Regular readers will know that I have spent quite a lot of time reading the…
Monetary system not behaving according to textbooks – system is wrong!
In a speech in Maryland on January 7, 2011, one of the US Federal Reserve Governors, Elizabeth A. Duke spoke about current monetary trends in the US. It was hot on the heels of the testimony that the Federal Reserve boss Ben Bernanke made to the US Senate (January 7, 2011). They echoed similar messages. The reality is that the US economy is stagnating with very moderate growth and a very weak labour market. The overwhelming reliance on monetary policy as the saviour (low interest rates and quantitative easing) is misguided and will not provide the spending support that the private sector requires to regain their confidence again. But the interesting point to come from Duke’s speech was her observation that the US monetary system is not behaving according to how the mainstream macroeconomics textbooks (and thousands of orthodox teachers) depict it. That comes as no surprise when it is clear from the perspective of Modern Monetary Theory (MMT) that the textbooks are a joke. But given the monetary system is not “behaving itself” you can guess what all those mainstream professors are out there telling their students. Simple, the system is wrong!
As background to this blog you might like to read the following blogs – Money multiplier and other myths – Why doesn’t this attract headlines? – Understanding central bank operations and Money multiplier – missing feared dead
Duke seems to have set a cat among some pigeons in her remarks about the linkage “between the level of reserve balances and the monetary aggregates” if the response to her comments out there in the Internet is anything to go by. Anyone with some understanding of the way the monetary system operates and the role of the central bank viz-a-viz the banks would have yawned and thought well so what.
The reality though is that her observation should have been read out to all macroeconomics students around the world just prior to tearing up all mainstream textbooks that they are currently using and recycling the material into community gardens.
What did she say?
At one point she makes the following observations:
One concern that has been raised about asset purchases is the resulting expansion of the Fed’s balance sheet and the corresponding increase in reserves. For example, some observers have noted that an increase in reserve balances could lead to an increase in the money supply, which would in turn generate inflation pressures. Others have worried that elevated levels of reserve balances might make it difficult for the Federal Reserve to remove monetary accommodation at the appropriate time. While we will need to remain alert to economic developments, I am convinced that we can and will manage these risks.
Moreover, the risks are non-existent. The “fears” are based on a erroneous understanding of the relationship between bank reserves (which are not “loaned” out) and credit money.
Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.
The monetary policy objective of asset purchases is to foster downward pressure on interest rates. But assets are “paid for” by crediting the reserve balances of banks, generating higher levels of reserve balances in the banking system. Reserves are relevant to the growth of the money supply because banks are required to hold a percentage of some types of deposits as reserves with the Federal Reserve. Thus, the total amount of reserves in the banking system acts to cap maximum reservable deposits. It is important to note that it is deposits, not reserve balances, that are included in the monetary aggregates used to measure the money supply. For example, M1 is made up of currency, traveler’s checks, demand deposits, and other checkable deposits, while M2 is made up of M1 plus savings, small time deposits, and retail money market mutual funds.
First, the assets are “paid for” by crediting bank accounts in the same way that all government spending is “paid for”. The US Federal Reserve is part of the consolidated government sector and just like the US Treasury it does not face any financial constraints on its ability to purchase anything for sale in US dollars. Voluntary administrative arrangements might make it appear as though this is not the case – that is, that revenue is required before the US Treasury can spend but they are just a mirage over the actual capacity of the government in a fiat monetary system.
Please read my blog – The consolidated government – treasury and central bank – for more discussion on this point.
Second, you appreciate that Duke is still wedded to erroneous ideas that reserves constrain lending – which is one of the basic propositions embedded in the false money multiplier model that is the centrepiece of mainstream macroeconomic theory.
In fact, available reserves do not constrain lending. The demand for credit constrains lending as does the capital the banks have. Please read my blog – Lending is capital- not reserve-constrained – for more discussion on this point.
