Deutsche Bundesbank exposes the lies of mainstream monetary theory

On one side of the Atlantic, it seems that central bankers understand the way the monetary system operates, while on the other side, central bankers are either not cognisant of how the system really works or choose to publish fake knowledge as a means to leverage political and/or ideological advantage. Yesterday, the Deutsche Bundesbank released their Monthly Report April 2017, which carried an article – Die Rolle von Banken, Nichtbanken und Zentralbank im Geldschöpfungsprozess (The Role of Banks, Non-banks and the central bank in the money-creation process). The article is only in German and provides an excellent overview of the way the system operates. We can compare that to coverage of the same topic by American central bankers, which choose to perpetuate the myths that students are taught in mainstream macroeconomic and monetary textbooks. Today’s blog will also help people who are struggling with the Modern Monetary Theory (MMT) claim that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency and the fact that private bank’s create money through loans. There is no contradiction. Remember that MMT prefers to concentrate on net financial assets in the currency of issue rather than ‘money’ because that focus allows the intrinsic nature of the currency monopoly to be understood.

A succinct summary of the full article in the Deutsche Bundesbank’s Monthly Review can be found here (again in German) – How money is generated (published April 25, 2017).

The full article begins by noting that during the GFC, the ECB and its national central bank partners (in the Eurosystem) ran a very expansionary monetary policy which “caused a sharp increase in the central bank assets of the (commercial) banks in the euro area”.

These assets are what we call bank reserves.

Please note the quotes begin and end where I have translated the German. For brevity, I will typically not include the original German text.

But, “the annual growth rate of the money supply M3” (that is, broad money) has “nevertheless remained at a moderate level over the last two years, which has rekindled the interest in the links between the creation of central bank deposits and the growth of broader money supply”.

In most university courses on banking, money and macroeconomics, students are taught what I call fake knowledge (aka lies).

I have covered that discussion in these blogs – Money multiplier and other myths and The Weekend Quiz – April 15-16, 2017 – answers and discussion (Answer to Question 1) and Money multiplier – missing feared dead.

By way of summary:

1. The mainstream textbooks claim that the money multiplier transmits changes in the so-called monetary base (the sum of bank reserves and currency at issue) into changes in the money supply (M).

2. By controlling the monetary base, the central bank then is alleged to control the broader money supply, via the money multiplier, which is a formula that depends on various monetary parameters (required reserves, cash-to-deposit ratio etc).

3. The ‘money creation’ causality is alleged to be as follows: Say $100 is deposited in a bank (which is constructed as a financial intermediary seeking deposits in order to loan them out), which is required by the central bank to hold 10 per cent in reserves. The bank loans out $90 which is then deposited elsewhere and that deposit receiving bank then loans out 90 per cent of that ($81) and so on.

4. The “important job” of the central bank (according to Mankiw’s textbook) “is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

5. Mankiw claims the central bank maintains that control by conducting “open market operations – the purchase and sale of … government bonds” and can deprive banks of deposits (reducing bank reserves) by selling bonds, which reduces the money supply and vice versa.

6. The mainstream also believe that an increase in bank reserves is immediately translated into a multiplied into a larger increase in the broad money supply because banks have more ‘money’ to loan out.

7. It follows that the central bank is responsible for causing inflation because the mainstream allege that inflation is the result of excessive growth in the money supply.

All of which is fake knowledge.

The Bundesbank clearly understand the false nature of the mainstream story as has the Bank of England and some divisions of the Federal Reserve Bank in the US.

For example, please read:

1. The New York Federal Reserve Bank’s 2008 paper – Divorcing Money from Monetary Policy.

2. The Bank of England’s 2015 working paper – Banks are not intermediaries of loanable funds – and why this matters.

The Bundesbank article seeks to address the links (if any) between bank reserves and broad money and also analysis the claims that banks (credit institutions) should cover 100 per cent of their deposits with reserves, a populist proposal of late.

The Bundesbank start by noting that commercial banks create most of the broad money supply via transactions with their customers.

They emphasise that when a credit worthy customer seeks a loan, the commercial bank approval creates, with the stroke of a pen (or computer key) a deposit (a credit to a bank account).

This is, of course, the familiar MMT statement: Loans create deposits.

Why that is important to understand (getting the causality right) is that it negates the mainstream view of the bank as an intermediary who waits for customers to make deposits before it loans them out again.

The Bundesbank establishes two important principles at the outset.

First:

Das widerlegt einen weitverbreiteten Irrtum, wonach die Bank im Augenblick der Kreditvergabe nur als Intermediär auftritt, also Kredite lediglich mit Mitteln vergeben kann, die sie zuvor als Einlage von anderen Kunden erhalten hat

Which means that the central bankers clearly understand that the commercial banks are not intermediaries in the way depicted in the mainstream monetary theory.

Second:

Ebenso sind vorhandene überschüssige Zentralbankguthaben keine notwendige Voraussetzung für die Kreditvergabe (und die Geldschöpfung) einer Bank.

That existing reserves (excess or otherwise) are not a prerequisite for lending (and money creation) by the commercial banks.

