It's Wednesday and I have comments on a few items today. I haven't been able…
On one side of the Atlantic, it seems that central bankers understand the way the monetary system operates, while on the other side, central bankers are either not cognisant of how the system really works or choose to publish fake knowledge as a means to leverage political and/or ideological advantage. Yesterday, the Deutsche Bundesbank released their Monthly Report April 2017, which carried an article – Die Rolle von Banken, Nichtbanken und Zentralbank im Geldschöpfungsprozess (The Role of Banks, Non-banks and the central bank in the money-creation process). The article is only in German and provides an excellent overview of the way the system operates. We can compare that to coverage of the same topic by American central bankers, which choose to perpetuate the myths that students are taught in mainstream macroeconomic and monetary textbooks. Today’s blog will also help people who are struggling with the Modern Monetary Theory (MMT) claim that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency and the fact that private bank’s create money through loans. There is no contradiction. Remember that MMT prefers to concentrate on net financial assets in the currency of issue rather than ‘money’ because that focus allows the intrinsic nature of the currency monopoly to be understood.
A succinct summary of the full article in the Deutsche Bundesbank’s Monthly Review can be found here (again in German) – How money is generated (published April 25, 2017).
The full article begins by noting that during the GFC, the ECB and its national central bank partners (in the Eurosystem) ran a very expansionary monetary policy which “caused a sharp increase in the central bank assets of the (commercial) banks in the euro area”.
These assets are what we call bank reserves.
Please note the quotes begin and end where I have translated the German. For brevity, I will typically not include the original German text.
But, “the annual growth rate of the money supply M3” (that is, broad money) has “nevertheless remained at a moderate level over the last two years, which has rekindled the interest in the links between the creation of central bank deposits and the growth of broader money supply”.
In most university courses on banking, money and macroeconomics, students are taught what I call fake knowledge (aka lies).
I have covered that discussion in these blogs – Money multiplier and other myths and The Weekend Quiz – April 15-16, 2017 – answers and discussion (Answer to Question 1) and Money multiplier – missing feared dead.
By way of summary:
1. The mainstream textbooks claim that the money multiplier transmits changes in the so-called monetary base (the sum of bank reserves and currency at issue) into changes in the money supply (M).
2. By controlling the monetary base, the central bank then is alleged to control the broader money supply, via the money multiplier, which is a formula that depends on various monetary parameters (required reserves, cash-to-deposit ratio etc).
3. The ‘money creation’ causality is alleged to be as follows: Say $100 is deposited in a bank (which is constructed as a financial intermediary seeking deposits in order to loan them out), which is required by the central bank to hold 10 per cent in reserves. The bank loans out $90 which is then deposited elsewhere and that deposit receiving bank then loans out 90 per cent of that ($81) and so on.
4. The “important job” of the central bank (according to Mankiw’s textbook) “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).
5. Mankiw claims the central bank maintains that control by conducting “open market operations – the purchase and sale of … government bonds” and can deprive banks of deposits (reducing bank reserves) by selling bonds, which reduces the money supply and vice versa.
6. The mainstream also believe that an increase in bank reserves is immediately translated into a multiplied into a larger increase in the broad money supply because banks have more ‘money’ to loan out.
7. It follows that the central bank is responsible for causing inflation because the mainstream allege that inflation is the result of excessive growth in the money supply.
All of which is fake knowledge.
The Bundesbank clearly understand the false nature of the mainstream story as has the Bank of England and some divisions of the Federal Reserve Bank in the US.
For example, please read:
1. The New York Federal Reserve Bank’s 2008 paper – Divorcing Money from Monetary Policy.
2. The Bank of England’s 2015 working paper – Banks are not intermediaries of loanable funds – and why this matters.
The Bundesbank article seeks to address the links (if any) between bank reserves and broad money and also analysis the claims that banks (credit institutions) should cover 100 per cent of their deposits with reserves, a populist proposal of late.
The Bundesbank start by noting that commercial banks create most of the broad money supply via transactions with their customers.
They emphasise that when a credit worthy customer seeks a loan, the commercial bank approval creates, with the stroke of a pen (or computer key) a deposit (a credit to a bank account).
This is, of course, the familiar MMT statement: Loans create deposits.
Why that is important to understand (getting the causality right) is that it negates the mainstream view of the bank as an intermediary who waits for customers to make deposits before it loans them out again.
The Bundesbank establishes two important principles at the outset.
Das widerlegt einen weitverbreiteten Irrtum, wonach die Bank im Augenblick der Kreditvergabe nur als Intermediär auftritt, also Kredite lediglich mit Mitteln vergeben kann, die sie zuvor als Einlage von anderen Kunden erhalten hat
Which means that the central bankers clearly understand that the commercial banks are not intermediaries in the way depicted in the mainstream monetary theory.