Duke then went on to make the point that seems to have surprised (shocked) the commentators:
Moreover, the linkage between the level of reserve balances and the monetary aggregates in the current environment is quite weak. You were probably taught, as I was, that the broad monetary aggregates increase when reserve balances increase because the larger volume of reserves supports increased lending, which in turn leads to a larger volume of reservable deposits. While that argument might hold in normal circumstances, in the current environment excess reserves are many multiples of required reserves, and adding reserves is unlikely to spark a further increase in the volume of deposits. As a result, the textbook linkage between reserve balances, bank loans, and transaction deposits just is not operative at present. Fundamentally, the levels of M1 and M2 are determined by the strength of the economy and the preferences of businesses and consumers for money, which depend on the yields on monetary instruments and competing assets.
That argument never holds in a fiat monetary system where the central bank stands ready to supply whatever reserves the banking system requires to square off at the end of the day. The teaching models that she is referring to are false depictions of the way the monetary system operates. and students should not be exposed to them other than as an historical artefact that shows how misguided the dominant paradigm of “the day” has been.
The relationship as depicted in the mainstream macroeconomics textbooks is never “operative” – the current period, while exceptional is so many other ways, is not exceptional in that respect.
The point is that she is correct in saying the money stock aggregates (M1 and M2) are driven by demand for credit which reflects the “strength of the economy”. Loans create deposits and reserves are then acquired to match the formal requirements which in many countries only requires non-negative reserve balances to ensure the payments system functions reliably.
The quite sharp deviation in the relationship between say M2 and bank reserves at present is a reflection of how deep this crisis has been and the deleveraging that the private sector is undertaking. But don’t think the relationship has been stable until now. It has not.
Duke noted that “(r)ecent experience has again illustrated the difficulty in identifying a reliable relationship between reserve balances and the monetary aggregates. Even though Federal Reserve actions to fight the financial crisis and support the economic recovery added roughly $1 trillion to a base of about $43 billion in aggregate bank reserves, M1 and M2 rose at relatively moderate rates over the same period.”
No surprise at all. Consider the following graphs which shows the evolution of the ratio between M1 and the monetary base and M2 and the monetary base from January 1959 to November 2010 (seasonally adjusted).
M1 is currency, traveller’s cheques, demand deposits and other checkable deposits. M2 is M1 plus retail MMMFs, savings and small time deposits. MMMFs are money market mutual funds.
You can get the data for Aggregate Reserves of Depository Institutions and the Monetary Base and Money Stock Measures from the excellent statistics made available by the US Federal Reserve.
The conclusion is obvious. The situation is not changed if I just used the measure for bank reserves instead of base money.
In 2006, Bernanke gave a speech (November 10, 2006) in Germany – Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective – where he discussed some of the evolution of monetary thinking among central bankers.
He noted that the US Federal Reserve had come close to a “monetarist experiment” in 1979 – that is, trying to control money supply growth because Milton Friedman and his clan had convinced the profession that this was the way to control inflation as per the monetarist agenda – but the Federal Open Market Committee abandoned the focus on monetary aggregates soon after when it became clear that they could not control the money supply.
Remember, a central tenet of the mainstream macroeconomics story that students learn from textbooks is that the role of the central bank is to control the money supply. This misconception is the first of many failings that the mainstream profession make when trying to pass on even a basic understanding of how monetary policy is implemented in a modern monetary economy to their students.
For example, in Mankiw’s Principles of Economics (Chapter 27 First Edition) he says that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system” and the second “and more important job”:
… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).
How does the mainstream economists claim the central bank accomplishes this task? Mankiw is representative of the plethora of textbooks that say that the:
Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.
This description of the way the central bank interacts with the banking system and the wider economy is totally false. The reality is that monetary policy is focused on determining the value of a short-term interest rate. Central banks cannot control the money supply. To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.