That position was also supported by the Bank of England in the paper cited above. They said:

The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist.

They said:

… in the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.

The BoE paper correctly noted that:

… banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But the most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency.

Please read my blog – Lending is capital – not reserve-constrained – for more discussion on this point.

Banks lend if they can make a margin given risk considerations. That is the real world. If they are not lending it doesn’t mean they do not have ‘enough money’ (deposits). It means that there are not enough credit-worthy customers lining up for loans.

Banks lend by creating deposits and then adjust their reserve positions later to deal with their responsibilities within the payments system, knowing always that the central bank will supply reserves to them collectively in the event of a system-wide shortage.

The Bundesbank notes that the money-creating capacity of the commercial banks is finite (“Unendlich sind die Geldschöpfungsmöglichkeiten der Geschäftsbanken allerdings nicht.”)

Why? Because there are regulutions (capital adequacy) and “not least by the profit maximisation calculus of the bank’s themselves … a bank needs to finance the created loans despite its ability to create money, since it require central bank reserves to settle transactions drawn on the deposits they create”.

How it finances the loans depends on relative costs of the different available sources. As costs rise, the capacity to make loans declines.

The banks’ capacity to create money is also “is limited by the behavior of companies and households, in particular by their credit demand and investment decisions” (“Die Geldschöpfungsmöglichkeiten des Bankensystems werden zudem durch das Verhalten von Unternehmen und Haushalten begrenzt, insbesondere durch ihre Kreditnachfrage sowie ihre Anlageentscheidungen.”).

MMT adopts the endogenous money theory that is the hallmark of the Post Keynesian approach, and, stands in stark contradistinction to the mainstream monetary theory of exogenous money (that is, central bank control of the money supply).

The mainstream monetarist approach claims that the money supply will reflect the central bank injection of high-powered (base) money and the preferences of private agents to hold that money via the money multiplier. So the central bank is alleged to exploit this multiplier (based on private portfolio preferences for cash and the reserve ratio of banks) and manipulate its control over base money to control the money supply.

It has been demonstrated beyond doubt that there is no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”.

When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans.

The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

The Bank of England paper is categorical:

The deposit multiplier (DM) model of banking suggests that the availability of central bank high-powered money (reserves or cash) imposes another limit to rapid changes in the size of bank balance sheets. In the deposit multiplier model, the creation of additional broad monetary aggregates requires a prior injection of high-powered money, because private banks can only create such aggregates by repeated re-lending of the initial injection. This view is fundamentally mistaken. First, it ignores the fact that central bank reserves cannot be lent to non-banks (and that cash is never lent directly but only withdrawn against deposits that have first been created through lending). Second, and more importantly, it does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate, in order to safeguard financial stability. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.

The Bundesbank article makes it clear that bank lending is not reserve-constrained.

Geldschöpfung erfolgt zunächst unabhängig von bestehenden Zentralbank-guthaben der Banken … Geldschöpfung zeigt im Besonderen, dass die Kreditvergabe grundsätzlich ohne vorherige Zu üsse von Kundeneinlagen statt finden kann.

Or, “Money is first created independent of the banks’ existing bank balances …” at the central bank and that bank “lending can always take place without prior inflow of customer deposits.”

The Bundesbank says that this insight:

Dies widerlegt einen weitverbreiteten Irrtum, wonach die Bank im Augenblick der Kreditvergabe nur als Intermediär auftritt, also Kredite lediglich mit Mitteln vergeben kann, die sie zuvor als Einlage von anderen Kunden erhalten hat.

Or, this insight “rejects the widespread error” that sees the bank as a intermediary allocating loans with funds “previously received as deposits from other customers”.

So the idea that building up central bank balances (reserves) will enable commercial banks to expand loans is dismissed as lies as is the idea that the bank relies on deposits to make loans – two central propositions of mainstream monetary theory that MMT has exposed in the past.

This also bears on the arguments early in the crisis that Quantitative Easing would help to expand loans because it would expand bank reserves.

It also rejects the mainstream claim that bank reserves are loaned out.

Banks do not lend out reserves and a particular bank’s ability to expand its balance sheet by lending is not constrained by the quantity of reserves it holds or any fractional reserve requirements that might be imposed by the central bank.

Loans create deposits, which are then backed by reserves after the fact.

Building up reserves at the central bank does nothing to enhance the capacity of the commercial banks to make loans, which is why there is no direct link between the central bank balance sheet and the broad money supply measures.

Compare that to the narrative provided by the Federal Reserve Bank of Minneapolis in its December 2015 issue of The Region, an in-house publication – Should We Worry About Excess Reserves (December 17, 2015).

I analysed that article in this blog, a few days after it was published – Central bank propaganda from Minneapolis.

I concluded that the article suggested that the author hasn’t really been able to see beyond his intermediate macroeconomics textbook and understand what is really been going on over the last several years.

It was all about how the excess reserves in the US banking system were a time bomb because the banks now had a massive extra capacity to make loans and this “greater liquidity is associated with higher prices”.

