aarhus universitet banks don’t lend money, they create it: demystifying monetary and banking...

AARHUS UNIVERSITET

Banks don’t lend money, they create it: Demystifying monetary and banking terminology

7th Critical Finance Studies ConferenceCBS, Copenhagen, August 20-21, 2015

Ib RavnResearch Program on Organization and Learning, Department of Education, Aarhus University, Denmark

tinyurl.com/banks-dont

Ib [email protected] AARHUS UNIVERSITY

Problems

• What does a bank do when it lends?

• Three theories of bank lending (Werner, 2014). Which is true? Or when?

• ‘Lending’ seems like mystification.

My presentation

1. How banks create money (account money).

2. The three theories of bank lending fit three different monetary and banking systems.

3. Some money and banking terms that need to be deobfuscated – and a few hypotheses as to why they haven’t been already.

1. Overview


• Bank of England paper, Money Creation in the Modern Economy: ”Banks do not act simply as intermediaries, lending out deposits that savers place with them” (McLeay et al., 2014, p. 14).

• Hugo Frey Jensen, (Deputy) Governor, Danmarks Nationalbank: "Banks create deposits, and thus money when providing loans” (Jensen, 2014, p. 1).

• Example: Loan 800,000 DKK. Entered into my current account (a bank liability)A new loan account: -800,000 DKK. My debt to the bank (a bank asset). The bank’s balance has been extended. No transfer of funds. No intermediation.

• Michael Kumhof, Senior Research Advisor, Bank of England: “…whenever a bank makes a new loan to a non-bank customer X, it creates a new loan entry in the name of customer X on the asset side of its balance sheet, and it simultaneously creates a new and equal-sized deposit entry, also in the name of customer X, on the liability side of its balance sheet. The bank therefore creates its own funding, deposits, in the act of lending.” (Jakab & Kumhof, 2015, p. 3).

2. When a bank lends? It creates money


• When loan has been made, the borrower spends it = payment, a transfer to another account. Doesn’t that require the bank to cough up the money?

• No, because millions of payments: the national payment system (in DK: Nets). Clearing (Norman et al., 2011). Only small net amounts are transacted. A payment system facilitates money creation (Ravn, 2015).

• Loans increase deposits. Increases money supply = money creationLoan repayments deduct from deposits. Decreases money supply = money destruction

• Consequence: In good times, banks over-lend and feed bubbles in fixed assets, driving boom-and-bust rollercoaster.

• Unchecked bank lending (money creation) is the main cause of the business cycle (Werner, 2005).

3. Lending + clearing => money creation


• Strange terminology. What lawn mower do you create in the act of lending it?

• And when you return it, does it cease to exist?

• Why has this term persisted?

• To justify the charging of interest? (Savers must be compensated for theunavailability of their funds, right?)

4. The term ‘lending’ confuses


1. The financial intermediation theory: A bank gathers deposits and lends them.

2. The fractional reserve theory of banking: A bank retains a fraction (10%) of every deposit and lends the 90%.

3. The credit creation theory: Bank creates new (account) money by bookkeeping (adding digits to customer accounts).

• Werner (2014) finds overwhelming evidence for no. 3.

• I’ll argue they are suitable for three different banking systems (Weberian types)

5. Three theories of bank lending (Werner, 2014)

Money. Jens Overgaard Bjerre

Money. Jens Overgaard Bjerre


• True when banks accepted gold and valuables for safekeeping (de Soto, 2012)

• The gold coins were lent, with or without depositor’s knowledge.

• This theory has survived later developments in banking and remains the popular theory of banks.

• Theory 1 is true for that type of bank (historically very rare).

6. (1) The intermediation theory fits a warehouse bank


• Theory was invented for a gold-type banking system

• Here, deposit slips circulate as money (bank notes) and depositaries write fake deposit slips, passing them off as loans (Ravn, 2014).

• Reserves are banks’ and nations’ safeguards against bank runs.

• “Reserve” only makes sense here (not in warehouse bank: no new money, thus no need for reserves).

• In the 1700-1900’s this theory was a fair fit (if we ignore account money!)

7. (2) The fractional reserve theory fits a bank with reserves


1. Theory: A bank credits the borrower’s account with the deposit and enters a corresponding asset (the value of the loan) on the other side of the ledger. No funds transferred. Deposit is created from scratch.

2. Suitable for a banking and monetary system where all money is account money (no gold or cash) (Jakab & Kumhof, 2015)

3. Bookkeepers discovered they could ”lend” by adding numbers to a borrower’s account, without honestly subtracting the same number from some other account.

4. When many amounts are transferred between accounts, they tend to clear. In the clearing of matching loans lies money creation.

5. As loans are not given as cash/gold today, this theory fits current banking system.

8. (3) Credit creation theory fits pure account-money bank


• Suitable to historically different banking systems.

• Past economists confused about bank lending?

• “Keynes… did little to enhance clarity in this debate, as it is possible to cite him in support of each of the three hypotheses, through which he seems to have moved sequentially” (Werner, 2014, p. 12).

• British banks in 1925 were a combination of warehouse banks, gold-reserve banks, and account-money banks.

• Theory 3 holds today (Werner, 2014; Benes & Kumhof, 2012). Our banking system is evermore account-based. For the other banking systems: the other theories are fine.

