As I often explain about my writing of this blog, much of my motivation for doing so is to work out what I think about an issue. This is why I will, for example, put half-formed ideas on here to test reaction to them, and why I am, on many occasions, willing to change my mind about things that I have said because others have presented me with better ideas.
When I first raised the subject of Sir Howard Davies not understanding that banks are not intermediaries, but do, instead, create money out of thin air to loan to their customers, I did not expect the number of blog posts that have followed, or the several hundred comments that have appeared on them. Sometimes issues get a life of their own, and this one certainly has.
What I think is worthwhile now is to summarise what has been established, and what now needs to be thought about some more. This is largely for my benefit, but if others find it useful that makes it doubly worthwhile.
In my opinion, evidence has been assembled here that unambiguously proves that central bankers are of the opinion that every time a commercial bank makes a loan to a customer then new commercial bank money is created. This now appears to be established fact. Bill Kruse has documented much of this, and I am grateful to him for sharing that documentation with me, and the readers of this blog. Others have now added to that collection.
It follows that if new commercial bank money is created every time that there is a loan made by a commercial bank, deposits in those commercial banks must always increase in exactly similar amount as a consequence of those loans. It cannot be otherwise.
It necessarily follows that in principle commercial banks do not require deposits to lend, but create deposits by lending.
What also necessarily follows, but which has not been much discussed here, is the fact that the reverse of the suggestions must also be true, i.e. the repayment of bank loans necessarily destroys commercial bank created money, and will reduce the quantum of bank deposits in the same amount. Once more, it cannot be otherwise.
There has also been discussion of government created money in the course of this narrative. It has been agreed, and central bankers have regularly confirmed this, that whenever a central bank funds spending by the government that it serves it necessarily creates a loan to that government. The represents new base money. This loan can be reduced by the receipt of either taxation revenues or the proceeds of government deposit taking (whether by offering government banking facilities, such as those provided by NS&I, or by the sale of bonds or gilts).
It has also been agreed that the singular transmission mechanism for funds between the central bank and the government and commercial banks are the central bank reserve account that the central bank, or the Bank of England in the case of the UK, maintain for commercial banks and a limited range of other financial institutions within the jurisdiction. The funds in these bank accounts, maintained with the Bank of England, represent what is called base money, which term also covers notes and coins, although these are now of much smaller proportionate value.
Importantly, although not discussed in detail in the narrative to this point, base money cannot become commercial money, or vice versa. This is a necessary consequence of the nature of money within the modern banking system. Money has no tangible or physical qualities within the modern economy. This is as true of notes and coins as anything else: they are not money in themselves, but are tokens that represent debt, which debt is as intangible as all other money is because all other money only exists as entries in bank ledgers.
The entries in government and central bank ledgers represent base money. All entries in commercial bank ledgers represent commercial bank money. However, money does not move between these ledgers. All that happens when payments and receipts are made within either of these banking systems is that the balance on one account within that banking system is either increased or reduced, and the equal and opposite transaction is recorded in another part of that system. Whilst this gives the impression of money moving that is quite incorrect: bank account balances might change, but nothing ever moves. The impossibility of base money becoming commercial bank money, and vice versa, is explained by this fact.
It is my suggestion that the above are established facts. I am aware that many commentators who refused to disclose their identity or qualifications sought to challenge these facts in the early stages of this narrative but they have, perhaps wisely, mainly stopped making their claims now.
Consequences
I now think it is appropriate to record some of the consequences that have arisen as a result of this discussion. These are not necessarily facts: they are suggestions with varying degrees of tentativeness.
Firstly, if there was a single commercial bank within a jurisdiction then the suggestion made that such a bank need never borrow as a consequence of making a loan would be true. In that situation, the deposit arising from any loan will necessarily flow back to the bank making that loan, and it would, as a result, always have a balanced loan and deposit ledger. In effect, the depositor loans their new funds back to the bank that made the loan that created them. I think this necessarily follow from the discussions noted above, and I am rather hoping that no one disagrees, but I am open to alternative suggestion.
The problem with bank regulation which has taken up a great deal of time in this narrative arises because there are multiple commercial banks within the UK. It does, therefore, necessarily follow that a bank may make a loan to a customer who then makes payment to a person who uses the facilities of another bank, meaning that this other bank gets the benefit of the deposit that the loan the first bank has made gives rise to. The risk within the banking system arises because of this disaggregation between commercial banks, and nothing else.
Banking regulation seeks to address the risk that this disaggregation creates arising from the different risk and timing profiles of deposits and loans between differing banks. It should, however, be noted that because banks almost invariably borrow short term and lend long term nothing within banking regulation can ever totally overcome the liquidity risk within the banking system as a whole. Any attempt to do so will always, necessarily, be futile in the event of their being a complete loss of confidence in that system.