The standard Monetarist lies.

The banks do not loan out reserves to retail customers. They shuffle them between themselves to cover daily shortfalls in liquidity in order to ensure all the transactions are settled (cheques do not bounce) but that is it.

The Bank of England also highlighted the:

… related misconception … that banks can lend out their reserves … Reserves can only be lent between banks … consumers do not have access … [to central bank reserve accounts].

This insight is also confirmed in an interesting article published in September 2008 by the Federal Reserve Bank of New York in their Economic Policy Review entitled – Divorcing money from monetary policy.

We learn that commercial banks require bank reserves for two main reasons. First, from time to time, central banks will impose reserve requirements, which means that the bank has to hold a certain non-zero volume of reserves at the central bank. Most nations only require the banks to keep their reserves in the black on a daily basis.

Second, the FRNBY states that “reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions”.

There is daily uncertainty among banks surrounding the payments flows in and out as cheques are presented and other transactions between banks are accounted for.

The banks can get funds from the other banks in the interbank market to cover any shortfalls, but also will choose to hold some extra reserves just in case. If all else fails the central bank maintains a role as lender of last resort, which means they will lend reserves on demand from the commercial banks to facilitate the payments system.

The Bank of England also concludes that the existence of new reserves, even if they are well in excess of the banks’ requirements to operate an orderly clearing system, “do not, by themselves … change the incentives for the banks to create new broad money by lending”.

The question then is, why are students in our universities forced to learn material that has no foundation in the system they are purporting to understand? The answer is that the educational opportunity is replaced by a propaganda exercise to suit ideological agendas.

The other question is, why does a branch of the Federal Reserve Bank in America allow an author to publish such misrepresentations of the way the banking system operates?

Finally, what about 100 per cent reserve regulations?

I have written about this in this blog – 100-percent reserve banking and state banks.

The Bundesbank paper notes the tension in the public debate where there are calls for a 100 per cent reserve system to be imposed as part of banking reform.

The claim is that by restricting the credit creation capacity of banks (the fractional reserve system noted above), the banks would be more stable and there would be less chance of crisis.

So if banks had to always have reserves equal to their loan book then stability would be enhanced.

But the Bundesbank is as on to that nonsense as MMT is.

It emphasises that banks make loans which create deposits in response to demands from credit worthy customers (borrowers).

So forcing banks to hold reserves equal to their loan book would have “little effect on the banks’ credit facilities”.

The provision of bank reserves is not really a choice factor for the central bank unless it desires to run a zero interest rate policy or is willing to pay interest on excess reserves.

So if the banks are making loans which then have to be backed by reserves, the central bank has to ensure there is sufficient liquidity in the system to accompany that level of banking activity or else lose control of its short-term policy interest rate.

Please read the following introductory suite of blogs – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3 – for more discussion on that.

The Bundesbank note that the only way to restrict credit creation is for:

In einem System der vollständigen Deckung von Sichteinlagen durch Zentralbankgeld müssen vielmehr zusätzlich die institutionellen Voraussetzungen oder bestehende Regulierungsvorschriften so geändert werden, dass eine Geldschöpfung durch Geschäftsbanken de facto nicht mehr möglich ist.

Or, “the institutional requirements or existing regulatory regulations must be modified in such a way that it is no longer possible to create money by commercial banks.”

Which would represent a major break on economic activity and largely undesirable consequences.

There is a case (which we outline in our upcoming book) for the nationalisation of banks. But to only allow banks to loan out deposits it has already gleaned is highly restrictive and would certainly limit economic activity.

Conclusion

The Bundesbank article is worth reading (if you handle German okay). I have summarised its main message which is becoming a common narrative from the more enlightened central banks.

Unfortunately, there are still nonsensical claims coming out of some divisions of the central bank in the US but they are becoming a minority.

But, still the classrooms continue to make these nonsensical misrepresentatinos of the way the banking system operates, which only serve to condition students attitudes in favour of poor and irresponsible macroeconomic policies, of the sort that have led to and prolonged the crisis.

The academy is slow to change unfortunately.

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.

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    36 Responses to Deutsche Bundesbank exposes the lies of mainstream monetary theory

    1. James Schipper says:

      Dear Bill

      It seems then that the Bundesbank has a correct understanding of the money creation process. If they also have a correct understanding of international trade, then they could perhaps enlighten Merkel and Schäuble about the follies and dangers of Germany’s mercantilistic policy.

      Regards. James

    2. Ralph Musgrave says:

      Very good article above by Bill. I actually spotted that Bundesbank article a day or two ago, and thought of asking them to produce an English translation. I’ll definitely do that now.

      Just a couple of reservations. First, I suggest Bill’s criticism of the “Manciw view” (paras numbered 1-7 near the start) is debatable. Obviously there are circumstances in which reserves are not a constraint on bank lending, e.g. at the moment there is an all time record volume of reserves sloshing around, so reserves clearly do not constrain bank lending at the moment. On the other hand where a minimum reserve requirement is enforced, which it is in some countries, then it strikes me that lack of reserves clearly CAN CONSTRAIN bank lending. And even where there is no imposed reserve requirement, banks still need a minimum amount of reserves with which to settle up with each other. So there is some sort of constraint there as well.

