RG10: Previous post in this sequence is RG9 Who Should Create Money? In this post, we pause to explain the process of money creation by private banks, and the role of Central Banks in enabling and facilitating this money creation. This is necessary in order to understand the history of Central Banking, which we are studying in Goodhart’s book. The standard explanation of this process found in textbooks is false and misleading, and creates many widely believed myths. The following 1m video provides the standard FALSE explanation of how banks create money. It is useful to understand the MYTHS of money creation, encapsulated in this video, in order to explain why they are wrong.
First Myth – Misunderstanding how fractional reserve works: The bank is required to keep 10% of the money you deposit somewhere safe, and is allowed to lend 90% of it out to other customers.
This is a massive misunderstanding of modern money, perhaps based on the idea of money as gold. Cash is now a very small part of money in circulation, most of which exists only as electronic entries in computer ledgers. To understand what happens when John deposits $1000 in form of cash – which is different from the deposit of a check – in his Bank ABC. it is useful to separate this into two different transactions. There is a Cash Kitty of the bank ABC, to which $1000 is added. At the same time, separately, an electronic entry is made in John’s account for $1000. If John deposits a check, then only an electronic entry is made, and there is no change in the Cash Kitty of the Bank ABC.
Second Myth: Bank is a Financial Intermediary – it takes money from depositors in order to give loans. Suppose that after John walks out of the bank, Mike comes in and asks for a loan of $1 Million. The bank will not go and look at its cash kitty to see if there is sufficient money to grant Mike a loan of $1 Million. Instead, it will assess the credit-worthiness of Mike and ensure that he has sufficent collateral — assets worth more than a $1 Million. It will take a pledge from Mike to repay $1M plus interest one year from now, backed by the collateral, to be seized in case Mike does not pay.
Bank ABC will open an account with keystroke entry of $1 Million. This $ 1M comes into existence when Bank ABC gives Mike a loan. This $1 Million is NOT taken out of depositors money – it is create ex nihilo – out of thin air. Now suppose Mike writes checks on his account so that, at the end of the day, Bank ABC must pay $1 M to other banks, where these checks have been deposited. Where will Bank ABC get the money it owes, which it created out of thin air?
The Role of Central Banks: Bank ABC will now BORROW over-night, funds required to cover what it owes. There are two markets where such borrowing is done. One is the Interbank Market – it can borrow keystroke money from any bank having an excess. Banks having an excess are only too happy to lend it overnight and make a profit. However, if liquidity is tight and no one has excess reserves to lend, the Central Bank is the lender of th last resort. It is legally obligated to loan ABC HOWEVER MUCH money Bank ABC wants, in return for good collateral. Here the collateral Bank ABC will offer to the Central Bank is the PLEDGE of Mike to repay the loan, backed by his assets worth $1M.
Maturity Transformation: Converting a one-year loan to a sequence of 365 overnight loans,. Both interbank borrowing and borrowing from the Central Bank are done at nearly the monetary policy rate, while commercial loans are significantly higher, at least by 2% or more. This means that if Bank ABC has to borrow this $1M overnite every night for the whole year, it will still make a profit when Mike pays back his loan with interest. For more details about this, see Monetization, Maturity Tranformation, and MMT
Overnight Clearinghouse: Generally speaking, Bank ABC will not need to borrow the $1 M every night. In the banking system, all the banks are creating money by making loans. At the end of the day, overnight clearing takes place. All of the checks written on all of the banks are cross-checked and balanced. Bank ABC loaned $1 M and may lose $1 M to other banks. However, it will also receive as deposits from money created by other banks, which are deposited into accounts at Bank ABC. Banks with more inflows than outflows will have excess (keystroke) money, which they will be happy to lend in the overnight inter-bank market to those banks which have excess outflows and less inflows. When banks as a whole fall short of funds, perhaps to due to withdrawals of money from the banking system, the Central Bank is the lender of the last resort, and will lend to cover any such shortfalls.
Monetary Consequences: The explanation given in the video, is also commonly used in textbooks. This suggests that if the reserve requirement is 10%, and there is $1000 of cash (called High Powered Money or HPM) in the system, then a maximum of $10,000 worth of money can be created. This is the myth of the money multiplier. It leads to the belief that Central Banks can CONTROL the amount of money in the system. However, since Central Banks are OBLIGATED by law to lend reserves to any Bank ABC which has suitable collateral, there is no restriction on the power of money creation by private banks. When Central Banks attempted to implement Friedman’s rule to keep monetary growth at a fixed rate of 6%, they found that they could not do so. The quantity of money was not subject to their control. It was after this failure that Banks shifted to using the overnight discount rate as the principal instrument of monetary policy decision.