In that case the greatest risk within banking regulation might be that it presumes risk within disaggregated banking can be controlled independently of the risk within the aggregate system. The possibility that almost all banking risk gives rise to the possibility of contagion, and that banks almost invariably stand or fall together, with all of them now being considered too big to fail, is an issue overlooked if banking regulation assumes (based upon microeconomic theory) that these entities are independent of each other and represent individual, siloed, risk. If there is a single problem with banking regulation, this might be it.
Having noted this issue, and having also noted that bank regulation appears to have failed to take into consideration the substantial change in balances held on central bank reserve accounts since 2008, which were deliberately provided to replace missing liquidity within that system, it is then appropriate to note that banking regulation requires that the working capital provided by governments through the inflation of central bank reserve accounts cannot be considered as a source of working capital within those banks' routine banking operations. The inevitable consequence of this is that a bank making loans in excess of the consequent value of deposits that it creates is required by banking regulation to borrow funds from those banks that have enjoyed a surfeit of deposits in excess of loans they have made, with funds necessarily being transferred between those banks through their central bank reserve accounts as a consequence.
The lending bank that has the surfeit of deposits does, of course, charge for making this loan at a rate above Bank of England rate. This is despite that fact that the deposited funds made available to them will be paid a rate much less than that they will charge the bank that made the original loan. In fact, it is likely that the bank enjoying excess deposits will probably make a bigger margin on its making a loan to the bank that initially created the credit that gave rise to its surfeit of deposits than will the bank that created that deposit creating loan to a third-party customer.
Banking regulation is not, as a consequence, likely to be a zero sum game between banks. Those banks that are considered the safest places of deposit, largely because of their size and length of establishment, may well make excess profits from lending funds to competitor banks who take greater risk in loan creation than do those banks who are actually engaged in providing credit within the economy.
If my suggestion in the previous paragraph is correct, and it is a tentative conclusion, then the reason for banking regulation in its current form becomes apparent. The largest, longest established, banks that enjoy oligopolistic power and that are most likely to enjoy excess deposits (most of whom will have names which are very familiar) will be heavily invested in this system of bank regulation that is likely to give them the opportunity to make substantial margins on bank lending to other financial institutions who are significantly more likely to actually create credit within the financial system. They have literally no incentive to do otherwise, and every advantage from the status quo. In that case, whether this form of regulation is necessary, or desirable, is not the question: it will be defended, very strongly, precisely because vested interest have a considerable interest in making sure that it persists.
Presuming that this logic is correct, then banking regulation creates a series of particularly perverse consequences. Firstly, those banks most able to lend have little incentive to do so: for them the accumulation of deposits that have no useful economic role within the economy, except to apparently be used as the basis for lending to those banks that do advance loans, is in itself one of their most profitable activities. The largest players within the banking market are, therefore, disincentivised from actually taking risk that they are able to bear, and they are instead incentivised to pass that risk to those banks least able to sustain losses. A more perverse outcome is hard to imagine.
Second, these banks are able to use their quasi-monopoly power to maintain the situation.
Third, as a consequence, credit availability can be inappropriately rationed within the UK economy, giving rise to all the phenomena of under investment resulting in low productivity and other consequences that have been well documented for a long time.
Fourth, the Bank of England, by refusing to recognise that it could overcome this deficiency in the banking market by using central bank reserve account balances as a form of capital moderation within the market, facilitates this situation.
Fifth, the apparent failure of banking regulation to take account of the systemic risk within the market as a whole when creating these obligations represents a failure on the part of those promoting that regulatory system.
Finally, let me clear as to why I am raising these issues. There are a number of very good reasons for doing so.
Firstly, the opacity of banking makes this a subject of inherent interest.
Secondly, as is apparent from data that I have already published, banks are profiting enormously as a consequence of the boost in the size of the central bank reserve accounts and the decision of the Bank of England to pay base rate interest on these sums when the banks had no involvement in the creation of these assets that they have had transferred to them, makes this an issue of real public concern.
Third, if as seems likely, banking regulation exists not so much to support the effectiveness of banking, but more to facilitate the transmission mechanism for Bank of England base rate decisions into the economy then this, too, is a matter of public concern, most particularly when the bank of England's base rate decisions are creating destitution for UK households and firms and a recessionary environment in the economy as a whole.
Fourth, if as seems likely, banking regulation assists the extraction of monopoly profits from the economy, then that is a matter of public concern.
Fifth, the absolute absence of scrutiny of these arrangements because of their complexity and opacity makes this discussion worthwhile.