Ebenso sind vorhandene überschüssige Zentralbankguthaben keine notwendige Voraussetzung für die Kreditvergabe (und die Geldschöpfung) einer Bank.
That existing reserves (excess or otherwise) are not a prerequisite for lending (and money creation) by the commercial banks.
That position was also supported by the Bank of England in the paper cited above. They said:
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.
… in the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.
The BoE paper correctly noted that:
… banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But the most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency.
Please read my blog – Lending is capital – not reserve-constrained – for more discussion on this point.
Banks lend if they can make a margin given risk considerations. That is the real world. If they are not lending it doesn’t mean they do not have ‘enough money’ (deposits). It means that there are not enough credit-worthy customers lining up for loans.
Banks lend by creating deposits and then adjust their reserve positions later to deal with their responsibilities within the payments system, knowing always that the central bank will supply reserves to them collectively in the event of a system-wide shortage.
The Bundesbank notes that the money-creating capacity of the commercial banks is finite (“Unendlich sind die Geldschöpfungsmöglichkeiten der Geschäftsbanken allerdings nicht.”)
Why? Because there are regulutions (capital adequacy) and “not least by the profit maximisation calculus of the bank’s themselves … a bank needs to finance the created loans despite its ability to create money, since it require central bank reserves to settle transactions drawn on the deposits they create”.
How it finances the loans depends on relative costs of the different available sources. As costs rise, the capacity to make loans declines.
The banks’ capacity to create money is also “is limited by the behavior of companies and households, in particular by their credit demand and investment decisions” (“Die Geldschöpfungsmöglichkeiten des Bankensystems werden zudem durch das Verhalten von Unternehmen und Haushalten begrenzt, insbesondere durch ihre Kreditnachfrage sowie ihre Anlageentscheidungen.”).
MMT adopts the endogenous money theory that is the hallmark of the Post Keynesian approach, and, stands in stark contradistinction to the mainstream monetary theory of exogenous money (that is, central bank control of the money supply).
The mainstream monetarist approach claims that the money supply will reflect the central bank injection of high-powered (base) money and the preferences of private agents to hold that money via the money multiplier. So the central bank is alleged to exploit this multiplier (based on private portfolio preferences for cash and the reserve ratio of banks) and manipulate its control over base money to control the money supply.
It has been demonstrated beyond doubt that there is no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.
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).
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 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.
The Bank of England paper is categorical:
The deposit multiplier (DM) model of banking suggests that the availability of central bank high-powered money (reserves or cash) imposes another limit to rapid changes in the size of bank balance sheets. In the deposit multiplier model, the creation of additional broad monetary aggregates requires a prior injection of high-powered money, because private banks can only create such aggregates by repeated re-lending of the initial injection. This view is fundamentally mistaken. First, it ignores the fact that central bank reserves cannot be lent to non-banks (and that cash is never lent directly but only withdrawn against deposits that have first been created through lending). Second, and more importantly, it does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate, in order to safeguard financial stability. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.
The Bundesbank article makes it clear that bank lending is not reserve-constrained.
Geldschöpfung erfolgt zunächst unabhängig von bestehenden Zentralbank-guthaben der Banken … Geldschöpfung zeigt im Besonderen, dass die Kreditvergabe grundsätzlich ohne vorherige Zu üsse von Kundeneinlagen statt finden kann.
Or, “Money is first created independent of the banks’ existing bank balances …” at the central bank and that bank “lending can always take place without prior inflow of customer deposits.”
The Bundesbank says that this insight:
Dies widerlegt einen weitverbreiteten Irrtum, wonach die Bank im Augenblick der Kreditvergabe nur als Intermediär auftritt, also Kredite lediglich mit Mitteln vergeben kann, die sie zuvor als Einlage von anderen Kunden erhalten hat.
Or, this insight “rejects the widespread error” that sees the bank as a intermediary allocating loans with funds “previously received as deposits from other customers”.
So the idea that building up central bank balances (reserves) will enable commercial banks to expand loans is dismissed as lies as is the idea that the bank relies on deposits to make loans – two central propositions of mainstream monetary theory that MMT has exposed in the past.
This also bears on the arguments early in the crisis that Quantitative Easing would help to expand loans because it would expand bank reserves.
It also rejects the mainstream claim that bank reserves are loaned out.
Banks do not lend out reserves and a particular bank’s ability to expand its balance sheet by lending is not constrained by the quantity of reserves it holds or any fractional reserve requirements that might be imposed by the central bank.
Loans create deposits, which are then backed by reserves after the fact.