• When banks use theory 1 concepts today it is misleading and self-serving:

- It justifies the charging of interest (no lender forgoes the use of their money)

- It hides banks’ enormous power to create money and control the money supply

- It portrays banks as humble servants of society’s needs when pursuing own profits

9. The three theories evaluated


Finansrådets hjemmeside: ”Banker skaber kontakt mellem de, der vil låne penge, og de, der ønsker at spare op. Bankernes unikke rolle som ‘pengeformidlere’ skaber blandt andet værdi ved at gøre det nemmere og billigere at låne og spare op. …[B]ankerne leder pengene i samfundet derhen, hvor de gør størst gavn….

http://www.finansraadet.dk/Tal--Fakta/Pages/bankernes-betydning-i-samfundet/bankerne-og-vaekst/uddybning-om-ind--og-udlaan.aspx

Translation: The Danish Bankers Association website:

“Banks establish contact between those who want to borrow money and those who wish to save. The banks’ unique role as ‘money intermediators’ creates value by making it easier and cheaper to borrow and save. …[T]he banks channel the money in society to where it does the most good….

10. Example: Theory 1 used for public communication


11. Theory 1 terms that obfuscate

1. Lending, loan. Warehouse terms conceal that banks create money

2. Loanable funds; funding. Suggest lent money derives from ‘funds’

3. Make a deposit. Nothing is deposited. It’s all numbers. No gold; rarely cash.

4. Repayment of a loan. No such thing. You don’t ‘repay’ freshly created money.

5. Business cycle – as if the boom-bust economy is normal, not

preventable.

• Create money: ”I’d like you create £200,000 for a new home for us.”

• Money creation. Unethical to pretend otherwise. Truth in advertising? Illegal?

• Coordinate numbers. “Would you jiggle some numbers in my accounts?”

• Destruction. “Let me destroy £500 a month. Erase it from my account.”

• Money bubbles – to underscore the money-created origins of boom-bust


1. Ignorance: When early trading houses allowed customers to go into debt and still trade, they didn’t know they were creating money.

2. Gradual awareness of deception: E.g., goldsmiths writing fake deposit slips.

3. Deliberate silence for gain. Why call attention to a fraud by naming it so?

4. ‘Bankers’ responsibility’ to guard the public’s ‘trust’ (Nielsen, 1930, s. 59)

5. Scholars unaware. Money and banks virtually absent from economics. Neutral veil; can be ignored.Highly convenient for bankers. Shared interests?

Major failing:

• Bankers practical – use extant concepts

• But finance scholars and economists should have updated theory (from no. 1 to 3) and reconceptualized ages ago. www.tinyurl.com/keen-krug

12. Possible reasons why no change in terminology


1. Lending and other terminology hidden behind a veil.Not veil of neutrality, but a veil of deception (Häring, 2013)

2. Three banking systems overlap, as do three models of lending.

3. (1) The warehouse theory legitimizes the charging interest and glorifies bank’s role (2) Banks seen as having gold reserves: fractional reserve banking(3) Best fit today: banks add to the money supply when lending = money creation

4. Responsibility of academics in (critical) finance: This really matters. Business cycles concentrate wealth at the top and deprive millions of their just share.

5. If we don’t understand this causal factor, bubbles will return. The nature of bank lending needs to be clear: banks’ money creation feeds bubbles and crises.

6. Help design a more equitable monetary system – which controls bank credit creation (Werner, 2005) or strips banks of their power to create money (Wolf, 2014; Jackson & Dyson, 2012; Sigurjónsson, 2015)

13. Conclusions


Benes, J., & Kumhof, M. (2012). The Chicago Plan revisited. IMF Working Paper WP/12/202.

De Soto, Jesús Huartes (2012). Money, bank credit, and economic cycles. 3rd edn. Auburn, AL: Ludwig van Mises Institute.

Häring, Norbert (2013). The veil of deception over money: How central bankers and text-books distort the nature of banking and central banking. Real-world economics re-view, 62: 2-18 (25 March).

Jackson, Andrew, & Dyson, Ben (2012). Modernising money. London: Positive Money.

Jakab, Zoltan, & Kumhof, Michael (2015). Banks are not intermediaries of loanable funds – and why this matters. Working paper No. 529, Bank of England, May.

Jensen, Hugo Frey (2014): Money at the bank is also good money. Danmarks Nationalbank, Press Release, Sept. 23, www.tinyurl.com/hugo-money

McLeay, Michael, Radia, Amar, & Thomas, Ryland (2014b). Money creation in the modern economy. Bank of England Quarterly Bulletin, Q1, 14-27.

Nielsen, Axel (1930). Bankpolitik. Bd 2: Læren. København: Hagerups Forlag.

14. References (a)


Norman, B., Shaw, R., & Speight, G. (2011). The history of interbank settlement arrangements: exploring central banks’ role in the payment system. Working Paper No. 412, Bank of England, June.

Ravn, Ib (2014). Private bankers pengeskabelse – belyst ud fra en episode i 1600-tallet med Londons guldsmede. Samfundsøkonomen, nr. 2, april, 4-10.

Ravn, Ib (2015): Explaining money creation by commercial banks: five analogies for public education. Real-Word Economics Review, 71: 92-111.

Sigurjónsson, Frosti (2015). Monetary reform: a better monetary system for Iceland. A report commisioned by the prime minister of Iceland.

Werner, Richard A. (2005). New paradigm in macroeconomics: Solving the riddle of Jap-nese macroeconomic performance. Houndmills, UK: Palgrave Macmillan.

Werner, Richard A. (2014). Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, 1-19. A blogger’s fine summary here: www.kortlink.dk/frkv

Wolf, Martin (2014): Wolf, M. (2014). Strip private banks of their power to create money. Financial Times, 24. April.

15. References (b)

aarhus universitet banks don’t lend money, they create it: demystifying monetary and banking...

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