Contrary to the account of monetary policy in mainstream macroeconomics textbooks, which tries to tell students that monetary policy describes the processes by which the central bank determines the total amount of money in existence or to alter that amount, MMT assumes that the central bank has very little capacity to control the monetary aggregates.
The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).
For a discussion of the difference between vertical and horizontal transactions in a modern monetary economy please see Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 and Deficit spending 101 – Part 3.
The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply.
As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 (Currency plus bank current deposits of the private non-bank sector plus all other bank deposits from the private non-bank sector) is just an arbitrary reflection of the credit circuit.
So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.
Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.
In this context, Bernanke (in his 2006 speech) asked:
Why have monetary aggregates not been more influential in U.S. monetary policymaking, despite the strong theoretical presumption that money growth should be linked to growth in nominal aggregates and to inflation? In practice, the difficulty has been that, in the United States, deregulation, financial innovation, and other factors have led to recurrent instability in the relationships between various monetary aggregates and other nominal variables.
There has been a long history of economists being “surprised” when their estimates of M1 or M2 don’t pan out in the real world. The development of broad monetary aggregates like M2 and beyond were an ad hoc response to repeated failures to accurately forecast the movements in M1.
But as Bernanke noted “over the years the stability of the economic relationships based on the M2 monetary aggregate has also come into question”.
The upshot is that these aggregates have very little relevance for policy making and only serve to excite Austrian-school devotees and remnant-Monetarists who don’t know any better.
Duke also had something to say about the monetarist logic although she didn’t intend it that way. She said:
Going one step further, I should note that the linkage between the monetary aggregates and either real economic activity or inflation has been very weak over recent decades.
To put all this in perspective the fact that people are making an issue of this divergence in the relationship between reserves (and base money) and the monetary aggregates is a statement in itself.
They have somehow concluded that the divergence is based on the decision of the central bank to pay the target policy rate on excess reserves. But other central banks have been doing this for year and still there has been no strict relationship between the aggregates and the base.
In fact, the inapplicability of the money multiplier is not dependent on whether the central bank does have a support rate in place.
Why is that?
As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.
The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.
The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).
As noted above the central bank does not have the capacity to control the money supply. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.
The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks. But it cannot allow this rate to deviate from the policy target rate because they will eventually lose control of the latter.
The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.
The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
MMT considers the credit creation process by banks to be the “leveraging of high powered money”. The only way you can understand why all this non-government leveraging activity (borrowing, repaying etc) can take place is to consider the role of the Government initially – that is, as the centrepiece of the macroeconomic theory.
Banks clearly do expand the money supply endogenously – that is, without the ability of the central bank to control it. But all this activity is leveraging the high powered money (HPM) created by the interaction between the government and non-government sectors.
HPM or the monetary base is the sum of the currency issued by the State (notes and coins) and bank reserves (which are liabilities of the central bank). HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them! All Government spending involves the same process – the reserve accounts that the commercial banks keep with the central bank are credited in HPM (an IOU is created). This is why the “printing money” claims are so ignorant.
The reverse happens when taxes are paid – the reserves are debited in HPM and the assets are drained from the system (an IOU is destroyed). Keep this in mind.
HPM enters the economy via so-called vertical transactions. Please refer back to Deficit spending 101 – Part 1; Deficit spending 101 – Part 2 and Deficit spending 101 – Part 3 for the details and supporting diagrams.
So HPM enters the system through government spending and exits via taxation. When the government is running a budget deficit, net financial assets (HPM) are entering the banking system. Fiscal policy therefore directly influences the supply of HPM. The central bank also creates and drains HPM through its dealings with the commercial banks which are designed to ensure the reserve positions are commensurate with the interest rate target the central bank desires. They also create and destroy HPM in other ways including foreign exchange transactions and gold sales.
We can think of the accumulated sum of the vertical transactions as being reflected in an accounting sense in the store of wealth that the non-government sector has. When the government runs a deficit there is a build up of wealth (in $A) in the non-government sector and vice-versa. Budget surpluses force the private sector to “run down” the wealth they accumulated from previous deficits.