Building up reserves at the central bank does nothing to enhance the capacity of the commercial banks to make loans, which is why there is no direct link between the central bank balance sheet and the broad money supply measures.
Compare that to the narrative provided by the Federal Reserve Bank of Minneapolis in its December 2015 issue of The Region, an in-house publication – Should We Worry About Excess Reserves (December 17, 2015).
I analysed that article in this blog, a few days after it was published – Central bank propaganda from Minneapolis.
I concluded that the article suggested that the author hasn’t really been able to see beyond his intermediate macroeconomics textbook and understand what is really been going on over the last several years.
It was all about how the excess reserves in the US banking system were a time bomb because the banks now had a massive extra capacity to make loans and this “greater liquidity is associated with higher prices”.
The standard Monetarist lies.
The banks do not loan out reserves to retail customers. They shuffle them between themselves to cover daily shortfalls in liquidity in order to ensure all the transactions are settled (cheques do not bounce) but that is it.
The Bank of England also highlighted the:
… related misconception … that banks can lend out their reserves … Reserves can only be lent between banks … consumers do not have access … [to central bank reserve accounts].
This insight is also confirmed in an interesting article published in September 2008 by the Federal Reserve Bank of New York in their Economic Policy Review entitled – Divorcing money from monetary policy.
We learn that commercial banks require bank reserves for two main reasons. First, from time to time, central banks will impose reserve requirements, which means that the bank has to hold a certain non-zero volume of reserves at the central bank. Most nations only require the banks to keep their reserves in the black on a daily basis.
Second, the FRNBY states that “reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions”.
There is daily uncertainty among banks surrounding the payments flows in and out as cheques are presented and other transactions between banks are accounted for.
The banks can get funds from the other banks in the interbank market to cover any shortfalls, but also will choose to hold some extra reserves just in case. If all else fails the central bank maintains a role as lender of last resort, which means they will lend reserves on demand from the commercial banks to facilitate the payments system.
The Bank of England also concludes that the existence of new reserves, even if they are well in excess of the banks’ requirements to operate an orderly clearing system, “do not, by themselves … change the incentives for the banks to create new broad money by lending”.
The question then is, why are students in our universities forced to learn material that has no foundation in the system they are purporting to understand? The answer is that the educational opportunity is replaced by a propaganda exercise to suit ideological agendas.
The other question is, why does a branch of the Federal Reserve Bank in America allow an author to publish such misrepresentations of the way the banking system operates?
Finally, what about 100 per cent reserve regulations?
I have written about this in this blog – 100-percent reserve banking and state banks.
The Bundesbank paper notes the tension in the public debate where there are calls for a 100 per cent reserve system to be imposed as part of banking reform.
The claim is that by restricting the credit creation capacity of banks (the fractional reserve system noted above), the banks would be more stable and there would be less chance of crisis.
So if banks had to always have reserves equal to their loan book then stability would be enhanced.
But the Bundesbank is as on to that nonsense as MMT is.
It emphasises that banks make loans which create deposits in response to demands from credit worthy customers (borrowers).
So forcing banks to hold reserves equal to their loan book would have “little effect on the banks’ credit facilities”.
The provision of bank reserves is not really a choice factor for the central bank unless it desires to run a zero interest rate policy or is willing to pay interest on excess reserves.
So if the banks are making loans which then have to be backed by reserves, the central bank has to ensure there is sufficient liquidity in the system to accompany that level of banking activity or else lose control of its short-term policy interest rate.
The Bundesbank note that the only way to restrict credit creation is for:
In einem System der vollständigen Deckung von Sichteinlagen durch Zentralbankgeld müssen vielmehr zusätzlich die institutionellen Voraussetzungen oder bestehende Regulierungsvorschriften so geändert werden, dass eine Geldschöpfung durch Geschäftsbanken de facto nicht mehr möglich ist.
Or, “the institutional requirements or existing regulatory regulations must be modified in such a way that it is no longer possible to create money by commercial banks.”
Which would represent a major break on economic activity and largely undesirable consequences.
There is a case (which we outline in our upcoming book) for the nationalisation of banks. But to only allow banks to loan out deposits it has already gleaned is highly restrictive and would certainly limit economic activity.
The Bundesbank article is worth reading (if you handle German okay). I have summarised its main message which is becoming a common narrative from the more enlightened central banks.
Unfortunately, there are still nonsensical claims coming out of some divisions of the central bank in the US but they are becoming a minority.
But, still the classrooms continue to make these nonsensical misrepresentatinos of the way the banking system operates, which only serve to condition students attitudes in favour of poor and irresponsible macroeconomic policies, of the sort that have led to and prolonged the crisis.
The academy is slow to change unfortunately.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.