Grist for The Money Mill
Okay, there hasn't been much activity here. I find most LJ communities thrive when the topic of their discussion is less in the news. Still, there is an aspect of monetary policy and discussion that can be corrected; that part that is wrong. Not wrong on opinion (that's pretty much impossible), but wrong on facts.
And one cannot come to any decent opinion without at least knowing the facts. Let's start with how banks create a vast majority (about 97%, IIRC) of our money supply.
First of all, the commonly held idea. I get this from Yves Smith, an excellent money and finance blogger at Naked Capitalism. Ms. Smith spent 25 years as a banker. Let's see what she has to say about money.
Banks hold deposits and pay interest on them. Depositors have the right to demand their funds at any time, but through experience, banks know that only a small percent of the funds they hold in trust will be withdrawn on any given day, and even that might be matched or exceeded by a new inflows. Thus banks, to earn additional profit, lend out a portion of their deposits, typically $9 for every $10, at a higher interest rate than they pay to their depositors. . . .
(Yves Smith, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Captialism, St. Martin's Press, 2010, pp. 204.)
Does that sound right? It does to most. The problem lies in some basic systemic realities. If banks hold deposits and lend at interest, where does the money to pay the interest come from? In other words, what mechanism creates the interest money added to the principal due at the close of the loan, or for that matter the depositor's interest on their savings and the bank's profits? Let's cut right to this chase. (From hereon, all emboldened words in those quoted will be my emphasis.) The Chicago Federal Reserve came out with a handy explanatory pamphlet once, which contained:
"Of course, [banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise [by the same amount]."
Chicago Federal Reserve, Modern Money Mechanics (1961, revised 1992).
"Credits to the borrowers' transaction account" is what most of us would call "money." Ellen Hodgson Brown maintains the banker-esque vocabulary to clarify:
When you lend someone your own money, your assets go down by the amount that the borrower's assets go up. But when a bank lends you money, its assets go up. Its liabilities also go up, since its deposits are counted as liabilities; but the money isn't really there. It is simply a liability -- something that is owed back to the depositor. The bank turns your promise to pay into an asset and a liability at the same time, balancing its books without actually transferring any pre-existing money to you.
(Ellen Hodgson Brown, Web of Debt, Third Millennium Press, 2008, p. 280, emphasis by the author.)
What Ms. Brown is trying to say is more clearly said by other authors, thankfully.
The amount of debt held by government, business and households is closely linked to the supply of money in the economy. Most of the "new" money in national economies is now created by commercial banks in the form of loans to customers.
(Tim Jackson, Prosperity Without Growth, Earthscan, 2009, pp. 25-26.)
But what of those deposits Yves Smith mentioned earlier?
Commercial banks play a dual role. They act both as "depositories" and as "banks of issue." In their role of depository, banks lend out depositors' funds (your savings and mine) to those who have need of them. That may be for either consumption or the creation of new productive capacity (capital formation). As banks of issue, they create new deposits (money) on the basis of short-term commercial bills that accompany the delivery of goods to market. That's the way it is supposed to work.
(Thomas H. Greco, Jr., The End of Money and the Future of Civilization, Chelsea Green Publishing Company, 2009, pp. 63.)
The dual role to which Mr. Greco refers is regulated by the "fractional reserve." Back to Mr. Jackson:
Governments through their central banks attempt to control how much money is created in the form of debt through two related instruments. One is the base rate -- the rate at which the central bank loans money to commercial banks. The other is the reserve requirement -- the percentage of deposits that banks are required to hold in reserve and which cannot therefore be used to make loans. The lower the base rate, the more likely commercial banks are to make loans. Over the last decade, the US Federal Reserve (and many other central banks) used an expansionary monetary policy to boost consumer spending. This worked to protect growth for a while but ultimately led to unsustainable levels of debt and destabilized the money markets. This is one of the reasons for calls to increase the reserve requirement.
(Tim Jackson, ibid., pp. 26.)
I hate to pick on otherwise excellent thinkers like Yves Smith, if only because her book EConned was (other than that quote above and a few minor quibbles) so enlightening. How could she not know of the loan creation of money? Yes, she spent 25 years as a banker; but it was as an investment banker. Investment banks are not allowed to create money through lending; only commercial or depository banks are. This is, in fact, the "firewall" in our financial system erected in the US by the Banking Act of 1933, aka the Glass-Steagall Act. Senators Glass and Steagall based this legislation on revelations into banking practice largely brought to light during the congressional hearings following the market crashes between 1929 and 1932, hearings conducted largely by Ferdinand Pecora. I've read half of the Stock Exchange Practices. Hearings before the Committee on Banking and Currency Pursuant to S.Res. 84 and S.Res. 56 and S.Res. 97, aka the Pecora Commission Report. Once one has a background into the loaning of money into existence, it's relatively easy to pick through the banker banter and decipher the actual meaning of some of the more dangerous practices the Glass-Steagall Act prevented.
