquely vulnerable to the shrinking of lender balance sheets arising from the tick-up in measured risks. Northern Rock shows that modern banking cannot be viewed separately from capital market developments.
Agreed
I covered the issue – indeed broke parts of the story – on this blog at the time
I am struggling to understand your argument.
Fractional reserve banking requires banks to hold in reserve a fraction of the money that they lend. Each individual loan is not “recycled” deposits – it is essentially newly created money – but it is backed by the reserves held by the bank. We seem to be in agreement on these points.
Where we part ways is that you argue that “All savings are therefore created by lending, representing the unspent and so deposited part of funds created out of monies borrowed”. I do not follow this argument. Deposits can represent any number of sources (including loans), but that is not the same as the reserves that a bank holds. In our fractional reserve banking system, a bank must hold a certain amount of reserves.
Fractional reserve banking is supported by the vast majority of economists, bankers and academics. If you want to try and undermine it then you need a much clearer and stronger argument than the one presented here.
I am struggling
Tell me why the Bank of England is wrong? They say we do not have fictional reserve banking and that all economics text books saying we do are wrong. Why are you right and they (and me) wrong? They could but be clearer that they think you are. And they are wholly happy to disagree with all economists who contradict them
Nowhere in that video does the Bank of England say that we don’t have fractional reserve banking. I’m really not sure where you’re getting that from. The video explains (in pretty basic terms) the idea that loans are not recycled deposits, and that loans are money created by the banks. These are the essential concepts behind fractional reserve banking.
Perhaps you could set out the exact quote in the video which you believe contradicts fractional reserve banking?
You say you are struggling and I think that may be right.
For heaven’s sake read the linked text too
Is spoon feeding really necessary?
And as the BoE say in the video – banking does not work as economics text books describe I.e, fractional reserve banking does not exist
I have, and nowhere can I see the Bank of England contradicting fractional reserve banking. You are making an assertion which flies in the face of modern economics and claiming that the BoE supports your position, but when challenged you just respond with insults.
I am genuinely trying to understand where you are coming from, so I ask again: where in the video, or the linked text, or anywhere else do you believe the BoE says that there is no such thing as fractional reserve banking?
You’ve edited your last response to now say: “And as the BoE say in the video — banking does not work as economics text books describe I.e, fractional reserve banking does not exist”
That is not what the video says. The quote I believe you are referring to is at 0:46: “[Notes and reserves] [are] not chosen or fixed by the central bank, as is sometimes described in some economics textbooks.” This quote is absolutely correct – notes and reserves are not just fixed by the central bank, it’s a lot more complicated than that. But this quote is not contradicting fractional reserve banking in any way, and I do not see how you can possibly interpret it that way.
So I ask again: Where in the video, or the linked text, or anywhere else do you believe the BoE says that there is no such thing as fractional reserve banking?
respectfully, there is not an informed person I know who does not agree with me having read the BoE statement
They say savings are not lent
And they say there is no money multiplier
In other words there is no such thing as fractional reserve banking
And they say the books that say there is are wrong
Now read it all and counter the above points every precisely quoting how they say otherwise or very politely please do not bother coming back
Respectfully, you claimed in your original blog post (and in many of the comments here) that the BoE supports your position that fractional reserve banking is wrong. You claimed that the video above and the linked text supported this. I asked you to let us know precisely what you were relying on, and despite asking five times you have refused to do so. Instead, you now completely change your argument and say “informed people” agree with you and challenge me to prove you wrong.
There’s an old latin maxim, “Affirmati Non Neganti Incumbit Probatio” — in other words, “He who asserts, must prove.” You asserted something, I asked you to back it up and you refused to do so. That is a very poor show. I am genuinely interested in what you have to say, and how you understand (or misunderstand) this issue. Sadly, you are completely unwilling to engage in a civil discussion and provide any support for your assertions.