      Second, I’m not impressed by the Bundesbank’s criticism of 100% reserve banking, at least as set out by Bill. The B-bank seems to think that banks under 100% reserve would be able to simply drive a coach and horses thru the basic rules of full reserve.

      The answer to that is that 100% reserve is a system that is or has in the past been supported by at least four economics Nobel laureate economists, plus several other leading economists. Amazing as it might seem, those people have given a little thought to how well 100% reserves can be enforced. And their conclusion is that enforcing it is not too difficult.

      One way is ensure that all loans are funded by equity rather than deposits. For an auditor, it’s not very difficult to examine the liability side of a lending entity’s balance sheet, and see if there is anything resembling a deposit there. Doing that is a thousand times simpler than enforcing the Dodd-Frank rules which run to a good ten thousand pages.

      Indeed, the latter “deposit/equity” rule has recently been imposed on money market mutual funds in the US. I have seen that criticised, but not on the grounds that that rule is easy to evade.

    3. Markg says:

      I fully understand how the monetary system works but I do get confused on this point:

      “a sovereign government is never revenue constrained because it is the monopoly issuer of the currency and the fact that private bank’s create money through loans.”

      Can you explain the difference between “issue currency” and “create money”?

    4. bill says:

      Dear Markg (at 2017/04/26 at 8:47 pm)

      Please read the following introductory suite of blogs:

      1. http://bilbo.economicoutlook.net/blog/?p=332 – Deficit spending 101 – Part 1

      2. http://bilbo.economicoutlook.net/blog/?p=352 – Deficit spending 101 – Part 2

      3. http://bilbo.economicoutlook.net/blog/?p=381 – Deficit spending 101 – Part 3

      And read them in the context of the difference between net financial asset impacts of government (treasury and central bank) transactions with the non-government sector and the net impacts of transactions within the non-government sector.

      Then you will see the difference. If you are still puzzled write in again.

      Summary:

      1. Banks can create ‘money’ but in doing so they create no new net financial assets – a loans create deposits – but these are offsetting assets and liabilities.

      2. Government spending (taxation) increase (decrease) net financial assets in the non-government sector to the penny. That is the unique capacity of a currency issuing government.

      best wishes
      bill

    5. Chris Herbert says:

      My confusion is that the ‘issuer of the currency’ can directly inject into the private economy, interest and debt free, substantial amounts of new currency albeit in digital form. How is this not influential on the money supply? I think I understand the basic influences presented by resources (or lack of same). But I definitely stumble when you maintain that a central bank has no control over the supply of money when it is the original source of same.

    6. Philip Kohlbacher says:

      Bundesbank: “Gleichwohl lässt sich hieraus nicht schlussfolgern, die Kreditvergabe der Banken sei gänzlich „immun“ gegenüber der Höhe des Reservesatzes, selbst wenn die Reserve verzinst wird. Denn in dem Maße wie eine verstärkte Refinanzierung über die Notenbank infolge einer Anhebung des Reservesatzes erforderlich wird, müssen Banken für sich genommen mehr notenbankfähige Sicherheiten für die nachgefragte Menge an Reserven hinterlegen.”

      Am I right that the available collateral is a binding constraint for the banking system? If so, what determines the amount of available collateral?

    7. Sean G says:

      Is the idea for 100% reserve backing of bank deposits fundamentally different than an MMT proposal to eliminate the interbank market, and just have the Central Bank provide unlimited liquidity on-demand? Perhaps the bank’s wouldn’t need to actually “hold” the reserves on their balance sheets, but if the Central Bank had an explicit policy to provide unlimited liquidity to a bank maybe the ultimate effect would look similar. The only difference is whether the reserves are held on-balance sheet or off-balance sheet. My understanding of this proposal is that if a bank is meeting its capital requirements, after adjusting for any asset quality issues, there is no reason to allow a failure due to illiquidity driven by an external shock or some kind of negative perception.

    8. Roberto says:

      @Chris Herbert,

      I think Bill is talking here only about monetary policy and about the central bank relationship with the commercial banks.

      My understanding is that the new reserves created by central banks in the banking system is the reaction to the expansion of money in the economy (that is caused by credits rated profitable by commercial banks), not the origin of it, as it’s normally assumed. So, Central Banks are not the cause of the growth of money even if they are essential to the system.

      In the case of government direct expending (fiscal policy instead of monetary policy) there is, of course, an increasing in the supply of money that, if unchecked and if it goes beyond the available real resources, could generate more inflation that desired.

    9. Roberto says:

      @Sean G

      I have heard about eliminate the need of government to emit bonds in order to finance itself, but this is the first time I heard about “MMT proposal to eliminate the interbank market”.
      Do you have any link I can read?

      Thanks.

