In a previous post on “Origins of Central Banking“ the history of creation of Bank of England was described. In this post, we discuss the deeper lessons to be learned from this history, and how this supports the MMT view of the world. We also clarify and make explicit some key aspects of the banking process embedded in this history.
Monetization of Debt & Maturity Transformation: Crucial concepts, relevant today, to understand how banking works. King William borrowed GBP 1.2 million from BoE. The “loan” should be understood as a maturity transformation – a key to how banks work, even today. Assume for simplicity that BoE does not actually have ANY gold in its possession. It makes a loan to King William III (KW3) of gold (which it does not have) by opening an account in the name of KW3, and promising to honor all checks written by KW3. Now BoE has made a Loan which will mature in 5 years, so this is a long maturity loan. In order to honor incoming checks, BoE will borrow gold short term from Gold Dealers XYZ and pay off, in gold, anyone who presents checks written by KW3. We can simplify the picture by assuming that BoE borrows only on an overnite basis, but does so continuously every day, in quantities required by the demands presented to it. So, the long-term loan five-year loan is transformed into a sequence of over-nite loans; this is the “maturity transformation”. But why would BoE want to do this? Because it gains great benefits by “monetizing” the debt. The monetization occurs when BoE issues paper notes of GBP 100 each, for any purpose whatsoever. On the face of the note, it is written that BoE promises to pay the holder of the note GBP 100 worth of gold upon presentation of the note. This promise of BoE is BACKED by a Sovereign Guarantee – that is the promise of KW3 to pay BoE 1.2 million pounds 5 years from now.
House of Smoke and Mirrors! The surface appearances are so radically different from the underlying reality! Let us analyze in greater detail what appears to happen, and contrast it with what actually happens. On the surface, it appears that KW3 needed gold of 1.2 million GBP, and BoE had this gold, which it gave to KW3 as a loan. It will make profits from the interest payments on the loan on an annual basis – collecting taxes on behalf of the King for this purpose. At the end of five years, BoE will get back the gold that it gave to the King. This is a standard interest-based loan. This understanding of how banks operate reflects the “Financial Intermediation” theory which is faithfully depicted in textbooks, and shapes thinking of conventional economists (like Krugman) about how the world of finance works. Now let us look at what really happens, in order to be able to admire the amazing audacity and cunning of the financiers – no wonder they rule the world today.
BoE lends KW3 1.2 million GBP with nothing in its pockets! They simply open an account and put an entry in the ledger in the amount, showing the KW3 has a deposit of this amount. They borrow gold as needed to pay off incoming checks in gold. Of course, to be able to borrow, they need to have good credit. This creditworthiness is achieved partly because they have their own reserves of gold. But an important additional factor is the “monetization”: The counterpart to this deposit of 1.2m GBP in the name of KW3, is an incoming payment, due in five years, of 1.2 million GBP of gold. This is an IOU note by KW3 where KW3 promises to BoE 1.2 million five years from now. Now this promise of the King is the asset which BoE will monetize. BoE can create 1.2 million GBP worth of paper notes, all of which are backed by a sovereign guarantee. A 100 GBP note issued by the BoE is actually a promise to pay the owner of the note from the gold which the KW3 will pay the bank five years from now – this is the sense in which the note is backed by the sovereign guarantee. However, the owner of the note might have an urgent need; he may not want to wait for five years to be paid in gold. No problem! Anyone who presents the note for encashment receives gold which BoE borrows in order to honor its long term guarantee. Once this system is operational and working smoothly, owners of the notes issued by BoE think of them as being “as good as gold”. The Bank of England honors all requests to convert notes into gold smoothly and quickly, without a hitch. People stop converting notes to gold because everyone is confident that this can be done. Once confidence in the promise of BoE is established, the BoE is in a position to print gold, because its notes are considered as being equivalent to gold by the public.
This is the bonanza for Bank of England – it acquires the ability to print notes which are considered as equivalent to gold by the public. The initial confidence in the notes is generated by the sovereign guarantee, and is reinforced by the ability of BoE to encash these notes for gold on demand. This ability depends on gold reserves at BoE and also on its ability to borrow gold as needed from other sources. Once it prints 1.2m GBP worth of paper notes backed by sovereign guarantee, it has already created 1.2m GBP of the (non-existent) gold that it loaned to King William — it does not need to get the money back, because it already created it!. This is why the BoE stated that the loan can be rolled over indefinitely. That is, at the end of five years, King William can (and will) say that I don’t have the 1.2million to pay you back, so give me another loan of 1.2million (plus accumulated interest) which is due in another five years. The BoE happily obliges the King by giving him a loan on paper which the king immediately surrenders to the bank as repayment of the initial loan, and the whole cycle repeats.
But this is not all; the implications of this heist of power of money creation are far more radical. No one is watching how much money is created by the Bank of England. Technically, it can only print 1.2 million GBP which are backed by the sovereign guarantee. However, as we have seen, this sovereign guarantee is an illusion – the King will never actually pay any gold to the Bank of England. What enables the bank to print notes is the confidence of the public that the notes are as good as gold. The BoE can print a lot more than 1.2 million pounds. The original loan to the King becomes only a side-show; the interest payments are also a side-show. The real game is that the power of creation of money has been transferred from the sovereign to the bank. Furthermore, this authority is enshrined in the law, in a charter signed by the King of England.