Sixth, I cannot help but think that a better system of banking regulation is available that would recognise the integral nature of banking as a whole, the systemic risks inherent in it, and the fact that the pretence of a market in banking when the whole banking edifice is underpinned by public funding is a sham.
I am not at present, suggesting an alternative regulatory system. What I am interested in is comments on these suggestions.
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Proof reading (hopefully helpful)
1. There’s ‘a parent’when I think you mean apparent.
2. There’s a reference to the ‘baking system’
Tim
Sorry “baking regulation”: which incidentally would be amazing!
“You can’t put flour in that!”
Both corrected now, thnak you.
🙂
I’ve long thought that this is the same problem as religion. History shows people being persecuted and even burnt at the stake for daring to translate the bible into a language other than Latin. Let’s be honest, the risk to the church (at the time the seat of almost all power, politically and socially) was that translation of the bible into a language the faithful could understand would inevitably open the book up to scrutiny and, heaven forfend, criticism. Hi-jinx ensued.
Look at banking now. Soooo many people working soooo hard to ensure that the basic nuts and bolts of the workings of the industry remains a Gordian Knot of eye-watering complexity that the average person who must use the system has no idea how it operates and therefore surrenders a degree of control.
We need to reframe the language to make more sense. I mean honestly… suggesting that me making a deposit in a bank is the same as me making a loan to the bank… shut up!! It’s a deposit. Call it a deposit. Then everyone knows where they are. It’s things like that which will give everyone a fighting chance to understand risks and even finally grasp the al important relationship between money and resources.
If we all must play the game, it’s only fair we understand the rules.
Also, I agree with Richard that there needs to be stronger baking regulation. Too many rogue pasties out there 😉
Typos will be created
But understanding a deposit in a bank is a loan is vital, first so that the depositor understands the risk that they are taking and second so that people realise the so-called national debt is all deposit taking, not borrowing, but is still a loan.
100% agree that transfers to banks do need to be understood as loans. It’s so counter to everyday language and understanding which demonstrates how well banks and others obscure how they operate. It’s in their interest to do it.
Yes banks and Governments account for money placed with them on the liability side of their balance sheet as they are obligated to transfer it back later. The original transfer was not a gift and made with the express intention of it being returned.
The general public, most press and political commentators have fallen into the trap of believing the government liability (money placed with institutions to buy gilts etc) has come about through not having sufficient funds – ascribing the biblical sense of being in debt – without understanding they didn’t ‘need’ the money to be placed there in the first instance to go about their daily business
The words debt and liability are a gift for the ignorant or manipulative
Howard – your final point is my whole point exactly. Words like “loan” and “debt” fill people with dread. They are things for the financially prudent to be wary of and most see them as the road to ruin.
Don’t get me wrong – I fully understand the processes behind banking. I understand that the customer’s asset is the bank’s liability and all that. From a double entry perspective it makes perfect sense… but to the “Easily Manipulated Voter On The Clapham Omnibus” it’s just total gibberish. From their point of view, when they make a deposit into [i]their[/i] bank account, they aren’t making a loan… they are effectively saying “Here, mate… hold this for me, will you?” It’s seen more as a bare trust. Nobody goes into a bank and says “Here is my money… do with it what you will. I am lending it to you for an undefined period, in return for which you will give me precisely squat all cos this is a current account”.
Maybe it’s different with savings accounts. Maybe.
Describing a deposit to the voting populace as a “loan” suggests that some form of ownership has been transferred – and they simply won’t buy that. Stewardship, yes… ownership, no.
It also begs the question “If the bank is borrowing my money, what do they need it for?” Now, we know the answer is that the banks needs it to manage their CBRA balances, but that means precisely eff all to Joe Public. The general mind will leap to the conclusion that banks take your deposits and do something with them… like, oooh, I dunno… lend it out to other people? Not an unreasonable assumption but a total 180 on the truth and the understanding we’re trying to promote.
I’m not saying we change the form, merely the descriptors. The language makes such a profound difference. People wouldn’t be nearly so terrified of the National Debt if they referred to it as Public Investments, but that’s not an inaccurate description of (the vast majority of) it.
Tbis is so very well put.
Not a comment on what you have written, which seems clear and logical, but a question.
How does the movement of funds to and from other financial systems, e.g. held offshore in other currencies or in other countries in their currency affect the system, if indeed it does?
Offshore makes no difference to this if held in sterling. That clears through London, proving what a sham it is.
And the issue being discussed is about sterling, not banking at large, which is a separate issue.
