Primer on the Widely Misunderstood Money Creation Mechanism

Remember that ‘money multiplier model’ which they taught you in economics classes and which was written in economics textbooks describing how money gets created in the fractional banking system?

Erase that from your memory and read on.

By the way, don’t get angry for being fed crap by your profs. The great majority (as in upwards of 90%) of economists and academia, let alone the average Joe-Six-Pack, get it wrong as well, so you are definitely not alone.

Although a fair amount of literature does exist in blogosphere explaining how money creation really works, a recent report commissioned by the prime minister of Iceland to look into ways to reform its monetary system in the aftermath of the country’s catastrophic collapse of the country’s banking industry in 2008 deserves special attention for two reasons.

For one, the report named “Monetary Reform: A Better Monetary System For Iceland” debunks the conventional myth of money creation and describes in layman’s terms how the process actually works. More importantly, by shining the light on how the money creation process in reality constitutes the most critical flaw of our current monetary system, the report brings the awkward topic of radical monetary reform, a topic avoided like the plague by the banking industry and half-heartedly dealt with by central banks and regulators all over the worlds, to officialdom and mainstream awareness.

Although the report deals specifically with the situation in Iceland, the principles behind how the system works apply equally well to the entire Western financial and banking system.

Before jumping into the mechanics of money creation, it would be instructive to refresh our minds on the different forms of money and the stated roles of the principal actors involved in the money creation process.

Broad Money Definition

Broad money includes physical money (cash and notes) and various forms of bank deposits with different level of liquidity:

  • Bank notes and coins in circulation (the physical money in your wallet)
  • Demand deposits (sight deposits or current account deposits)
  • General savings deposits
  • Time deposits such as GICs

So the overall money supply can be sub-categorized based on the above levels of availability on demand at any one time.

  • M0 (base money) – central bank reserves (more on this below) + notes + coins in circulation
  • M1 (money supply) – notes and coins in circulation + demand deposits
  • M2 – M1 + general savings deposits
  • M3 (broad money) – M2 + time deposits

Who Creates What Types of Money

The creation of money or credit of different forms is supposed to be done primarily by two entities – the central bank and the deposit taking commercial banks.

The central bank issues notes and coins which are circulated in the economy. As banker to the banks, the central bank also creates central bank reserves which allow commercial banks to make payments with each other by transferring reserves between their respective accounts created for them by the central bank. Central bank reserves are not available to non-bank entities such as businesses and individuals.

Demand deposits and all other forms of deposits are created by depository banks.

Fractional Reserves and the Money Multiplier Theory

 

How money gets created in a fractional banking system

How money is created using the money multiplier model in a fractional reserve banking system (Source: hotpapermoney.com)

 

In a fractional reserve banking system (see wiki: fraction-reserve banking) which is practiced pretty much worldwide, a bank takes in deposits from savers, makes loans and reserves a tiny portion of the deposit to meet demands for withdrawals according to the ‘reserve ratio’ set by the central bank.

How the textbook version of money multiplier process works per “A Better Monetary System For Iceland”:

The money multiplier process is often explained with a story that begins with a customer depositing cash into his bank account, say ISK 1,000. Because the average customer keeps his money in the bank most of the time, the bank keeps only a small ‘reserve’ of say 10% (ISK 100) to meet occasional withdrawals, and lends out the remaining ISK 900 to a borrower. The borrower takes the ISK 900 and buys product. The seller deposits this money with another bank: the seller’s bank balance is updated to ISK 900, whilst the bank takes the ISK 900 cash as its own property. The money supply, measured by the total stock of deposits, has now increased by ISK 900. On the second cycle, the seller’s bank keeps 10% of this new deposit as reserve (ISK 90) and lends out the remaining ISK 810. This process of re-lending and keeping a fraction for reserve continues with ever decreasing amounts. In this example the increase in money supply tops out at ISK 10,000 (ISK 100/10%). The banks have multiplied the original ISK 1,000 of the initial ‘base’ money (cash) tenfold.

 

How Money Gets Created: Textbook Version

“A Better Monetary System For Iceland” continues:

The money multiplier model of banking implies three things:

  1. Banks have to wait until someone puts money (usually assumed to be in the form of cash) into a bank before they can make loans.
  2. The central bank has ultimate control over the total amount of money in the economy. It can control the amount of money by changing either the reserve ratio or the amount of ‘base money’.
  3. The money supply cannot grow out of control, unless the central bank allows it to.