So, let us take a step back from the detailed analysis of this amazing theft, where the BoE actually stole the power of money creation from the sovereign state of England. Let us look at the bigger picture. The BoE not only gave KW3 the money that he needed, they also gave him a promise to provide him with all funds that he might need in the future. The principal of the loans that they would give to the King would never be paid back; the Bank would only collect the interest on the loans. The entire principal of the first loan (and any subsequent loans) stays at the bank in the form of an IOU from the King, and serves as a sovereign guarantee which authorizes the Bank to issue notes which are backed by a promise of the King. But the trick goes deeper, because this promise is actually an illusion – the king will never pay. So whereas the public trust in money created by the Bank of England is apparently based on the sovereign guarantee, it is actually based on something rather different. It is based on the ability of the Bank of England to smoothly and quickly convert notes to gold on demand. Once public confidence in this ability is established, only a small amount of gold is needed by the Bank of England, since confidence creates the impression that the paper is good as gold. Secure in the knowledge that paper can be converted to gold on demand, people rarely actually do so since paper is much more convenient to carry and store than gold. Complications in this basic story created by international trade will be discussed later.
For a more detailed history of the origins of Bank of England, see my previous post on “Origins of Central Banking“. Understanding this history is extremely helpful in understanding the central claims of Modern Monetary Theory. The BoE can make any amount of loans to the King of England, and never require repayment from him because they can monetize all sovereign debt. They can convert the IOU of the King to money and use it for their own purposes. This power of monetization means that the IOU of the King itself is the money. We could take away the smoke and mirrors, and the king could issue his own IOU directly (without incurring interest payments on loans from BoE). The money would be fiat currency and circulate by sovereign authority – the law makes it legal tender. Here the widespread myth, still widely believed, that money must be backed by gold, is of great value to the financiers who possess gold (which the king does not). The King’s fiat currency is not backed by gold, but the BoE can issue currency which appears to have gold backing. So, it seems that the BoE currency is more “sound” to a public conditioned to believe that money is gold. In fact, using fractional reserve methods, the BoE currency is also unsound in the sense that there is never enough gold to back all of it. In the final analysis, money is about trust and confidence. This trust and confidence can be created by a variety of tricks. In small communities, trust can be created by character – the movie “It’s a Wonderful Life” shows the central importance of trust, and its relationship to the viability of banking.
The central message of MMT is that once the illusion of gold is removed from the picture, money is valued because everybody has confidence in it. This confidence can be safely created by sovereign authority. The King, or the state, can create any amount of money, without limits. There is no issue of sustainability of deficit. Creation of money has powerful effects on the economy, and printing too much money would definitely cause inflation, so it would never be advisable to freely print money. But the state does have the power to do so, and the state will never have to “pay back” for money it created today. The focus should shift from the wrong question of how the government can generate revenue to finance its spending, to the right question of what are the effects of money creation by the sovereign state? By analyzing the impact of money creation on employment, inflation, debt, we can figure out the right amount to create. The conventional idea of “neutrality of money” embodied in Real Business Cycles and DSGE models is a major obstacle in the path asking the right questions, because these theories say that the quantity of money does not matter.
An important side note here is that international trade matters a lot. As long as the paper circulates within the British empire, conversion to gold or otherwise does not make difference. As long as the gold is within the Empire, the BoE will be able to borrow it temporarily to meet its daily needs. But if the notes are used to purchase foreign goods, and foreigners demand gold in return for notes, gold will flow out of the empire, and this can create problems. We ignore these issues for the moment; these will be discussed in greater detail later. My talk at the State Bank of Pakistan provided an introduction to basic MMT concepts, to people schooled to believe in other theories of money:
Another similar introductory talk on MMT is “Key Insights from Modern Monetary Theory” This post analyzed the opening shots in a battle which has raged through centuries, determining the fates of millions of lives: “The Battle for the Control of Money.” Today, this battle threatens the future of mankind on this planet. The central strategy in this battle is deception and creation of illusions. This is captured in the following scene from the Wizard of Oz — Dorothy and her team quake with fear in front Oz, the mighty and powerful, until Toto lifts the curtain behind which the magician is hiding. As Ellen Brown has pointed out in her wonderful book on The Web of Debt, the Wizard of Oz is actually an allegory about the powers of money creation, with OZ standing for ounce, as in a gold ounce. If we have correct understanding of how the system works to provide massive benefits to creators of money, who get to mint money for free, we can easily fix it. So this understanding must be denied. Multiple myths are created which prevent understanding. The most basic of these is the myth of neutrality of money. If money itself does not matter, than what does it matter how it is created. The second myth is that banks do not create money, the banking system as a whole does, widely taught in textbooks even today. The third myth is the money multiplier story, according to which the amount of money in the system is just a fixed multiple of the high powered money created by the Central Bank. Increasingly powerful attacks, together with damaged credibility after the Global Financial Crisis, has led to a confession: “The Truth is Out: Banks Create Money“ The confession may be motivated by the need to regain credibility and hence to manufacture new myths to replace the old ones. The central question to ask about money is: “Who Creates It?”. As recent papers by Bank of England clarify, it is the private banks, and now, far more important, the shadow banks. It is these shadowy financial institutions which run the world today, by the power of the money that they create.