Andrew Simms: it\’s the way he tells \’em

Umm:

This has been left almost entirely to the commercial banks, who create credit when making loans (it is one of the oldest myths in economics that banks merely lend out other people\’s savings).

Righty ho, banks create money then, magic it up out of thin air.

Second, and critically, the unreformed banking sector looks set to hit the edge of a funding cliff, according to Bank of England data analysed in the New Economics Foundation\’s (Nef) new report, \”Where Did Our Money Go?\”, published this week. Just to keep functioning, the main banks\’ monthly borrowing needs look set to more than double next year, rising to around £25bn a month.

And banks have funding needs, do they? They need to go and find the money that they can then lend out?

Quite how a man can put the two entirely contradictory points into the same article I\’m really not sure. If banks simply create what they lend out then they don\’t have funding needs: if they have funding needs then obviously they\’re not simply creating the money they use to make loans.

Simms reminds me of a boss I used to have. We were approached by a spiv who claimed to be able to make gold from lead. I thought it would be fun to play along and see how weird he got. My boss got quite taken in. I gave what I thought was the killer argument against \”investing\”: anyone who can make gold at will doesn\’t need investment money. Anyone who does need investment cannot create gold at will.

My boss just couldn\’t see it. Similarly Simms.

19 thoughts on “Andrew Simms: it\’s the way he tells \’em”

  1. Okay then: if banks do not create money, where does it come from? In particular, what do people mean when they talk about “the growth of the money supply”?

    Tim adds: The crucial distinction is: a bank does not create money while the banking system as a whole does indeed do so. Thus a bank requires deposits to lend out.

  2. Surely banks do create money, out of fractional reserve banking.

    They take the risk (with their shareholders’ funds) between the terms on which savers lend to them (typically no risk) and the terms on which borrowers borrow from them (typically some risk, often partially or totally covered by mortgage or debenture).

    When the interest rate spread gets too large, it is clear that the bankers are lending at a spread of risks that is also too large. Either that or there are not enough banks, usually through government licensed or supported monopoly, and the ones there are have got greedy (and hence careless).

    When those spreads get so large for all banks, the risk spreads outside the banks into the whole economy. When that happens, someone beyond the people and retail banks(ie government and/or central bank) has taken a risk beyond their own competence; this is in the terms under which retail banks and licensed to trade.

    International lemming-like behaviour is not really a justification; merely an excuse. I mean: do you run up a stupid level of debt just to keep up with those of your neighbours that do?

    Best regards

  3. Nigel: despite what others will tell you (inc. what Tim has written elsewhere), the UK operates a no reserve requirement system, like Canada–therefore reserves do not influence credit growth in the UK.

    Even in so-called FRB systems like the US, the money multiplier is not a good model for actual bank behaviour. FRBNY fedpoint:

    “Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.”

  4. Tim: care to flesh out your model? How do you go from individual banks borrowing to lend (no net new money) to the whole banking system extending net credit?

  5. Vimothy: ‘Okay then: if banks do not create money, where does it come from? In particular, what do people mean when they talk about “the growth of the money supply”?’

    The central bank creates the currency (M0). Banks take in (M0) as deposits and then lend them out. The deposits are counted as money (M4) and added to the cash in circulation (M0) to get the total money supply.

    What should be obvious from that is that the M4 element, which is a result of the bank’s operations, is not just conjured out of thin air, the bank finances its lending through borrowing.

    There’s nothing special about banks in that respect either; if you lend me £10 and I write you and IOU for £10, it increases the money supply in a functionally identical (but unmeasured) way.

  6. “There’s nothing special about banks in that respect either; if you lend me £10 and I write you and IOU for £10, it increases the money supply in a functionally identical (but unmeasured) way.”

    You are down £10 but up an IOU, and I am up £10 but down an IOU. When I repay you, this relationship will revert back to the situation that existed before you granted me a loan, i.e., you have £10 and I don’t. In the process we have created no new money, just moved around claims on the existing stock.

  7. vimothy: “You are down £10 but up an IOU, and I am up £10 but down an IOU.”

    And that’s exactly what happens between depositors and borrowers at banks, with the bank acting as a middleman.

    “When I repay you, this relationship will revert back to the situation that existed before you granted me a loan, i.e., you have £10 and I don’t.”

    As happens when borrowers repay a bank and depositors withdraw their money.

    “In the process we have created no new money, just moved around claims on the existing stock.”

    Which is exactly the process that occurs at banks, so if we aren’t creating money, then neither are they.

    “Base money is for final settlement between banks. It is not lent out to the non-bank sector.”

    If I have no money in my current account, but an agreed overdraft and I withdraw £100 from a cash machine, that is the bank very much lending me some M0, unless you’re implying that they print their own cash.

  8. Vault cash is a component of M0. Bank money trades at par for vault cash–because also it is also money. M0 is just vault cash + cash in circulation + reserve balances held at the BoE. Your bank can convert all of the bank money in your deposit account into cash, if you so wish. Though the magnitude of the effect would be small, in principle this represents a drain on total reserves for the banking system. But if the effect is large enough and since the banks can’t create this type of money by definition, the BoE simply lends them some more via repo, at whatever its target rate is. I.e., it doesn’t matter how much currency you want to hold. Personally, I think it’s a big pain in ass and I much prefer plastic, but then I’ve always been an old fashioned type.