From what I understand sending money between 2 bank accounts which happen to be in 2 different countries is the same thing as sending money via paypal without paypal. Most international transactions travel via SWIFT. Also there is the IBAN, which essentially means all bank transactions in greater Europe (86 counties) go through the same institutions and regulated the same way. It is the same financial banking system, and the currency denomination doesn’t change that. Though in terms of risk it does matter. That is my understanding.
Why do banks pay interest on savings accounts? And why have those rates increased in the last 18 months. This surely needs explaining. The starting point should be what would be the consequences for withdrawals if they didn’t.
Because regulators require that banks hold deposits and politicians bring pressure to bear on payments.
Banks make money on deposits. A deposit increases the total in their reserve account at the Bank of England. The Bank of England pays the base rate interest on the balance in the reserve account. If a bank can get deposits and pay less than the base rate they make money.
This is zero risk for the bank.
Banks also make money by making loans, but making loans involves some risk whereas taking deposits does not.
I think that that the tone of this post is very reasonable.
You are in my view – and I am no banker nor at your level of expertise – attempting to reconcile a very complex system of micro behaviours at the banking level with clear facts about the nature of the money creation at the macro level in a very poorly conceived context (poor regs, too much faith in markets and an almost religious belief in rationality, when in fact rationality may not actually exist or is marginal at least).
My view is that bankers don’t really think about the the macro level at all – their reality is governed by what they see and do on a daily basis which is so fluid it’s almost impossible to keep track of it and rules and regs may even struggle to keep up. This is because other factors come into play – competition, growth strategies, bonuses, size – all distort the picture at the micro level, leading to macro problems.
I’ve done my best to sum this up.
What we need is an honest conversation.
Will we get it?
I hope so.
We need it.
Thanks for this clear exposition.
As I comprehend all of this these questions immediately came to mind:
At what point does this political Ponzi scheme fail ?
For instance, would it be when hedgefunds based upon corporate pensions fail to keep expanding ahead of the ever expanding merry go round of interbank loans ?
If international investment in UK property ( especially London) is suddenly withdrawn, how would that play out economically and socially ?
Finally, how do you view Sunak’s ERG/Tufton Street Charter City project of privatization of huge areas of GB into corporate city states separated from rule of law in Westminster in relation to all of this neo liberal monetary insanity ?
I have no idea when this Ponzi scheme fails
If foreign funding of UK property departs we may get a hiuyse prcie fall and a banking crash
Much as I dislike freeports I do not think they are Charter Cities.
Typo: “hiuyse prcie”. No idea what the first word is. Though the second is obviously ‘price’.
House price
@Sarah Lanier,
What on earth is a ‘hedge fund based upon corporate pensions’ ??
The whole pension industry is a Ponzi scheme. There is nowhere for people to save other than in the stock market. The constant inflow of money into the stock market from pensions inflates stock prices. This encourages further inflows of money. A classic Ponzi scheme, and not one that helps in the real economy.
The pension Ponzi ends when the demographics change, which will happen in a few decades. When more people start to withdraw money from their pensions than are contributing the process goes in reverse and stock markets will crash. This will happen suddenly, as for all Ponzi schemes, as pension holders rush to extract their savings. Many people will be hurt.
Some estimates indicate global population will peak in 2050, which gives an idea of when this will happen.
UK property is a similar situation. At the moment we are not building sufficient houses for the growing population, so house prices will continue to increase. Money from inheritances contributes to this process due to recycling of inheritances into property purchase. This adds, perhaps, 2% per annum to property prices in the long term. This will stop when the demographics change and, again, the property price will collapse, though this will take longer than for pensions. Perhaps the collapse of stock market based pensions will hasten the collapse.
These scenarios suggest that the government needs to provide a safe investment for pensions. This should be used to invest in the real economy to provide real resources for people’s pension, which doesn’t happen with the current stoke market purchase pension schemes.
Similarly, the government needs to invest in house building. No private company will ever build sufficient houses to reduce the price since this would erode their profit margin. Only the government can do this.
Pensions do not only save in stock markets. Some hardly do that now, at all, depending on their risk profile.
They also use bonds and property
I agree that none of this creates real investment, but that is not just because of stock market investment
…”the government needs to invest in house building. No private company will ever build sufficient houses to reduce the price since this would erode their profit margin. Only the government can do this.” Building 300,000 affordable new homes a year requires heavy duty funding for land, infrastructure & construction costs. It can be & should be done by Government. The only downside will be the ‘howls’ from existing home owners as prices fall! Also following New Zealands example & banning foreign investors from speculating in UK residential housing would help reduce high housing costs (which are the biggest cause of in-work poverty).
Richard, not part of the discussion.