    10. Mel says:

      Re central bank not controlling money supply..
      The way I understand it so far, most of the money that circulates has been created by commercial bank lending (“when a credit worthy customer seeks a loan, the commercial bank approval creates, with the stroke of a pen (or computer key) a deposit (a credit to a bank account).”) The amount of circulating money has already been determined by the commercial banks’ optimism that their borrowers will be able to pay them bank.
      If a central bank took on the Treasury’s role and spent money on government projects, then it would be injecting circulating money into the economy. But typically a CB doesn’t do that. Typically a CB writes balances in to the reserve accounts that commercial banks hold, and the chief effect of that is on interbank clearing (“a bank needs to finance the created loans despite its ability to create money, since it require central bank reserves to settle transactions drawn on the deposits they create”.”)
      As much as I think I’ve figured out up to now.

    11. Sean G says:

      @Roberto

      Not sure how to respond directly on this blog.

      Here is a link to the proposals I am referencing. I am not sure if these are as much “MMT proposals” as they are proposals of just this one person. The first proposal under “Federal Reserve” covers Fed lending and the interbank market.

      http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

    12. Benedict says:

      My comment was just tossed as spam because “Benedict@Large” was in the name field. I have been using that name here for 6 years without ever having a problem. What’s up?

    13. Ralph Musgrave says:

      Sean G,

      Your suspicion that there are similarities between 100% reserves and MMT are correct. That is, MMTers tend to talk as if the only important form of money is central bank issued money (base money), though of course MMTers are well aware of the existence of private bank issued money. In contrast, advocates of 100% reserves have got further with spelling out exactly how a “base money only” system would work. Basically it works by splitting the bank industry in two. One half lends, but is funded by equity (or something similar), not by deposits. The other half accepts deposits, but does not lend them out – except perhaps to an ultra safe borrower like government.

      If you’re interested, here are some of the advocates of 100% reserves.

      1. Milton Friedman. See his book “A Program for Monetary Stability”, Ch3, starting at the heading “How 100% reserves would work”.
      2. James Tobin. See under heading “deposited currency” at:
      https://www.kansascityfed.org/publicat/sympos/%201987/S87tobin.pdf
      3. See also this Bloomberg article:
      https://www.bloomberg.com/view/articles/2013-03-27/the-best-way-to-save-banking-is-to-kill-it

    14. Stuart Davies says:

      That is an excellent analysis, Bill, even if it is a bit redundant and eye glazing at times. Here is a segment that I see as being particularly worthy of zeroing in on:

      “Banks lend if they can make a margin given risk considerations. That is the real world. If they are not lending it doesn’t mean they do not have ‘enough money’ (deposits). It means that there are not enough credit-worthy customers lining up for loans.

      Banks lend by creating deposits and then adjust their reserve positions later to deal with their responsibilities within the payments system, knowing always that the central bank will supply reserves to them collectively in the event of a system-wide shortage.

      The Bundesbank notes that the money-creating capacity of the commercial banks is finite (“Unendlich sind die Geldschöpfungsmöglichkeiten der Geschäftsbanken allerdings nicht.”)

      Why? Because there are regulations (capital adequacy) and “not least by the profit maximisation calculus of the bank’s themselves …”

      How it finances the loans depends on relative costs of the different available sources. As costs rise, the capacity to make loans declines.

      The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.”

      All of the above is, ah, right on the money. At least, it accurately describes key aspects of monetary reality in a privately owned, debt based monetary system.

      One way of rephrasing a point made elsewhere in your article is to say that injections of central bank funds into the banking system have little or nothing to do with the circulating money supply available to the general economy.

      I’m glad to see that you are planning to address the question of a public banking system, because I think it offers the only solution to one of the crucial flaws (for everyone but the large bank owners!) in the existing privately owned debt based monetary system, aka fractional reserve banking. What I am referring to is the built in cyclical “boom and bust” phenomenon that is effectively both a cause and an effect behind fluctuations in a demand driven monetary supply derived from private bank lending. These boom and bust positive/negative feedback loops are a key defining characteristic of a privately owned banking system. This is something you touch on only tangentially in your article when you say “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks.”

      A fairly obvious point about the above mentioned boom and bust cycle rarely seems to get mentioned in these abstruse discussions – contrary to the commonly held view that loan defaults are problematic for banks, in fact they are precisely what makes this long running fractional reserve scam so dependably profitable. The interest they collect on loans created from thin air is icing on the cake, but the physical assets they take ownership of when loans default are the real point of their game. This may appear nonsensical if we suppose that the risk of insolvency of individual banks is a deciding factor, but in reality that risk applies only to a relative handful of individual private investors, and has no effect whatsoever on the incentives for a privately owned banking system as a whole. That larger system not only relies upon the boom/bust/physical asset grab cycle, it deliberately encourages it, so why don’t we get that important truth right out in the open for once?

      The fact is that this up and down fluctuation in the money supply available to the common person – which is tied the boom/bust “business” cycle built into the existing banking system – is not our only alternative. At least in theory, we do have a public option. Here is an eye opening account of a largely forgotten period of history which gives us a compelling example of what a sovereign currency system with a stable money supply looks like (don’t be put off by the bad grammar in the title, this wasn’t Franklin’s doing!) : https://www.peakprosperity.com/forum/hidden-history-according-benjamin-franklin-real-reason-revolutionary-war-has-been-hid-you/4358

    15. Gregory Long says:

      “But to only allow banks to loan out deposits it has already gleaned is highly restrictive and would certainly limit economic activity.”

