Read part 1 here
After having discussed the history of money and banking, the authors now turn to modern banking practices in chapter 4. And in chapter 5 the regulation of money creation and allocation is discussed.
The authors start this chapter by making the distinction between cash and central bank reserves on hand and commercial bank money on the other hand. Cash and central bank reserves constitute what is known as the monetary base.
As we have seen in the previous installment of this review, commercial bank money is nothing but a claim of the account holders against the bank. If I have £1,000 on my bank account, the bank is obligated to provide me with £1,000 in cash, if I would request this.
In reality commercial bank money is not fully backed by cash or central bank reserves hold by commercial banks. Or put simply there is more commercial bank money than “base money”.
So this money is somehow created by commercial banks. This money is created by extending loans to the public. In order to understand this, we need to discuss a little bit of elementary bookkeeping.
In bookkeeping we distinguish between assets and liabilities. Assets are the thing ones owns (e.g. a car, houses and so on). Liabilities are what one owes to others (e.g. rent to a landlord, wages to employees).
Bookkeepers record assets and liabilities on a so-called balance sheet. Usually assets are listed on the left-side and liabilities on the right-side. Now what happens when a bank provides a loan.
If a bank provides a loan to me, say £10,000, the bank gains an asset, namely my £10,000 debt. Simultaneously, the bank gets a liability, namely the obligation to pay me £10,000. So on both sides a sum of added and the books are balanced once again.
Notice that this loan does not involve any cash nor central bank reserves at all. The money I borrow is just created out of thin air and is nothing but a bookkeeping entry.
As long as I keep the money on my account and make payments only to people who have an account at the same bank, there are no problems for the bank. But what if I want to transfer £1,000 from my account to my friend John, who has an account with a different bank?
Now the bank has a problem. And this is where central bank reserves come into the picture. Just like ordinary members of the public have an account with a bank, commercial banks have an account with the central bank.
When I transfer £1,000 to John, my bank will transfer this amount from its central bank account to that of John’s bank. So my bank needs to have at least £1,000 in central bank reserves.
We have to make a few important observations. First, unlike cash central bank reserves do not circulate among the public. Secondly, the main purpose of central bank reserves is to facilitate interbank payments.
However, commercial banks can reduce their dependency on central bank reserves the following way. Suppose that at the end of the day my bank has to pay £11 million to John’s bank, but at the same time John’s bank has to £10 million to my bank. Now the mutual debts between these banks almost cancel each other and my bank only needs to transfer £1 million.
Even though the total value of all transaction is £21 million, only one million pounds in central bank reserves is actually needed. So twenty million is just created by commercial banks!
Though banks can create money out of nothing, they can get into trouble. It could happen that my bank as to pay more in central bank reserves to John’s bank, that it actually has. There two ways to solve this problem:
- borrowing central bank reserves either from the central bank or other banks, or
- sell securities to the central bank or other banks, in exchange of central bank reserves.
In practice commercial banks prefer to borrow from other banks.
An interesting question which now arises, is if commercial banks can create money at will, why can they into troubles? As the authors point out, banks can face two problems: insolvency and illiquidity.
Insolvency means that a bank has more outstanding liabilities than assets. For instance if I get a £5,000 loan and use that money to buy John’s car. Assuming we have an account with the same bank, the bank has a £5,000 liability to John, while my debt is an asset to the bank.
However, if I would default on my loan, the bank has to write off five thousand pounds on its balance sheet. But simultaneously there remains a five thousand pound liability to John. A bank cannot solve this problem by issuing another loan, as this would increase both the asset and the liability side with an equal amount.
Illiquidity means that a bank has too few cash or central bank reserves to provide cash withdrawals or transfer money to other banks. Even if a bank has sufficient assets, it might still become illiquid, as certain assets (such a mortgage loans) cannot easily be converted into money.
Even though commercial banks create money out of nothing, they have to borrow central bank reserves and cash. Here seems a possibility to regulate the money creation by commercial banks. But as the authors will argue in chapter 5, the traditional monetary policies are highly ineffective.
Traditionally central banks seek to control the money supply through interest rates and capital requirements. I will end this section with a short discussion of the effectiveness of interest rate policy.
The usual story on interest rates is that low interest rates will stimulate economic activity and high rates will reduce activity. However, reality shows differently and the authors cites the case of the Japanese economy.
Despite extremely low interest rates (0.001%), the Japanese economy shows little growth. Similar coincidences of low interest rates and low growth has been observed in other countries.
Why does low interest rates not result in more activity? The answer is simple, whether commercial banks will provide loans to the public is not determined by interest rates. Instead what matters is the confidence a bank has that a borrower will repay the loan (and interest).