I have spotted a typo in the glossary entry for CBRAs. It’s the first point in the explanation of QE & QT.
now should be new?
1. At any time it wishes the government can decide to issue now financial instruments.
Thnak you
Corrected
Richard
Thanks for all this
but it has left me confused- ever since I first came across your blog some 6 years ago
I can understand the concept of banks creating new money when they make a loan
but i struggle to see it as “out of thin air”
the corresponding deposit to off-set the loan makes the loan itself a sort of “transfer”, not new money
where does the deposit come from?
in the whole of the economy it’s just moving money around
and then we throw in the idea of whose money is it- and who should therefore receive any interest that’s going around– but that’s another story for another day
Rob
Try this
https://youtu.be/vsF1J9dDwsk?si=JFMuNOG42EI7O9Ta
Richard
I read all the above and sort of understood it. You make a very complicated system less opaque. Banks must have a lot of soft, possibly hard, power over politicians. It seems crazy that the BoE pays interest out at the base rate.
As for mortgages & banks, thanks to austerity, Liz Truss, Brexit, smoke & mirrors or whatever I am now paying 5 times the interest on my new Barclays 2 yr fixed mortgage compared to the one that just ended. Barclays said it would be no fee yet 95 quid has been taken in fees. It appointed a conveyancer with known IT problems (who said on its website it could not action mortgages at that time) then, after I protested, instructed a second. The delay has resulted in me forking out hundreds of pounds extra at the variable rate while it takes days for the old mortgage with Halifax to be paid off. And Barclays charged 200 for administering this fiasco.
Always bet on the banker. When they system goes against them, they charge the system.
Apologies for the typos. Actually, it’s autocorrect doing its ‘correcting for no good reason’ thing…
lots of good stuff here…. I am writing something but it just gets longer and longer (as you can imagine, I DO have a bit to say!!) But in a few lines….
Oligopoly.
Yes, you are correct to identify this. Banks pay zero on current accounts because they can. Efforts to promote competition to “solve” this have been partially successful in that new “challenger” banks exist… but the big clearers still pay zero. There are three solutions.
(1) Set up a State run competitor that pays “fair” rates. The government still pays but it goes straight to individuals. Could be
(a) NS&I – very easily done
(b) Girobank Mk2 run through the Post Office network. Harder but can do other things, too – so better.
(2) Pay interest on a much smaller portion of CBRA reserve bank balances. Fairly simple to execute but some thought required.
(3) recoup these interest payments back from banks through tax
Regulation.
This is complex… suffice to say that
(1) I don’t think regulation enhances monopoly. It tries to do the opposite – but fails
(2) Macro and micro risks/regulation intertwine in very complex ways. No system will be completely safe (unless we lose all the benefits of banks) but
(a) all regulation has to be “delivered” in a micro way. Individuals need rules that are by definition micro
(b) If you want a strong rope it’s best you start with strong strands.
More will follow on this knotty issue of regulation…
Thanks Clive
Me too Clive.
But all of this has to be looked at differently too.
I can understand why those that USE MONEY in a capitalist system need to be incentivised, take risks etc.
But surely, a different set of rules should exist for those who pump that money into the system?
It seems to me that the banks themselves are suffused with a ‘capitalist spirit’ that is not in-keeping with their role and more in-keeping with their customers.
And that to me is where the problem is. It undermines the principle of imprimatur – and the objectivity that is needed to make that work and even internal imprimatur on themselves.
Look at credit default swaps and how these are essentially a means to insure yourself against the failure of something even though you don’t own it or even bet on it and get a pay out if it fails.
In the real world, you can only insure what you own. The next best thing is betting on the races!!
Yet in the banking world, there seems to be no limits to what – in particular – are derivatives which are just truly ideas borrowed from the real world but twisted to make people rich.
So, its not just about regulation – it’s about asking about what modern banks do and whether they should be allowed to do it at all.
And I don’t believe that they should. Banks should be operating within the same rules as everyone else. Period.
PSR,
I think you are right. The 1929 crash led to the separation of “banking” and “trading” (its watering down in the 90s probably did contribute to the 2008 crash but the major reasons lie elsewhere).
Perhaps it is now time to consider a different split…. “Transaction banking” – the normal everyday stuff, “lending” and “trading”. This is tricky in the sense that lending and trading often overlap and a lot of things get done by non-banks (hedge funds, money market funds etc.)
It really is a minefield – but there is a decent case to be made that current accounts and payments are like water and electricity – essential services that should be under State control….. or at least a State controlled option for us to choose if we wish.
Credit Default Swaps!!! Don’t get me started.