      Wouldn’t it be possible to increase deficit spending by the federal government to counter any limit on economic activity? In other words, you would move to a system where all money creation would come from deficit spending by the federal government and none would come from bank loans.

    16. It seems to me that this is a Bundesbank torpedo on the floating line of the ECB’s asset purchases. The expansion of the balance sheet of the ECB only makes sense in the context of the inflation target if one believes in both the bank multiplier and the quantity theory of money.

    17. bill says:

      Dear Benedict@Large (at 2107/04/27 at 1:34 am)

      Sorry for the inconvenience. I installed a new spam filter because I was getting bombarded with spam at an increasing rate. It will at times generate false positive rejections.

      It seems that Benedict works so stick to that.

      best wishes
      bill

    18. William Allen says:

      Great article, Bill. Thank you.
      I think the “Loans create deposits” headline might be easier for many to understand if we reverted to the language used in 1950s and 1960s era money and banking books that seemed to get it right (eg John Ranlett, “Money and Banking: An Introduction to Analysis and Policy,” Wiley, 1965). These books, before the corruption by monetarist economists, distinguished between “Derived Deposits” and “Primary Deposits”. Thus, loans create derived deposits, which are then drawn (or spent) into primary deposits. Banks do not wait for receipt of primary deposits before they are willing to make loans to credit worthy companies.

      Of course today we should also add that depending upon the nature of the primary deposit (demand/current account versus time, transactional versus non transactional, stable versus non-stable), this new liability might (or might not) attract reserve requirements and/or additional high quality liquid assets (HQLAs required from the Liquidity Coverage Ratio requirements from Basel III). And of course the asset and liability creation must be within the constraints of both the new Basel III leverage ratio and capital to risk weighted assets ratio. Therefore, the creation of deposits sets in motion a complex and interactive asset-liability-capital management process for each bank.

    19. Dave says:

      Hi Bill,
      I love your work. ‘m only new to this but I think I’m starting to wrap my head around MMT. I frequent Prepper forums and you work has helped me to explain to them how the system really works. There are two things which I would like more info on. How does the US dollar being the world reserve currency effect the US. 2nd China is talking about taking the economy back to the Gold Standard. Preppers see this as a reason for the US economy to collapse. If I understand MMT correctly the US can continue to create money irregardless of whether China and its allies go back to the Gold Standard.

    20. Postkey says:

      “Banks lend if they can make a margin given risk considerations. That is the real world. If they are not lending it doesn’t mean they do not have ‘enough money’ (deposits). It means that there are not enough credit-worthy customers lining up for loans.”

      The money supply is exogenous?

    21. MRW says:

      Postkey,

      “It means that there are not enough credit-worthy customers lining up for loans.”

      “…not enough credit-worthy customers…” is the endogenous factor, for lack of a better expression. Makes it endogenous. Banks have no control over a customer’s (business, household, state or local govts) desire for a loan.

    22. MRW says:

      Roberto,

      “In the case of government direct expending (fiscal policy instead of monetary policy) there is, of course, an increasing in the supply of money that, if unchecked and if it goes beyond the available real resources, could generate more inflation that desired.”

      NO WAY. Not the way it works.

      When the US Treasury spends into the economy based on congressional appropriations (which means enacting fiscal policy), the dough goes into the vendors bank accounts across the country via the Federal Reserve handling the transactions. Dont forget the US Treasury still fulfills relevant congressional appropriations from decades ago, like Social Security administration and payments, and the like. (Social Security payments are mandated by law, and come directly from the US Treasury via their General Account at the Fed; they have nothing to do with the imaginary trust fund, which is nothing more than the various insurance programs: disability, unemployment, old-age, see the full list here: https://www.ssa.gov/policy/docs/progdesc/sspus/.

      So, the US Treasury spends, let’s say $50 billion. The ‘money supply’, the new money now sloshing around in the real economy, increases by $50 billion.

      And the US Treasury’s General Account (TGA) is $0. That is the big no-no.

      Because of a law dating from the gold standard days, which Congress never got rid of, the US Treasury is not allowed to have a zero balance or overdraft at the TGA.

      So, again from the gold standard days, the US Treasury issues treasury securities (bills, notes, and bonds) automatically *in the exact same amount*—in our case $50 billion—of the original congressional appropriations. That was how they protected the gold supply in those days. You couldn’t cash in the treasury security *for gold* no matter who you traded with or sold it to until the treasury security matured, anywhere from 1 to 30 years.

      No such restriction today. The US Treasury spends or buys stuff, then creates treasury securities in the same amount as the spending two to four weeks after the Fed sent the government’s dough out to each approved vendor, draining the US Treasury’s General Account. Then the US Treasury sells these treasury securities at public auction. The Federal Reserve is not allowed to buy them from the US Treasury auction; that would drain USD from the real economy, not add to it.