    When you get a loan, you don’t an equal amount of M0. You don’t get any M0 at all. You get a deposit–M4. The bank can convert it into M0, but its ability to do so has nothing to do with the fact that it made you the loan.

    Banks use M0 for interbank final settlement at the central bank in its clearinghouse role.

  9. As happens when borrowers repay a bank and depositors withdraw their money.

    First problem with the banking system is that the depositors are given the delusion that they can withdraw their money at any time, before the borrowers have repaid the bank. The fact that we get away with it most of the time is not good enough.

    if you lend me £10 and I write you and IOU for £10

    By contrast, my local shop won’t take your IOU, so I have to wait until you have repaid my £10 before I can spend that money. My alternative is to sell your IOU to someone else, but they may not give me £10 for it. At all times in this deal I know my money is at risk and that it is not currently available for me to spend.

    The second problem with the banking system is the existence of deposit insurance. Deposits are considered to be risk-free because the government will guarantee the banks. By pretending that credit risk doesn’t apply to them, depositors underprice risk and hence demand too little interest from the banks. This only encourages the banks to lend too much to borrowers at too low an interest rate, creating the credit bubbles that cause havoc elsewhere and ensuring that over time the risks will increase until the point the government guarantee breaks the government, as is happening now in Ireland.

  10. Vimothy: “When you get a loan, you don’t an equal amount of M0. You don’t get any M0 at all.”

    I gave you a example, with an overdraft, where that is clearly not true, because the loan is issued, at the point of the lending, in cash.

    Other than that, the rest of the comment is fairly sound.

  11. Encyclopaedia Britannica Vol 12 p357 ( 15th ed 1981):
    “In the course of issuing money the commercial banks actually create it by expanding their deposits,but they are not at liberty to create all they may wish for the total is limited by the volume of bank reserves and by the prevailing ratio between these reserves and bank deposits- a ratio set by law,regulation or custom.”

  12. Ed: “First problem with the banking system is that the depositors are given the delusion that they can withdraw their money at any time, before the borrowers have repaid the bank. The fact that we get away with it most of the time is not good enough.”

    True, but, as an issue, it’s not just related to banking. You could say the same about insurance companies not being in a position to meet their obligations if an abnormally large number of people claim at once.

    “By contrast, my local shop won’t take your IOU, so I have to wait until you have repaid my £10 before I can spend that money.”

    Maybe it won’t, or maybe, if the proprietor knows me, it will. By the same taken, the shop may accept a debit card or other bank based payment, or it might refuse to accept anything other than cash. The difference isn’t structnot really relevant to the issue at hand. Alsural, just a difference in perception of credit-worthiness.

    “The second problem with the banking system is the existence of deposit insurance. Deposits are considered to be risk-free because the government will guarantee the banks. By pretending that credit risk doesn’t apply to them, depositors underprice risk and hence demand too little interest from the banks.”

    That, I absolutely agree with.

  13. Tim,

    I could get this wrong, and I do not mean to endorse all the potty MMT / NEF view of banking but there is one reason why banks might need to raise money whilst also having the power to create money at will.

    I think the story goes that you first create money by making a loan, then second go and find depositors or wholesale financing or whatever to finance it. Quite why people think this account is so fundametally different from the standard undergrad macro account that reverses the timing and talks about banks taking a deposit first then lending it out second, I don’t know. But I digress – the point is that this story has the liabilities equalling the assets in form of loans made and money borrowed. It doesn’t include an equity cushion, some shareholder capital. So you might need funding in order to establish an equity cushion even if you have the money creation power.

    I offer the above tentatively – it’s based on a conversation by the coffee machine that I may well have misunderstood.

    oh and the model in which individual banks don’t create money but the system as a whole does can be found in any introductory macro text book

    Tim adds: Reasonable ish on the funding point. But the banks simply don’t need £25 billion a month of new equity, the sums that Simms is talking about. He must be talking about funding for loans.

  14. Kitty Ussher (Economic Secretary to the Treasury) writes to Greg Clark (Conservative MP for Tunbridge Wells) 5 Aug 2008:
    “Your constituent asked some questions about the way in which credit is created and the present crisis in the banking system.By far the largest role in creating money is played by the banking system itself….When banks make loans ,they at the same time create a new deposit for those that have borrowed the money ..banks ability to accept new deposits and to lend them again when they are returned to the banking system ,leads to an ongoing process of credit creation.There is nothing new in this process of credit creation ..goes back centuries” .

    Bit basic this discussion is n’t it?

  15. My boss just couldn’t see it.

    You actually had a boss who believed in a lead into gold investment scam? Wow…

  16. Tim

    yes, before I wrote that I should have checked whether the nef were talking about bank equity – as you say the figures they are talking about suggest not.

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