What we cannot have is the payment platform on which the state relies under private ownership
I will look out what I wrote about this in 2008
I have long thought that the banking basics are like a utility. Indeed, my interview for my first job in banking (1985) involved a discussion about this! My views have not changed much but back in those days they seemed relatively uncontroversial… or at least not too subversive because they did offer me a job. Of course, we still had Girobank and Utilities were still publicly owned then.
I would add that in my Economics O level in 1979 I was told that (1) Government spend first, then tax and then makes up the difference with borrowing and (2) Banks decide to make a loan first then raise deposits afterwards. Did I have a radical teacher? No, it really amazes me that all these self evident truths have been lost in the intervening 40 years.
So true
And I will discuss banking a a utility but I have only just stopped recording tonight….
Excellent Clive!! Good item on your postal bank idea
https://www.salon.com/2014/02/26/the_post_office_can_save_america_10_ways_postal_banking_can_fix_some_of_societys_worst_problems/#.WkZLtMvzcUc.twitter
Richard, at times your blogs are like watching Tiger Woods play golf at his best – takes our breath away.
But given various major regulatory efforts from 1844, 1913, 1935, … in the UK and U.S. I suggest your blog convinces me we need a paradigm shift – one which would make banking work like most people think it works – Banks would be a savings and loan institution and government would create the money, and lend it to the banks if there was a shortage of deposits needed for profitable loans to mobilize idle resources, or invest in better innovations.
QE was a tipping point choice – we could have used the Greenback strategy of 1861, or the Bradbury of 1914, but instead we used the preferred approach by the bankers which was in the best interest of shareholders – at least in the short term.
Pauline referenced the Chicago Plan of the 1930’s. Friedman’s 1948 proposal was a very simple version of it. Tobin, Minsky, Allais, Stiglitz and other great economists have offered similar paradigm shifts. A number of fine academics, both in Economics and Law have done so recently particularly with a yet simpler start – CBDCs – Kumhof, Huber, Omarova, Desan, …
OK
You are persuading me to think again
I think I am a bit overloaded with all this right now
I might need a breathing space
I tend to agree – with everything except the CBDC 😉
“Chartalist scholarship has advanced the concept of a ‘hierarchy of money’ to explain the relationship between state money and commercial bank money. Each tier of economic actors uses the IOUs of the higher tiers as settlement balances and creates settlement balances for the lower tiers. The commercial banking tier settles payments with the top IOUs in the country, namely state money or central bank reserves. Non-bank firms and households, in turn, use commercial bank deposits for settlement of payments, and banks create money endogenously in the act of lending to such non-bank entities”.
Referenced yesterday elsewhere: The self-financing state: An institutional analysis of government expenditure, revenue collection and debt issuance operations in the United Kingdom
UCL Institute for Innovation and Public Purpose (IIPP) Working Paper Series: IIPP WP 2022/08
https://www.ucl.ac.uk/bartlett/public-purpose/publications/2022/may/self-financing-state-institutional-analysis
Accepted
But does that take us forweard – not least because ‘Chartalist’ is a barrier to understanding in itsef
It seems to me that this mess is essentially inherited from fractional reserve banking.
Fractional reserve banking was, basically, fraud. Goldsmiths gave out IOUs for gold deposits and then, fraudulently, lent the gold out (or sold it) as well. It all worked until someone noticed the goldsmith sneaking out with gold at night. Then that person withdrew their gold, before anyone else could, and precipitated a run on the goldsmith/bank.
But, politicians were persuaded that fractional reserve banking was useful and so legalised it.
You know you’re in trouble when politicians legalise fraud.
I guess fractional reserve banking really disappeared with fiat currencies (???). Until then there had to be some gold in the system somewhere. That left us with the mess we are currently in.
And the paradigm changed again with quantitative easing with the Great Financial Crash and the Covid Pandemic. This led to the large central bank reserve balances that we currently see (and which I see no way of reducing without crashing the economy).
So, I’m minded to agree with Joe Polito and suggest perhaps we should return to banks operating as financial intermediaries (only), and not acting as an arm of government controlling the creation of money without having political accountability. The government should have the role of both creating money and destroying it (taxation). This separation of responsibilities, in the creation and destruction of money is, perhaps, a large part of the problem.
In short, we need a reset.
This idea would take us back to the dark ages
But let me offer more views on that tomorrow.
You may well be right that it’s a terrible idea. Infallibility is not one of my strengths.
My thinking was as follows.
We need money creation in the economy, so someone has to do it.