I am not sure how many more times I can say they say
A) savings are not loaned, ever
B) There is no money multiplier – which is the core idea in fractional reserve banking
C) they say text book explanations of banking claiming otherwise are wrong
In other words they say there is no fractional reserve banking.
Can you say I am wrong?
Can you offer offer me alternative plausible expkanation of what they mean when saying the above?
Do they say there is fractional reserve banking?
If you can quote them saying so, please do
If not, you are wrong
Respectfully, you claimed in your original blog post (and in many of the comments here) that the BoE supports your position that fractional reserve banking is wrong. You claimed that the video above and the linked text supported this. I asked you to let us know precisely what you were relying on, and despite asking five times you have refused to do so. Instead, you now completely change your argument and say “informed people” agree with you and challenge me to prove you wrong.
There’s an old latin maxim, “Affirmati Non Neganti Incumbit Probatio” – in other words, “He who asserts, must prove.” You asserted something, I asked you to back it up and you refused to do so. That is a very poor show. I am genuinely interested in what you have to say, and how you understand (or misunderstand) this issue. Sadly, you are completely unwilling to engage in a civil discussion and provide any support for your assertions.
I have proved
See a comment just posted
If you deny the truth of what I am saying that us a wholly different issue
I have shown my argument and it is about as easy as 2+ 2 to follow
All I said is I know no informed person who has reached any alternative opinion to thee one I reach. That did not change the argument
It just shows you are being a pedant by suggesting it
Now either prove me wrong or don’t waste my time again by task matter of fact the Fed, BoE and Bundesbank think you are wrong – all sources noted here . You have offered none
AJ Brown,
For God’s sake man.
The loans, which are ex-nihilo, as the BoE suggests, are deposited.
Once they are lent they are deposited back into the banking system by the person who recieved the funds after they were lent. Thus – loans create deposits.
The fact that there are capital and reserve requirements does not alter this.
Precisely
It appears beyond the wit of some to realise that a debit = a credit, even when it flows through the inter-bank system
I have been out of the loop today. Am I to presume that the defenders of Fractional Reserve Banking have not in fact responsed to the request to present a case that specifically answers the arguments made against the Multiplier or Intermediation, in important technical papers published by Central Banks (and presumably therefore meeting an equivalent to academic peer review); i.e., no bland waffle merely parrotting textbook claims is acceptable, but high standard research and analysis demonstrating, with rigour the alleged flaws in the critics of Fraational Reserve Banking’s arguments?
Have they all just ‘left the field’?
Is Fractional Reserve Banking unable to present a case based on close argument and empirical evidence; or an advocate equipped to make the case, or who has actually done the research (beyond abstract theorising that simply repeats the very propositions that are under both theoretical and empirical challenge)?
I fo not say this to score a cheap point; but I have noticed (here and elsewhere) that every time this issue is raised somebody claiming “authority” preaches Fractional Reserve Banking dogma, but never actually to address the specific failures of the doctrine raised by modern critics. Should we therefore assume that Fractional Reserve Banking has become a form of religious doctrine instead of monetary theory; not subject to rational challenge, or empirical test, but based whooly and solely on ‘sola fide’ fractionalism?
I have deleted nothing
They are MIA
Your conclusion appears sound
Richard, I know you are well aware of this but perhaps a simple explanation may help.
Like any other business, a bank requires working capital and this may come from shareholders’ input and/or loans from other banks. Some banks may use part of this capital for ventures into derivatives and other speculative instruments.
All loans to private and commercial borrowers are created by computer entries as new money, not from banks’ capital. These loans may be sold on to third parties as mortgage or loan-backed securities.
Barclays did manage to invent a scheme which involved lending to an operation in Qatar and after deducting large expenses the remainder was used to introduce new capital into the bank, thus avoiding the risk of requiring a bailout.
This matter is under investigation and heads may roll.
Some details covering the Barclays case here:
http://www.bankingtech.com/878991/barclays-hit-with-fraud-charge-over-qatar-capital-raising/