One we understand the transactions between the government and non-government then we can consider the non-government credit creation process.
The important point though is that all transactions at the non-government level balance out – they “net to zero”. For every asset that is created so there is a corresponding liability – $-for-$. So credit expansion always nets to zero! In previous blogs I have called the credit creation process the “horizontal” level of analysis to distinguish it from the vertical transactions that mark the relationship between the government and non-government sectors.
The vertical transactions introduce the currency into the economy while the horizontal transactions “leverage” this vertical component. Private capitalist firms (including banks) try to profit from taking so-called asset positions through the creation of liabilities denominated in the unit of account that defines the HPM ($A for us). So for banks, these activities – the so-called credit creation – is leveraging the HPM created by the vertical transactions because when a bank issues a liability it can readily be exchanged on demand for HPM.
When a bank makes a $A-denominated loan it simultaneously creates an equal $A-denominated deposit. So it buys an asset (the borrower’s IOU) and creates a deposit (bank liability). For the borrower, the IOU is a liability and the deposit is an asset (money). The bank does this in the expectation that the borrower will demand HPM (withdraw the deposit) and spend it. The act of spending then shifts reserves between banks.
These bank liabilities (deposits) become “money” within the non-government sector. But you can see that nothing net has been created.
Only vertical transactions create/destroy assets that do not have corresponding liabilities.
But what gives the unit of account chosen by the Government its primacy. Why do all the banks and customers demand it? The answer is that state money (in our case the $A) is demanded because the Government will only allow it to be used to extinguish tax liabilities. So the tax liability can only be met by getting hold of the Governments own IOU – the $A. Further, the only way that we can get hold of that unit of account is by offering to supply goods and services to the Government in return for their spending. The Government spending provides the funds that allow us to pay our taxes! That is the reverse of what most people think.
This process is how the Government ensures it can get private resources in sufficient quantities to conduct its own socio-economic policy mandate. It buys labour and other resources and creates public infrastructure and services. We are eager to supply our goods and services in return for the spending because we can get hold of $A.
So the private money creation activity that is central to many progressive models misses the essential point – that the credit creation activity is leveraging of the HPM – and is acceptable for clearing private liabilities (repaying loans) only because it is the only vehicle for extinguishing one’s tax liabilities to the state.
So I yawned when I read Duke’s speech. I am not the slightest bit surprised with the data trends at present. But then I have not bound myself up in lies and misconceptions of the way the monetary system works. I am happy to float free of the mainstream nonsense – I sleep well at night as a result.
As an aside (although not to understate its importance) – it is a sorry day when public officials get gunned down by people who have been taken in by the deficit terrorists and seem to think the fiat currency system is an oppressive regime. I guess the deficit terrorists have been so vehement in their claims over the last 2 years and some notable public participants have used various arms and weapons analogies that the shootings in Arizona were just a matter of when. And the terrorists are just one word away from calling anyone who advocates public sector activity to be a dangerous communist!
That is enough for today!
This Post Has 14 Comments
Bill, There is an article supporting you here: http://pragcap.com/greenspan-critics-proves-he-doesnt-understand-u-s-monetary-system
A little off topic but I came across this and wonder what are you thoughts.
I don’t know whether or not you have seen this but, according to this monetary economist, the Australian government implemented the ‘correct’ policies.
“The correct answer to the crisis was either for central banks to clarify that, with full government support, they would lend without limit to solvent banks (and charge a high interest rate) or for government to extend a blanket guarantee on the liabilities of any bank asking for one (and demand an expensive guarantee fee). The inter-bank market could then have reopened. That would have stopped the tens of millions of job losses and trillions of output foregone. Tidying up the financial system thereafter might have taken five to ten years, but the macroeconomic disaster of 2009 could have been avoided. In only one advanced country, Australia, did officialdom see clearly what had to be done when it introduced a general deposit guarantee in October 2008. Uniquely it has not had a recession.”