That Act, though, was largely repealed in 1999 by the Gramm-Leach-Bliley Act of 1999. It took a non-investment banker to predict what might - did - happen afterward.
[Hyman] Minsky's knowledge of banking wasn't confined to what he had read in books. For years he served as a consultant to and director of the Mark Twain Bank in St. Louis, taking a keen interest in all aspects of its business. In the traditional banking model, which dates back centuries, banks take in money from their customers and lend most of it out to businesses and other borrowers, keeping a small amount in reserve to meet depositors' demands for cash. The source of banks' profits is the "spread" between the interest rate they pay depositors and the rate they charge borrowers. In this version of banking, the banking sector's role is essentially passive: it acts as an intermediary between savers and borrowers, and its activities don't have much impact on the overall level of economic activity.
Minsky pointed out a number of deficiencies in this analysis, beginning with the fact that when a bank extends a loan it creates a very special commodity: money. When banks lend more together, the total supply of money in the economy grows, which means total spending power increases. Similarly, when banks call in loans and refuse to make new ones, the money supply contracts and overall spending power falls. Apart from the government, banks are the only institutions in the economy with the ability to create money, and that is what makes them so important.
Unfortunately, there is nothing in a banker's employment contract that says he should take into account the impact of his actions on the economy as a whole. . . . As an employee of a public company, his only obligation is to maximize profits, which involves expanding lending when he things the outlook is good and refusing to lend when he is worried about the future. But the level of bank lending that makes sense for individual banks doesn't necessarily make sense for the country.
(John Cassidy, How Markets Fail: The Logic of Economic Calamaties, Princeton University Press, 2009, pp. 210-211.)
"The level of bank lending that makes sense for individual banks" is simply the level of lending that banks can issue at interest with the most likely chance either of return . . . or of possibility to seize valuable assets obtained after default. That last is what many enamored of the gold standard don't realize, that the same system of money creation through lending was in place at that time. When the availability of gold got low, bankers simply called in their loans to be payable only in gold and waited for the defaults to lower the credit money supply. This correction hardly cost them much, since the farms and factories they repossessed more than made up for the paper losses. But I digress.
I'll return to Greco to outline the fallout of improper lending.
As pointed out earlier, the vast majority of money is created by commercial banks by the process of lending it into circulation. They have the power to make loans (issue money) on either a proper basis or an improper basis. It is not the amount of money per se that causes inflation, but the basis upon which it is created. Loans made on an improper basis have the effect of inflating the money supply. What would be an improper basis?
An improper basis is any loan that does not put goods or services into the market either immediately or in the very near term. [Here he refers to the "dual role" of banks referred above.]
In practice, however, banks these days make little distinction between these two roles and they commonly create deposits (money) by making loans to finance both the flow of goods and services into the market as well as making loans that take them out of the market. When a bank makes a loan for the purpose of financing consumer purchases [credit card debt, for example] or for investment in long-term productive assets [stocks and bonds, for example], those newly created deposits are inflationary - because they deliver goods and services to the marketplace only in the distant future, or not at all. Improper bases of issue, then, include the purchase by banks of government bonds in excess of time deposits held by savers, as well as loans that finance market speculation.
(Thomas H. Greco, Jr., ibid., pp. 63-64.)
"Finance market speculation" was exactly the lending the Glass-Steagall Act outlawed . . . until its slow erosion starting in about 1983 and eventual repeal in 1999.
Many economists do not understand this, including Paul Krugman, an economist I otherwise hold in high esteem. The misinformation campaign has been waged long and hard enough for few to understand how our banking system works, and that mis-understanding has become the root of our undoing, allowing banks everywhere to take advantage of our ignorance through their questionable practices.
What we don't know is questionable cannot, after all, be questioned.
Several have warned through history of this conflict of interest banks represent. Sadly, not enough do. Worse, few realize that commodity banks are legally allowed to create money almost by fiat, money that can be used to further gather more money. As the money supply inflates, those in control of money's creation more and more concentrate their power in the society in which they issue their money, even as actual physical wealth might remain stagnant. Thus the financial sector has grown from about 5% of the economy to almost 40%, even as the living standards of average Americans and Britons has remained stagnant or fallen. We can neither fight nor hope to reform what we simply do not understand.
I'll let some former presidents close.
This money trust, or, as it should be more properly called, this credit trust, of which Congress has begun an investigation, is no myth; it is no imaginary thing.
(Woodrow Wilson from his book The New Freedom.)
"All the perplexities, confusions and distresses in America arise not from defects in the Constitution or Confederation, not from want of honor or virtue, as much as from downright ignorance of the nature of coin, credit and circulation."