At the moment it is partly the commercial banks and partly the government/BoE through quantitative easing. Bank money creation is counter cyclical, which is unhelpful. Banks are also ultimately limited in the amount of money they can create because they need to loan out more and more over time. This requires lower and lower interest rates and even this has a limit as rates approach zero. So commercial bank money creation is not ideal and is limited. The government/BoE has to make up the slack, which they do reluctantly with periodic bouts of QE. Putting money creation more firmly in the hands of the government/BoE seems to make sense.
But how could this be achieved? Commercial bank lending could be limited by regulation (they would hate that). For example, they could be limited to a multiple of their reserve balance (whilst still requiring capital adequacy). Which takes us back to fractional reserve banking. This leaves some money creation in the hands of banks, but it would not be unconstrained as at present, and it is under government control. No interest would be paid on reserves (they’re just a record of bank deposits). The government/BoE would then adjust money creation/destruction as required by the economy.
OK, this is probably crazy and impractical. But I hope it is useful to stretch the bounds of what is possible to enhance discussion and understanding.
I will return to the theme if banking regulation, but probably not today
I think we might need a break from it
Well if we can’t trust the banks to be straight up and honest, surely we can trust the Post Office?
Oh hang on…..
I agree
We are in desperate need of a new culture of public service.
Bank regulation is born to fail
Archbishop Welby should know as he was a financier in London before taking the cloth. As a member of the parliamentary Banking Standards Commission set up after the Great Financial Crisis, he had the evidence before him. He said ”The biggest weakness of all in the analysis of the failure of banks to be good banks has been around understanding about human beings. At the heart of good banks have to be good people” (1). Bankers see their role, not as providing a service for customers, but as making money for themselves. As banking is one of the most highly regulated businesses in the world, their prime task is to circumvene regulation at which they are adept. Securitisation of mortgages lowered the banks regulatory minimum capital requirements and was the cause of the Great Financial Crisis of 2007. Since then shadow banking has evaded banking regulation yet accounts for half total bank liabilities in the UK and globally in 2023 (2). One solution is to change the banking system and make regulation unnecessary. The approach is best described in a book by a Swiss economist and banker – The End of Banking by Jonathan McMillan (3). Two simple rules which change the accounting and solvency law for all companies are all that are required to make banking regulation redundant:-
1. The value of the real (non-financial) assets of a company has to be greater than the value of the company’s liabilities.
a. A financial asset is an asset that appears on the liability side of another balance sheet. Financial assets are excluded from this solvency rule.
b. A liability is something owed – and excludes common equity.
2. The value of financial liabilities has to be less than the equity of the company.
Richard, you will immediately see how this works. For your readers here is an illustration
(Can send in email)
This accounting and solvency change means that banks cannot fail as they, like other companies, cannot finance credit with someone else’s credit. The change has other advantages too. It eliminates “too big to fail” banks and the systemic risk of daisy chain failures. It stops speculation with other people’s money. It places banks and shadow banks on a level playing field. These are practical financial gains which make regulation unnecessary. On a more conceptual basis it allows the money supply function of banks to be separated from credit supply. How simple life will become! The bankers will not like it; the non-monetary financial institutions will and those Fintech companies that digitalise and offer pooling of small deposits over the internet, diversification of credits using hard big data, scoring, rating and monitoring borrowers credit risk using digital algorithms, and maturity transformation and supply of liquidity services achieved by offering market (not contractual) liquidity will replace the big banks. Two simple rules are all it takes.
Over to you Richard to assess and, if you approve, endorse this approach!
References
1. Banks must serve society, not rule it says incoming Archbishop Justin. The Independent (2013) https://www.independent.co.uk/news/uk/home-news/banks-must-serve-society-not-rule-it-says-incoming-archbishop-justin-welby-8451320.html [Accessed January 10, 2024]
2. Global Financial Stability Report, April 2023: Safeguarding Financial Stability amid High Inflation and Geopolitical Risks. IMF https://www.imf.org/en/Publications/GFSR/Issues/2023/04/11/global-financial-stability-report-april-2023 [Accessed January 10, 2024]
3. McMillan J. The end of banking: money, credit, and the digital revolution. Zurich, Switzerland: Zero/One Economics GmbH (2014).
I think this is mildly ludicrous
To pretend that banking can only be accounted for by taking non-financial assets into account is absurd
Shall we live in the real world?
I am hoping this is failed sarcasm.
A small point, but given the major problems of complexity and understanding in these issues, I think worth mentioning. You criticise the use of the word “move” twice: “money does not move between these ledgers” and ” but nothing ever moves”. I understand the issue, which is about identity and accounting, but then you refer to “any loan will necessarily flow back to the bank making that loan”; a movement analogy. It is further made a little confusing because although the identity and accounting is static, people ordinarily understand that cash is moveable; hence ‘cash flow’; also used by accountants.