Haven’t read the full speech, but some of the stuff you quote is just disgraceful coming from a Fed Governor in the year 2011- verging on criminally incompetent, from a technical perspective.
I’m sure I missed it, but can someone explain to me why both the base money and M2 have been mostly falling over the last three decades. I understand that loans create their own reserves, but with people going more into debt over the last few years, wouldn’t that mean an increase in the money supply? Also, is the falling money supply a signal of some deflation to come.
Again, I was reading Hussman this morning a he quoted an Austrian economist, Ludwig Von Mises, as saying basically that savings equal investment. Is that the case?
I am a little confused by your observation and question.
It appears M2 grew 500 percent over the period.
Thanks for the post. I was hoping to see your comments after reading about Duke’s speech this weekend. I agree that the Fed’s behavior is the most important thing to judge them by and that guessing at their intent is not productive work (awk …//smile). As a puzzle, I have to wonder if one accepts that Bernanke and Duke understood that the MMT perspectives are accurate (I’m not convinced,) what could they realistically do other than insert observations that conventional economic wisdom isn’t working? The Fed is watched so closely that an inadvertent pause during a speech changes the stock market within 10 minutes. Perhaps they are only noticing that what parades as wisdom isn’t wisdom and haven’t completely figured out an answer they like yet. I think the press tv/print/web is our best way to enlarge the public debate. Politicians never will. I love “… the system is wrong!”
GLH, loans create their own deposits, not their own reserves. The missing link between the two is the non-existing multiplier. I suspect the reason base money and M2 have been in decline in the last 30 years is because of the increasing availability of consumer credit. How often do you pay for things with cash or by wire transfer? But maybe one of the professionals can chime in with a more detailed account.
This is off topic. I ran into the name of Hjalmar Horace Greeley Schacht, Reich Minister in 1934. Was it Scahacht’s idea to issue special treasury notes and spend them into the German economy to finance public works? This program of special treasury notes seems to be the same idea as Kalacki’s (spelling?). In short, what was Schacht’s role in using a sovereign currency issue without creating debt to save the German Economy in the 1930’s?
A retired proletarian wants to know. Thanks again for your blog.
Oliver said: “GLH, loans create their own deposits, not their own reserves.”
I think it is private loans create their own deposits, but not any central bank reserves.
I think it is gov’t loans create their own deposits, but also create their own central bank reserves 1 to 1 with deposits.
NOTICE the difference!!!
Jobhed: I looked at the chart you referred me to and I can understand how M2 increased with all the credit. But, what I was confused about was the chart above on this page. Now that I Look closer I see that the good professor is relating M1 and M2 to the base money and I think he is saying that they are declining in comparison to the base, which has increased.
Thanks for the correction.
the mainstream macroeconomics textbooks are wrong and a joke because the central banks are deliberately restricting the supply of money and credit to fight inflation and that caused unemplyment and depression.
“Deflation does not reduce wages »automatically«. It reduces them by causing unemployment. The proper object of dear money is to check an incipient boom. Woe to those whose faith leads them to use it to aggravate a depression!”
»The Economic Consequences of Mr. Churchill« (1925), Essays in Persuasion, London 1963, p. 259.
Do you tell your students the true story of the Great Depression? All those mainstream professors are telling their students the fairy-tale of the central bank, controlling the money supply, and not the truth about the central banks causing all the crises and depressions and massunemployment in our history.
Their students and the people would insist, that if a deflationary policy, initiated for financial reasons or to fight inflation, has deleterious economic or political effects, it must be abandoned. Therefore the students and the people are told the story of controlling the quantity of money and the great mystery of unemployment and economic depressions.
Benanke has said “…although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.”
So what difference does this ‘credit easing’ make, as opposed to Japanese style QE? I’ve read commentary suggesting that this credit easing has encouraged banks to go out and purchase other assets, which has caused the rally in the stock market, but I thought the reserves were only available for settlement between banks and/or the fed – is that not the case?