(John Adams, in a letter to Thomas Jefferson.)
X-Posted to the_recession.
And one cannot come to any decent opinion without at least knowing the facts. Let's start with how banks create a vast majority (about 97%, IIRC) of our money supply.
First of all, the commonly held idea. I get this from Yves Smith, an excellent money and finance blogger at Naked Capitalism. Ms. Smith spent 25 years as a banker. Let's see what she has to say about money.
Banks hold deposits and pay interest on them. Depositors have the right to demand their funds at any time, but through experience, banks know that only a small percent of the funds they hold in trust will be withdrawn on any given day, and even that might be matched or exceeded by a new inflows. Thus banks, to earn additional profit, lend out a portion of their deposits, typically $9 for every $10, at a higher interest rate than they pay to their depositors. . . .
(Yves Smith, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Captialism, St. Martin's Press, 2010, pp. 204.)
Does that sound right? It does to most. The problem lies in some basic systemic realities. If banks hold deposits and lend at interest, where does the money to pay the interest come from? In other words, what mechanism creates the interest money added to the principal due at the close of the loan, or for that matter the depositor's interest on their savings and the bank's profits? Let's cut right to this chase. (From hereon, all emboldened words in those quoted will be my emphasis.) The Chicago Federal Reserve came out with a handy explanatory pamphlet once, which contained:
"Of course, [banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise [by the same amount]."
Chicago Federal Reserve, Modern Money Mechanics (1961, revised 1992).
"Credits to the borrowers' transaction account" is what most of us would call "money." Ellen Hodgson Brown maintains the banker-esque vocabulary to clarify:
When you lend someone your own money, your assets go down by the amount that the borrower's assets go up. But when a bank lends you money, its assets go up. Its liabilities also go up, since its deposits are counted as liabilities; but the money isn't really there. It is simply a liability -- something that is owed back to the depositor. The bank turns your promise to pay into an asset and a liability at the same time, balancing its books without actually transferring any pre-existing money to you.
(Ellen Hodgson Brown, Web of Debt, Third Millennium Press, 2008, p. 280, emphasis by the author.)
What Ms. Brown is trying to say is more clearly said by other authors, thankfully.
The amount of debt held by government, business and households is closely linked to the supply of money in the economy. Most of the "new" money in national economies is now created by commercial banks in the form of loans to customers.
(Tim Jackson, Prosperity Without Growth, Earthscan, 2009, pp. 25-26.)
But what of those deposits Yves Smith mentioned earlier?
Commercial banks play a dual role. They act both as "depositories" and as "banks of issue." In their role of depository, banks lend out depositors' funds (your savings and mine) to those who have need of them. That may be for either consumption or the creation of new productive capacity (capital formation). As banks of issue, they create new deposits (money) on the basis of short-term commercial bills that accompany the delivery of goods to market. That's the way it is supposed to work.
(Thomas H. Greco, Jr., The End of Money and the Future of Civilization, Chelsea Green Publishing Company, 2009, pp. 63.)
The dual role to which Mr. Greco refers is regulated by the "fractional reserve." Back to Mr. Jackson:
Governments through their central banks attempt to control how much money is created in the form of debt through two related instruments. One is the base rate -- the rate at which the central bank loans money to commercial banks. The other is the reserve requirement -- the percentage of deposits that banks are required to hold in reserve and which cannot therefore be used to make loans. The lower the base rate, the more likely commercial banks are to make loans. Over the last decade, the US Federal Reserve (and many other central banks) used an expansionary monetary policy to boost consumer spending. This worked to protect growth for a while but ultimately led to unsustainable levels of debt and destabilized the money markets. This is one of the reasons for calls to increase the reserve requirement.
(Tim Jackson, ibid., pp. 26.)
I hate to pick on otherwise excellent thinkers like Yves Smith, if only because her book EConned was (other than that quote above and a few minor quibbles) so enlightening. How could she not know of the loan creation of money? Yes, she spent 25 years as a banker; but it was as an investment banker. Investment banks are not allowed to create money through lending; only commercial or depository banks are. This is, in fact, the "firewall" in our financial system erected in the US by the Banking Act of 1933, aka the Glass-Steagall Act. Senators Glass and Steagall based this legislation on revelations into banking practice largely brought to light during the congressional hearings following the market crashes between 1929 and 1932, hearings conducted largely by Ferdinand Pecora. I've read half of the Stock Exchange Practices. Hearings before the Committee on Banking and Currency Pursuant to S.Res. 84 and S.Res. 56 and S.Res. 97, aka the Pecora Commission Report. Once one has a background into the loaning of money into existence, it's relatively easy to pick through the banker banter and decipher the actual meaning of some of the more dangerous practices the Glass-Steagall Act prevented.