      This restores the money supply to balance—because they are sold at public auction, everyone around the world wants them because they are the safest short and long-term no-risk financial instrument in the world, usually sell in a nanosecond, and pay interest started in the gold-standard WWI days when the US Treasury had to protect against public hoarding of gold the US needed to pay for troops overseas, so they offered interest because gold didn’t pay any. They generated the desire by calling their initial issue, Liberty Bonds, and said by buying them the public would help pay for war, patriotism the pitch.

      All this occurs today at the level of the US Treasury’s statutory fiscal duties.

      Under no stretch of the imagination do these required US Treasury transactions enter into the alternate universe of the domestic private sector where inflation occurs and real resources exist.

      (The modern differences of treasury securities is that today they are highly liquid, generate $750 billion (!!) in trade daily on the open market, and are handled by people called Primary Dealers. Even the Federal Reserve has to buy and sell through Primary Dealers, with the buyer and seller being opaque to each other.)

    23. Sean G says:

      Ralph,

      Thanks for the links. Interesting thought process. I am curious what the offsetting balance sheet entry to the loans would be in the “lending banks”. Would their loans result in new deposits in the “deposit taking banks” , or would this be something more like a fixed reserves system where the “lending bank’s” compete for deposits (asset side deposits) from equity investors?

    24. MRW says:

      ” Would their loans result in new deposits in the “deposit taking banks” , or would this be something more like a fixed reserves system where the “lending bank’s” compete for deposits (asset side deposits) from equity investors?”

      The loan would result in a deposit at the bank issuing the loan.

      And the required reserves for the deposit remain in their bank checking account (reserves acct) at the Fed.

      If the borrower decides to move the deposit to another bank (buying a house, for example), the reserves travel with the deposit to bank B. And if bank A doesn’t have enough reserves in its account when the borrower makes the transfer, the bank borrows reserves from other banks, or in a worse case scenario, the Federal Reserve’s Discount Window which charges a penalty.

    25. Jake says:

      This is key though” … a bank needs to finance the created loans despite its ability to create money, since it require central bank reserves to settle transactions drawn on the deposits they create”

      “How it finances the loans depends on relative costs of the different available sources. As costs rise, the capacity to make loans declines.”

      Looking at:
      “The banks told him that, if the Government did not guarantee their foreign debts, they would not be able to roll over the debt as it became due. Some was due immediately, so they would have to begin withdrawing credit from Australian borrowers. They would be insolvent sooner rather than later …”(Big business wants government to cut funding them immediately (if only)march 22)

      “A firm is just as insolvent if it is not able to meet its financial obligations as they fall due because it cannot roll over debt, as it is if the value of the assets in its balance sheet is deeply impaired”

      -I don’t think the supply of credit is all that dynamic, banks create loans and then have to finance them via
      domestic or foreign deposits. These deposits debits the banks’ reserve account, on its asset side, and credits a deposit, held on the liability side. Any reserve outflow is settled by this funding base of domestic and foreign deposits.By my reasoning this is intermediation.

      -“If they are not lending it doesn’t mean they do not have ‘enough money’ (deposits)”-Garnaut book(the great crash of 2008 points out that the banks would “so they would have to begin withdrawing credit from Australian borrowers” if they couldn’t roll over their foreign wholesale liabilities.Surely this is a shortage of deposits.

      Surely a bank flush with deposits is better capable to expand lending then if it held either worthless private financial assets or had liabilities it can’t roll over.It could create loans to the general public and meet interbank withdrawl demands to settle payments with other banks.

      also
      “5. Mankiw claims the central bank maintains that control by conducting “open market operations – the purchase and sale of … government bonds” and can deprive banks of deposits (reducing bank reserves) by selling bonds, which reduces the money supply and vice versa.”
      -also pretty sure this blog maintains prior to IOR this was standard interest rate control mechanism,govt debt issued to absorb reserves to set interbank interest rates.(which won’t relate too the cost of foreign wholesale funds)

    26. Jake says:

      >These deposits debits the banks’ reserve account, on its asset side with a reserve*, and credits a deposit, held on the liability side.

    27. Some Guy says:

      MRW – I think you are misinterpreting Roberto, he was basically correct, but speaking loosely perhaps. The Treasury’s fiscal policy is the primary and obvious and direct way of increasing “the (base) money supply” broadly considered – including government bonds, NFA – and of course it does have the potential to cause inflation. Yes, the Treasury’s bond sales exchanging bonds for the central bank’s reserves do not really enter the alternate universe of the private domestic sector, and don’t really change the NFA-“money supply”, but the actual spending certainly does.

    28. Postkey says:

      “Banks have no control over a customer’s (business, household, state or local govts) desire for a loan.”

      Of course not. They do, however, decide who is to be given a loan.

    29. Jake says:

      “It has been demonstrated beyond doubt that there is no unique relationship of the sort characterised by the erroneous money multiplier model in mainstream economics textbooks between bank reserves and the “stock of money”. Where has this been demonstrated? Has the bundesbank provided any proof?