If the bank has no confidence I will repay my loan, it will refuse my application – as they would likely lose the money. However, if the bank think I will repay , they would happy to give me a loan (especially if the interest is high).
Unfortunately, the authors only consider the supply side of money creation by commercial banks. What about the demand-side? Text-books say after all the low interest rates will increase the demand for loans, and high rights will reduce demand.
Steve Sharpe and Gustavo Suarez have conducted a survey among US CFOs on how interest rates affect their investment decisions. The results they received contradicted convention economic “wisdom”.
A majority of the CFOs would not increase investments if interest rates would decrease. On the other hand, investment decisions are more sensitive to increase of rates, but only to a limited extent.
Why are businesses insensitive to changes in interest rates? One explanation would be that most businesses finance investment with retained profits and hence do not require loans. Another explanation might be that the expected return on investment (ROI) is higher than the interest rate.
If a certain business expects a ROI of 5% while the interest rate is 2%, it will make a 3% profit. Even if the interest rate is increased to 3%, this investment is still attractive. Only a substantial increase of interest rates would affect investments.
So both the supply and demand for credit is not directly influenced by interest rates. In particularly the tinkering with small changes as is done by both the FED as the ECB have little impact on the real economy and are mostly intended for the financial markets.
For a more detailed discussion of the Sharpe and Suarez study, see here.
In the previous chapter the authors discussed how commercial banks are able to create the money supply. In this chapter they discuss how central banks seek to control the amount of money created by the financial sector.
Above we discussed the assets and liabilities of a bank. In order to continue we need to introduce another accounting term: capital. Capital is defined as: assets – liability = capital.
The difference between liabilities and capital (also equity) of bank is that deposits can be withdrawn at will by the depositors, whereas shareholders cannot do the same.
Central banks can require that banks maintain a certain level of capital. The rationale behind this capital requirement is that capital works as an absorber. If a bank’s capital is 100 million, it could take a total default of 100 million on loans, before deposit holders are hit.
In theory capital requirements should also restrain banks to create money. As we have seen if a bank extend credit, it also increases its liabilities and hence the capital/liability ratio is decreased.
The authors, however, argue this capital requirements do not limit credit creation. One reason is that more loans also mean more interest the bank can collect and hence the bank’s capital is increased. Also banks can issue more shares to increase capital.
Another method used by central banks to regulate the credit creation by banks are liquidity requirements, i.e. the amount of cash and central bank reserves held by banks. The idea here is that if a bank has to maintain a, say, 5 percent of its liabilities in central bank reserves, it will be restrained in its ability to create credit.
However, many countries such as the UK or Sweden do not have such liquidity requirements and even in countries which do, such as the US, banks have found ways to get around those. securitization is the magical word here.
What is securitization? Suppose I lend John £10,000 which he will pay back with interest in a year. Now I have a £10,000 claim against John but I cannot spend it directly. However, I could sell my claim to a third party for cash.
When a bank provides a loan, it could exactly the same. By using their outstanding loans as security to a special type of bond, banks can sell of their illiquid assets and hence increase their liquidity.
So if neither capital nor liquidity requirement do restrain credit creation and interest rate policy has only a limited impact on the demand of credit what policy could work?
Instead of attempting to control the creation of credit indirectly, the authors propose direct controls or credit guidance. This means that the monetary authorities say how much credit a bank is allowed to provide to the public. And not only should the amount of credit be regulated, also what types of credit should be extended.
People borrow money for different purposes, to buy a house, to start a business and so on. Essentially there are three main types of loans: consumptive, productive and speculative loans. It matters what loans banks provide. Credit extended for speculative purposes will result in asset bubbles, while productive loans will result in economic growth.
In a deregulated financial sector, banks tend to provide credit to those purposes which generates the most profit for the banks. However, this is not necessarily also what is in the best interest of society as a whole. The authors show that banks prefer to extend credit to speculators but are reluctant to lend to small and medium-sized business.
Credit guidance as a tool of monetary policy is not without precedent. It has been applied in Germany and the USA in the early twentieth century and from 1940 on by Japan, South Korea and Taiwan. The authors argue that this policy of credit controls had been a key factor in the economic success of these East Asian countries.
In these countries banks were effectively prohibited to lend to speculators and stimulated to provide credit to businesses.
An additional benefit of credit guidance is the loans for productive loans are less inflationary than consumptive or speculative loans. This because the increase of the money supply is offset by an increase of the quantity of goods and services.
Next week the third and last installment of this review, covering chapters 6 and 7.
Ryan-Collins, Josh, Tony Greenham, Richard Werner and Andrew Jackson, Where does Money come from? A guide to the UK banking system, New Economics Foundation, London 2015.