In conclusion, the money multiplier theory sees the causality in the money creation process occurring in the following way:

  • The central bank sets the reserve ratio, creates base money and injects it into the economy.
  • Banks lend out most of the money deposited with them and keep a fraction ‘in reserve’.
  • The loans are spent and the money circulates, before it is re-deposited into another bank. The bank uses this new (smaller) deposit to make a further (smaller) loan, again keeping a fraction of the deposit ‘in reserve’.
  • The process continues until the amounts being re-lent are miniscule. The money supply is now a multiple of the base money (with the multiple being determined by the reserve ratio).

 

How Money Actually Gets Created in the Real World

In a word, it gets created by commercial banks out of thin air.

Contrary to the theoretical ‘money multiplier’ process through which the money gets created, commercial banks create new money when they make loans and are not as constrained in their money creation as the multiplier model suggests.

Again, per “A Better Monetary System For Iceland”

A commercial bank creates new bank deposits when it advances loans. These bank deposits are liabilities (IOUs) of the bank, which represent a promise to deliver cash on demand to the deposit owner, or to make an electronic payment to a third party on the owner’s request. Deposits can therefore be used to make payments in the economy through debit cards and electronic fund transfers.

A bank does not need to acquire money from a saver before it can make a loan to a borrower. Through some simple double entry accounting, when a bank lends money, it increases both the quantity of money in the economy, as well as the quantity of debt. The Bank of England explains this process in the following way:

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.”

Money creation in practice differs from some popular misconceptions – banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ Central Bank money to create new loans and deposits.

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the description found in some economics textbooks:

  • Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
  • In normal times, the Central Bank does not fix the amount of money in circulation, nor is Central Bank money ‘multiplied up’ into more loans and deposits.”

“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money.

That the ‘money multiplier theory’ described in economic textbooks is detached from reality, per a 2014 Bank of England Quarterly Bulletin:

 “Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money [M3] to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves. While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality.

….

And how bank reserves are dealt with.

If a bank needs central bank reserves to settle any payments to other banks that arise as a result of it’s lending, it will be able to borrow them either from the CBI or from other banks.

As Alan Holmes, then Senior Vice President of the Federal Reserve Bank of New York put it in 1969:

“In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.”

And here’s what the head of the Financial Services Authority has to say about what is taught as it relates to the multiplier model.

Speaking on a panel in a conference in Toronto in April 2014, Lord Adair Turner, head of the Financial Services Authority 2008-2013, describes the money multiplier model as “mythological” and explains how banks create new money when they make loans:

“If you pick up most undergraduate textbooks…and you see how they describe the role of the banking system, they make two mistakes. First of all they describe a system which takes money from savers, and lends it to borrowers, failing to realise that the banking system creates credit, money and purchasing power ab inicio, de novo, and with an important role therefore within the economy.

But also, again and again, [the textbooks] say “Well what banks do is they take deposits from households and they lend money to businesses, making the capital allocation process between alternative capital investments.” As a description of what modern advanced economy banking systems do, this is completely mythological.”

Finally, “A Better Monetary System For Iceland” sums up how modern day money is created in the real world:

In conclusion, the credit creation model sees causality in the banking system occurring in the following way:

  • When banks lend they create new deposits and thereby new money.
  • Lending may increase a bank’s demand for reserves in order to settle payments to other banks.
  • The central bank must provide reserves when a bank needs them.
  • While money is created when banks lend money, money is deleted when bank loans are repaid.

 

 

The fundamental implication of the credit creation theory is that commercial banks, rather than the central bank, determine the money supply. The central bank is obliged to support the lending decisions of banks by providing sufficient reserves to ensure that all payments are settled at the end of the day. This is the opposite of money multiplier theory, which implies that the central bank controls the money supply.

Inherent Problems with the Credit Creation Model

By now it should be clear that it is the depository banks which create the money supply and that the central bank has limited policy tools at its disposal to control the quantity of money created by the banks.

Since it costs them essentially nothing to do so, Commercial banks have a strong incentive to create as much money as they can as long as they can find creditworthy borrowers or a way to shift the loan risks from not-so-creditworthy borrowers to third parties through loan securitization or other means. While they enjoy money for nothing, society in general bears the costs of an uncontrolled expansion of money supply in the form of asset inflation or financial bubbles.

In the case of Iceland, upwards of 90% of the money supply was created this way by commercial banks while less than 10% was created by the central bank. The collective loan assets of Iceland’s three largest banks when they were nationalized during the country’s banking collapse was 11 times the size of Iceland’s GDP. Talk about uncontrolled money supply expansion.

 

Reference:

 

 

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