    30. Steve says:

      Bill says” 2. Government spending (taxation) increase (decrease) net financial assets in the non-government sector to the penny. That is the unique capacity of a currency issuing government.”

      As MRW points out though, the Treasury has to sell bonds or collect taxes to offset this exact amount. So where is the creation of assets? All of the money spent by the government is equaled by private money (either in taxes or in exchange for bonds).

      And isn’t quantitative easing really the same as a bank creating money by lending? The corresponding liability (bond) is still held for later redemption.

    31. Kingsley Lewis says:

      It is very strange that Prof. Mitchell allies himself with Deutsche Bundesbank regarding 100% reserve banking. According to the annex to their paper, their conclusions stem from:
      “model-theoretic investigations. This was done within the framework of a dynamic general equilibrium model.”
      .
      No details are given or referenced, but DSGE modelling is very unlikely to be consistent with MMT.
      Moreover, it is unlikely that their model properly incorporates either current fractional reserve banking or the Chicago Plan/Fisher proposals.

    32. bill says:

      Dear Steve (at 2017/04/29 at 7:23 am)

      The bond sale is just a swap of financial assets already held by the non-government sector – so there is no change in the net asset position of the non-government sector arising from that part of the arrangement.

      But the government spending side of the arrangement is a new injection of financial assets, that were previously not within the non-government sector.

      best wishes
      bill

    33. Yes, bank loans create bank deposits, but note that those deposits ‘belong to’ the depositor, and the bank has to compete with other banks to keep those deposits. Hence, what’s call the ‘cost of funds’. This cost of funds per se does not restrict lending, but it does influence the rates banks attempt to charge for loans as they attempt to profit from a positive interest spread. ‘Attempt’ in that banks compete with each other when making loans as well.

      Also, while in the very short term equity capital is a constraint on lending, longer term capital can pretty much always be had at a price. So in that sense capital, too, is endogenous, and the cost of capital influences the spread banks attempt to work for when lending.

      Last, regarding the role of bank lending, it goes back to ‘Underconsumption Theory’ (1589?) where, by identity, for every agent that spent less than its income another must have spent more than its income or the output would not have been sold. That is, unemployment is always an unspent income story, with deficit spending- public or private- filling the ‘spending gap’ created by unspent income (saving).

    34. Steve says:

      Hi, Bill.

      I guess I don’t understand: “The bond sale is just a swap of financial assets already held by the non-government sector – so there is no change in the net asset position of the non-government sector arising from that part of the arrangement.”

      During the initial bond sale, does not money come from non-governmental sources to the Treasury, where it is used to offset spending? Therefore, is not all US government spending sourced with money from non-governmental sources (from taxes or bond sales)?

    35. Ralph Musgrave says:

      It’s true, as Warren Mosler points out, that banks compete for deposits. But I think it’s misleading to conclude, as Warren seems to, that we therefore have a genuinely free and competitive market here. Reason is that the latter point ignores how the private bank system as a whole obtains those deposits in the first place: it didn’t need to compete with non-bank entities to obtain those deposits. It just printed them! I.e. if you can hire out money which you’ve produced on your own printing press, well that’s better than having to pay interest to someone to obtain that money.

      To illustrate, the bank system is a bit like a scenario where car hire firms in the US obtained their cars by going across the border to Canada and stealing cars. Having obtained the cars, US car hire firms would compete among themselves, but the initial method of obtaining the cars would not be legitimate.

      [Bill notes: I edited out a link to a paper that I do not wish to promote here]

    36. /Lars says:

      Just to inform, the ”here (again in German) – How money is generated (published April 25, 2017)” is available in English. At the right side on the top bar there is links to “FR” and “EN”. The same for the main Bundesbank report “Monthly Report April 2017”, then on the English version [or french] there is link to the article about money creation in the actual language.
      Bundesbank is a subsidiary of ECB and is probably not allowed to publish only in German. Hopefully they will continue publish in English even when it no longer is an official language in EU.

      It’s bit late but how does it work in an international perspective? In Sweden the private debt (household and non financial corp) have debuts of 235-240 % of GDP. Recently the CB (Riksbanken) wanted to raise it’s foreign reserver due to the risk involved in the 4 big Banks have loans in foreign currency to the tune of 175 % of GDP. An important part of bank lending is “ever” rising housing market.
      https://s26.postimg.org/hjr4mjfcp/swed_debt_61-14.png
      BIS data 1961 to 2014, debt/GDP. It have stayed roundabout the same 2015/16), down a few points on public and company debt.
      Could this mean that the banking sector is borrowing foreign currency to feed a housing bubble? While the gov. is as it self say is frugal and “saving” (it’s own fiat money) for the future?
      The number on public finances from the latest budget:
      https://s26.postimg.org/4n7a1p1mh/swed-spring-budget_2017_2.png

      https://s26.postimg.org/thqrvrmgp/swed-spring-budget_2017_3.png
      That is “strong” public finances. But is the gov. frugal on the back of Banks borrowing foreign currency? And in what way is Current Account surplus a factor in this?

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