Banks just create money out of thin air! The truth is out there!

By Tim Worstall , written on March 19, 2014

From The News Desk

There's been a certain amount of hyperventilating over a recent explanation paper from the Bank of England showing that banks simply create money every time they sign someone up for a new loan. Here's an example of such breathlessness from David Graeber, the anthropologist and political activist.

Back in the 1930s, Henry Ford is supposed to have remarked that it was a good thing that most Americans didn't know how banking really works, because if they did, "there'd be a revolution before tomorrow morning".

Last week, something remarkable happened. The Bank of England let the cat out of the bag. In a paper called "Money Creation in the Modern Economy", co-authored by three economists from the Bank's Monetary Analysis Directorate, they stated outright that most common assumptions of how banking works are simply wrong, and that the kind of populist, heterodox positions more ordinarily associated with groups such as Occupy Wall Street are correct. In doing so, they have effectively thrown the entire theoretical basis for austerity out of the window. The thing is, and I wouldn't have expected someone like Graeber, a member of the Wobblies, to have known this, there's nothing at all surprising in that paper from the BoE. Of course banks create money out of nothing: what else did anyone ever think they were doing? The paper itself is here.

The short explanation is that banks do indeed just create money. Someone comes along looking for a loan, the bank says sure, and then they create a credit account and a debit account for that loan. They have, if you like, split zero in order to produce a positive amount of money, the credit, and a negative amount, the debt. And yes, it works the other way around as well, when the debt is paid off, cancelling the credit, money is destroyed. But as I say, why anyone is surprised by this is a bit of a mystery. This has been generally known for many a long year.

It's just that in the standard explanations we think of the central bank as making money and the banks are doing something rather different: they're creating credit, not money.

At which point we need a small digression into matters linguistic. When we talk of money we can mean a number of different things. We might mean just cash itself. We might mean reserves and the central bank, we might add mortgages, or loans to commercial companies and call all of these money. And indeed all of these can be and are called money, it's just they're slightly different types of it. Our different definitions of money are often distinguished by the names M0, M1, M2 and so on. The two that we actually pay attention to these days are M0 and M4. Which are cash money plus central banks reserves (M0) and then the whole kit and caboodle, all loans, bonds, wholesale money markets and also cash and those reserves (M4). Another way of making this distinction is to call M0 "base money" and M4 "broad money". Or, as the standard textbook descriptions have it, base money is money and broad money is credit.

So we can indeed say that banks just create money out of thin air: but we'll be rather misleading ourselves if we do. For they do indeed create broad money, or credit, or most of M4, but this isn't the same thing as stating that they can create cash, or base money, or M0.

Which is a difference that we need to be aware of. As some of the people reading this BoE paper haven't quite managed as yet. For there's something called seigniorage. This is the profit that you make by creating money: and if the banks are just creating money then why are we allowing the bastards to profit from that? Because we're not is the correct answer: seigniorage comes from creating base money, not broad.

The Fed certainly makes good profits by doing this. Combining 3 cents of ink with 5 cents of paper to make a $100 bill produces a profit of some $99.92 each and every time it's done. This is why the Fed is the only branch of government that routinely turns a profit. Sure, they lose on minting the pennies too but you've got to mint an awful lot of them to wipe out the profits being made on the Benjamins. If the banks were making the same sort of profits out of creating credit, or broad money, then obviously this is a gift that we should steal from their mouths and have the Fed do it. But the thing is they don't: as above they create both a credit and a debit at the same time. They charge interest on the loan, sure, but they also pay interest on the associated deposit.

Another way of proving the same thing is to look at the actual figures for the creation of broad money. Here's the BoE page on M4. Without bothering to be too tediously accurate in 2012 M4 (for the UK, obviously) rose by £30 billion odd. In 2013 it fell by £273 million. Thus whatever process by which the banks profit from the creation of broad money went into reverse and thus their profits must have fallen, right? Well, no, not really, for operating profits increased even as their supposed seigniorage money making machine went into reverse. Final profits fell, as various fines and settlements were made, but operating profits increased. Thus, sadly, we have proof that seigniorage is not an important part of banking profits: if indeed it is any part of them.

The importance of this is that there's various people's mouth there with the wrong bit firmly grasped between their teeth and they're galloping for the horizon. Positive Money is one such grouping I know of and their argument is that because the banks do make those large seigniorage profits then we should nationalise that part of banking and thus none of us ever need to pay taxes ever again. Government can be funded just through money creation. But as we can see, there's no great pot of gold to nationalise however appealing the idea of turning bankers into civil servants is.

However, we can indeed fund government through the creation of base money, that's not a problem. Just keep printing the notes to pay the bills. We've even a real world example of someone who did this, Mugabe in Zimbabwe and it all worked just fine until hyperinflation meant they ran out of enough money to buy the ink to print the banknotes. So perhaps there is a smallish problem with this idea as well.

Past that sort of lunacy there is a fertile plain of reasonable logic it should be said. This is the basis of Modern Monetary Theory. Sure, let's just do the money printing, let the government spend however much they feel they need to. We control the resultant inflation through the tax system: indeed, that becomes its only function. We don't need tax in order to fund anything, but we do need to destroy some portion of that new money that we're creating. Thus we tax, call in some portion of that new money and destroy it again. This is indeed logical although I have to admit that I remain unpersuaded.

Quite whether it is the politicians to blame, they all being flaphead spendthrifts, or whether it is us the voters as we like being given stuff but hate to pay for it, is a bit murky. But I think we can all agree that our current method of governance does find it very difficult to keep a close relationship, in fact any kind of relationship at all, between the amount that is spent and the amount that is collected in taxation. That's even when we all do realise that voting for some new goodies that Uncle Sam will provide us with does indeed mean that, at least in theory, someone somewhere else is going to have to pay for it. If we were to lift this constraint and argue instead that taxes were only to stop the inflation caused by our spending as much as we wished to I am absolutely certain that there will be even less control over spending and even less desire to raise taxation to accommodate that new money creation. That is, the MMT solution leads us, as a result of political reality not any economic considerations, into a permanently high inflation world.

As I say this BoE paper doesn't say anything different from the standard explanations that have been accepted for decades. Sure, banks create broad money, as this paper says, and sure, banks create credit, the same thing as broad money, as all the textbooks say. But this is not the same thing as stating that the banks create base money, or cash, which is where the seigniorage profits are. So there's no massive profit there to be nationalised. All we've really had here is a slight change in the terminology we're using to describe the process.

[Image via thinkstock]