I agree how hard this concept is
That is why I raised it….
I think that it is not just the complexity (and if financial instrument is too complicated I immediately get suspicious BTW) it’s also about VOLUME – the amount of business bankers tell us makes it almost impossible to check everything – so should that not also be looked at?
It seems to me that as we see retrenchment in State spending, ‘investment ‘ is being concentrated in a private sector that is telling us that it already has problems doing this properly/safely. And part of that problem is the bonus system.
Thank you so much for your great analysis and the time you spend on questions.
I think I grasp the essentials of how money is created. This leads me to a question. If we simplify all of banking to one single bank that can create and issue money, then destroy that money by receiving it back, we have only one thing left to consider. Interest. In essence, the bank will receive back more than it created.
Supposing we start at zero. No money in the economy. Then the bank creates £100 at 5%. After one year the borrower is able to pay off the £100, but cannot get hold of the £5 interest, since it does not exist. In this ludicrously simplified example, the bank must create more money to cover interest repayments.
My question is: do interest repayments explain why the amount of money in the economy always seems to grow?
The £5 need not be new money. It instead reduces the consumption spending of those who create value and transfers the benefit of that consumption to those who do not. Remember, money is used to transfer value as well as to create and destroy loans.
Many thanks Richard. This problem has been going round my head for months. I can see I simplified it to the point I got the wrong answer. I now see that the quantity of money need not grow because it can circulate to transfer value. Money can also be created and destroyed but the significance of interest is that it favours a kind of wealth that does not carry value , i.e., it’s nonproductive. I hope I’ve got it right now. Thanks for your help.
The original ‘purpose’ of banks, to safely hold customers’ money, facilitate payment transfers & lend for productive and socially worthwhile economic purposes has long past !
Richard. Thank you for your efforts in clarifying this (excessively) complex system. I think I’m beginning to understand it. But my comprehension of the subject has perhaps progressed less than I thought as I don’t understand the phrase “capital moderation within the market” in the fourth of your list of the perverse consequences created by banking regulation.
It simply means ‘balancing the books’
Did you see on Radio4 More or Less yesterday. Answered the query has Tory government increased rather than reduced taxes. Answer Yes. That was OK, so was the justification.
What was not OK was the usual economic nonsense on the debt, and the cost thereof, and “taxayer’s money”.
I emailed mororless@bbc.co.uk, complaining and got acknowledged, but amore cogent complaint would have been possible from you or one of your expert followers.
When will it ever change?
Maybe
One day
Maybe
I had to read it twice to fully appreciate it
We can use your insight at the Green Party, Richard. Many of us have been thinking about this for some time.
I do realise there are issues from an operational MMT perspective with split-circuit theory of money because many of the Positive Money advocates do not see gilts as money; many of us disagree on that issue. However, the monetary framework proposed by them works to solve all these problems. The Green Party of the United States proposed to make the Monetary Authority (Central Bank) the sole depository institution for the private sector. Banks become users of money rather than issuers. A revolving loan facility is provided to the member banks that funds their credit operations. You can do this with existing capital adequacy rules and drive the Green agenda without worrying about inflation from pro-cyclical bank credit expansion because the limits for the revolving loan facility would be set centrally at the Central Bank. Instead of issuing gilts, fixed term deposits can replace the essential function that term money has in the current system. All money would become sovereign money. Individuals would operate in the same money circuit as banks. Bank funding liquidity risk would no longer be an issue, credit risk would be transformed, and systemic risk would be diminished significantly.
This proposal is absolutely and emphatically the very last thing the Green Party wishes to do unless it wishes to shred its whole credibility, forever, even if its whole existing polocy is based on this uterly bizarre idea that denies what money actually is.
I explain why, by implication, here https://www.taxresearch.org.uk/Blog/2023/11/08/the-political-economy-of-money/
Money is an IOU, whether private or sovereign. I agree with you, and Green Party views can always change with your help.
I am trying to use the MMT operational framework to make sense of all this. Let’s imagine that there is a single commercial bank that accepts deposits for the private sector (i.e. the aggregate MFI balance sheet). Let’s further imagine that this bank is wholly owned by the central government. How would you describe this in the MMT model? What happens when you aggregate the balance sheets of the Central Government, Central Bank and this single aggregate depository institution.
Thank you for your time. Your views are helpful for our discussions, especially when it comes to overcoming the political obstacles to government debt and the dreadful national debt to GDP ratio.
That situation does not and would not exist so I can’t be bothered thinking about it.
Our task is to deal with the real world. That is going to include private sector banks that create money for a very long time to come – in fact, until we ever learn to live without it.
I have discussed this with Molly Scott Cato.