Just imagine that there is only one commercial bank in AUSTRALIA (styled XYZ BANK) which the central bank regulates and supervises. All the country’s banking transactions are thus handled by XYZ. Let us suppose that I decide to deposit AUD 1000 IN CURRENCY NOTES to my Savings account at XYZ. Applying the conventional double entry accounting, the bank credits my account and debits CASH a/c in its computer system. Assuming an obligatory cash reserve ratio at 5%, XYZ would normally keep AUD 50 in its vault and the surplus AUD 950, if not otherwise utilized, would be deposited at the Central Bank, where XYZ’s current account would be credited NOT by a corresponding debit, but by the withdrawal of those CURRENCY NOTES from circulation, because the Central Bank, as the printer, issuer and creator of CURRENCY has no CASH account per se. Let us now assume that at the same time XYZ finds a creditworthy client (ABC) that needs a loan of AUD 950. XYZ inputs a loan account debit in ABC’s name and credits ABC’s current account, thus creating an ADDITIONAL deposit of AUD 950, which becomes liquid. This amount may be withdrawn (1) in CURRENCY NOTES by simple debit or (2) by way of cheque drawn by ABC in favour of a third party. In the first case, XYZ would have to call back its cash deposit of AUD 950 at the Central Bank (which re-issues the notes) to pay ABC who can circulate these. The result is that XYZ computer records (balance sheet) will show my deposit AUD 1000 as a liability, matched by ABC’s loan AUD 950 as an asset, together with vault CASH 50, giving the ILLUSION that my deposit has financed ABC’s loan. Now, recall there is only one bank in town and therefore, in the second case, by drawing the cheque, ABC’s account is debited, and whoever is the beneficiary is credited, so that this procedure enhances by AUD 950 both the assets and liabilities sides of XYZ balance sheet. We can say that the illusion now disappears and that bank loans effectively create new deposits as long as these are not withdrawn in CURRENCY for circulation. What happens if ABC defaults on its debt? Well, XYZ’s shareholders, not depositors, will foot the bill, out of their capital/retained earnings. That is the reason why XYZ would be careful in creating new money by leveraging its capital to a reasonable and prudent level, so that should there be substantial loans’ default, there would be no need for taxpayers’ bailouts by the central bank.
Overall debt has been increasing in an unsustainable way. There is however a simple solution for the monetary system to generate “the right amount of debt”.
When a bank makes a loan it requires an asset for collateral and it deposits money in someone’s account. At the time of creation of the deposit it does not know whether it has enough money available from repayments and other transfers to make the loan but it doesn’t worry because at the end of each day it, (and all other banks) check to see if they all meet their regulatory requirements. If a bank has made more loans than it has deposits to match the loans then it gets a loan from another bank secured against its existing loans. This is where the extra debt and extra money comes into the system. This happens when the total amount of debt created is greater then the total deposits.
The system is designed to operate this way because it means that the amount of money will increase or decrease automatically to meet the demand for loans. This is an excellent feature to have in a system and it should be retained.
The problem is that banks make too many loans backed by loans and the amount of money circulating gets too great. We see this because there are many more loans than there are assets, the speed of money circulating drops, and we get inflation.
One of many possible solutions is to make sure there are enough money tokens in the system for banks to make loans. We can do this by issuing interest free (or low interest) loans throughout the community but with the proviso that the loans must be invested to produce something of value. HECS loans are a good example. This increases the money supply while increasing the number of assets. This means that assets tends to balance loans.
If we do this then it will prove unprofitable for banks to create extra money as interest bearing money because interest bearing money is more expensive than money created without interest. Banks will tend to stop having to create extra money at the end of each day. We can adjust the amount of interest free loans we issue according to general economic indicators such as excess capacity, interest rates, and inflation rates.