That Act, though, was largely repealed in 1999 by the Gramm-Leach-Bliley Act of 1999. It took a non-investment banker to predict what might - did - happen afterward.
[Hyman] Minsky's knowledge of banking wasn't confined to what he had read in books. For years he served as a consultant to and director of the Mark Twain Bank in St. Louis, taking a keen interest in all aspects of its business. In the traditional banking model, which dates back centuries, banks take in money from their customers and lend most of it out to businesses and other borrowers, keeping a small amount in reserve to meet depositors' demands for cash. The source of banks' profits is the "spread" between the interest rate they pay depositors and the rate they charge borrowers. In this version of banking, the banking sector's role is essentially passive: it acts as an intermediary between savers and borrowers, and its activities don't have much impact on the overall level of economic activity.
Minsky pointed out a number of deficiencies in this analysis, beginning with the fact that when a bank extends a loan it creates a very special commodity: money. When banks lend more together, the total supply of money in the economy grows, which means total spending power increases. Similarly, when banks call in loans and refuse to make new ones, the money supply contracts and overall spending power falls. Apart from the government, banks are the only institutions in the economy with the ability to create money, and that is what makes them so important.
Unfortunately, there is nothing in a banker's employment contract that says he should take into account the impact of his actions on the economy as a whole. . . . As an employee of a public company, his only obligation is to maximize profits, which involves expanding lending when he things the outlook is good and refusing to lend when he is worried about the future. But the level of bank lending that makes sense for individual banks doesn't necessarily make sense for the country.
(John Cassidy, How Markets Fail: The Logic of Economic Calamaties, Princeton University Press, 2009, pp. 210-211.)
"The level of bank lending that makes sense for individual banks" is simply the level of lending that banks can issue at interest with the most likely chance either of return . . . or of possibility to seize valuable assets obtained after default. That last is what many enamored of the gold standard don't realize, that the same system of money creation through lending was in place at that time. When the availability of gold got low, bankers simply called in their loans to be payable only in gold and waited for the defaults to lower the credit money supply. This correction hardly cost them much, since the farms and factories they repossessed more than made up for the paper losses. But I digress.
I'll return to Greco to outline the fallout of improper lending.
As pointed out earlier, the vast majority of money is created by commercial banks by the process of lending it into circulation. They have the power to make loans (issue money) on either a proper basis or an improper basis. It is not the amount of money per se that causes inflation, but the basis upon which it is created. Loans made on an improper basis have the effect of inflating the money supply. What would be an improper basis?
An improper basis is any loan that does not put goods or services into the market either immediately or in the very near term. [Here he refers to the "dual role" of banks referred above.]
In practice, however, banks these days make little distinction between these two roles and they commonly create deposits (money) by making loans to finance both the flow of goods and services into the market as well as making loans that take them out of the market. When a bank makes a loan for the purpose of financing consumer purchases [credit card debt, for example] or for investment in long-term productive assets [stocks and bonds, for example], those newly created deposits are inflationary - because they deliver goods and services to the marketplace only in the distant future, or not at all. Improper bases of issue, then, include the purchase by banks of government bonds in excess of time deposits held by savers, as well as loans that finance market speculation.
(Thomas H. Greco, Jr., ibid., pp. 63-64.)
"Finance market speculation" was exactly the lending the Glass-Steagall Act outlawed . . . until its slow erosion starting in about 1983 and eventual repeal in 1999.
Many economists do not understand this, including Paul Krugman, an economist I otherwise hold in high esteem. The misinformation campaign has been waged long and hard enough for few to understand how our banking system works, and that mis-understanding has become the root of our undoing, allowing banks everywhere to take advantage of our ignorance through their questionable practices.
What we don't know is questionable cannot, after all, be questioned.
Several have warned through history of this conflict of interest banks represent. Sadly, not enough do. Worse, few realize that commodity banks are legally allowed to create money almost by fiat, money that can be used to further gather more money. As the money supply inflates, those in control of money's creation more and more concentrate their power in the society in which they issue their money, even as actual physical wealth might remain stagnant. Thus the financial sector has grown from about 5% of the economy to almost 40%, even as the living standards of average Americans and Britons has remained stagnant or fallen. We can neither fight nor hope to reform what we simply do not understand.
I'll let some former presidents close.
This money trust, or, as it should be more properly called, this credit trust, of which Congress has begun an investigation, is no myth; it is no imaginary thing.
(Woodrow Wilson from his book The New Freedom.)
"All the perplexities, confusions and distresses in America arise not from defects in the Constitution or Confederation, not from want of honor or virtue, as much as from downright ignorance of the nature of coin, credit and circulation."
(John Adams, in a letter to Thomas Jefferson.)
X-Posted to the_recession.