How is money created?

[Dovahkiin]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

 

[Dovahkiin]

Deficit spending 101 – Part 1

Budget deficits or surpluses occur in a modern monetary economies. A modern monetary economy such as Australia and almost every major economy has four essential features:

• A floating exchange rate, which frees monetary policy from the need to defend foreign exchange reserves;
• Modern monetary economies use money as the unit of account to pay for goods and services. An important notion is that money is a fiat currency, that is, it is convertible only into itself and not legally convertible by government into gold, for instance, as it was under the gold standard.
• The sovereign government has the exclusive legal right to issue the particular fiat currency which it also demands as payment of taxes – in this sense it has a monopoly over the provision its own, fiat currency.
• The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.

The diagram depicts the essential structural relations between the government and non-government sectors. First, despite claims that central banks are largely independent of government, there is no real significance in separating treasury and central bank operations. The consolidated government sector determines the extent of the net financial assets position (denominated in the unit of account) in the economy. For example, while the treasury operations may deliver surpluses (destruction of net financial assets) this could be countered by a deficit (of say equal magnitude) as a result of central bank operations. This particular combination would leave a neutral net financial position. While the above is true, most central bank operations merely shift non-government financial assets between reserves and securities, so for all practical purposes the central bank is not involved in altering net financial assets. The exceptions include the central bank purchasing and selling foreign exchange and paying its own operating expenses. While within-government transactions occur, they are of no importance to understanding the vertical relationship between the consolidated government sector (treasury and central bank) and the non-government sector. We will consider this claim more closely in a future blog.

Second, extending the model to distinguish the foreign sector makes no fundamental difference to the analysis and as such the private domestic and foreign sectors can be consolidated into the non-government sector without loss of analytical insight. Foreign transactions are largely distributional in nature.

As a matter of accounting between the sectors, a government budget deficit adds net financial assets (adding to non government savings) available to the private sector and a budget surplus has the opposite effect. The last point requires further explanation as it is crucial to understanding the basis of modern money macroeconomics.

While typically obfuscated in standard textbook treatments, at the heart of national income accounting is an identity – the government deficit (surplus) equals the non-government surplus (deficit). Given effective demand is always equal to actual national income, ex post (meaning that all leakages from the national income flow is matched by equivalent injections), the following sectoral flows accounting identity holds

(G-T) = (S-I) – NX

where the left-hand side depicts the public balance as the difference between government spending G and government taxation T. The right-hand side shows the non-government balance, which is the sum of the private and foreign balances where S is saving, I is investment and NX is net exports. With a consolidated private sector including the foreign sector, total private savings has to equal private investment plus the government budget deficit.

In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In a closed economy, NX = 0 and government deficits translate dollar-for-dollar into private domestic surpluses (savings). In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.

It remains true, however, that the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save (financial assets) and thus eliminate unemployment is the currency monopolist – the government. It does this by net spending (G > T). Additionally, and contrary to mainstream rhetoric, yet ironically, necessarily consistent with national income accounting, the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.

So how do deficits arise? How does the Federal government spend?

The Federal government has cash operating accounts – to ensure that they can spend (G) on a daily basis and receive daily receipts (T). The Reserve Bank of Australia (RBA) “provides a facility to the Australian Government that is used to manage a group of bank accounts, known as the Official Public Account (OPA) Group, the aggregate balance of which represents the Government’s daily cash position.” (see details here).

When the Federal government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this. You will note that:

• Governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is “printed” but that is a separate process from the daily spending and taxing flows;
• There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where but we will have to wait for another blog soon to fully understand that. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained. This means it does not have to “finance” its spending unlike a household, which uses the fiat currency; and
• Any coincident issuing of government debt (bonds) has nothing to do with “financing” the government spending – again this will be explained in a further blog.

All the commercial banks maintain accounts with the RBA which permit reserves to be managed and also allow the clearing system to operate smoothly. These so-called Exchange Settlement Accounts or Reserves always have to have positive balances at the end of each day, although during the day a particular bank might be in surplus or deficit, depending on the pattern of the cash inflows and outflows. There is no reason to assume that these flows will exactly offset themselves for any particular bank at any particular time.

In addition to setting a lending rate (discount rate), the RBA also sets a support rate which is paid on these commercial bank reserves. Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the RBA pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries do not offer a return on reserves which means persistent excess liquidity will drive the short-term interest rate to zero (as in Japan until mid 2006) unless the government sells bonds (or raises taxes). The support rate becomes the interest-rate floor for the economy. We will investigate this in a further blog.

So Federal spending by the Treasury, for example, amounts to nothing more than the Treasury debiting one of its cash accounts (say by $100m) which means its reserves at the RBA decline by that much and the recipient deposits the cheque for $100m in their private bank and its reserves at the RBA rise by that amount.

Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only. The taxation does not go anywhere! It is not stored anywhere and certainly does not “finance” the spending. The non-government sector cannot pay its taxes until the government has spent! It is a good practice to think of taxes as just draining liquidity from the non-government sector reflecting the Government’s desire for that sector to have less spending capacity.

A simple example helps reinforce these points. Suppose the economy is populated by two people, one being government and the other deemed to be the private (non-government) sector. If the government runs a balanced budget (spends 100 dollars and taxes 100 dollars) then private accumulation of fiat currency (savings) is zero in that period and the private budget is also balanced.

Say the government spends 120 and taxes remain at 100, then private saving is 20 dollars which can accumulate as financial assets. The corresponding 20 dollar notes have been issued by the government to cover its additional expenses. The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not have to do this to finance its deficit. The government deficit of 20 is exactly the private savings of 20.

Now if government continued in this vein, accumulated private savings would equal the cumulative budget deficits. However, should government decide to run a surplus (say spend 80 and tax 100) then the private sector would owe the government a net tax payment of 20 dollars and would need to sell something back to the government to get the needed funds. The result is the government generally buys back some bonds it had previously sold. The net funding needs of the non-government sector automatically elicit this correct response from government via interest rate signals.

 

[Luddly Neddite]

Start with some cotton rags and some green ink ...

 

[Dovahkiin]

Start with some cotton rags and some green ink ...

The overwhelming majority of money is electronic. You refer to physical currency, which only exists because of the government.

 

[Confounding]

You sure do spend a lot of time defending the banks.

 

[Toddsterpatriot]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

 

[Dovahkiin]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

No, they don't. What makes you think banks lend out deposits and multiply up central bank money?
Here's an authority on the question:
http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)

 

[Dovahkiin]

You sure do spend a lot of time defending the banks.

I'm not defending the banks, in fact, I favor cracking down on the banks.

 

[SwimExpert]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I take issue with the fact that your post boils down a complex phenomenon as if it were a simple push-button. The reality is that money is created only when the general population, through direct or indirect agreement or tacit agreement, agrees that it is created.

 

[Dovahkiin]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

The Money Multiplier...and Other Myths about Banking - Positive Money

The money multiplier model of banking has several implications:

1. Firstly, this model implies that banks have to wait until someone puts money into a bank before they can start making loans. This implies that banks just react passively to what customers do, and that they wait for people with savings to come along before they start lending.
2. Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio or the amount of ‘base money’ – cash – at the bottom of the pyramid.
   For example, if the Bank of England sets a legal reserve ratio and this reserve ratio is 10%, then the total money supply can grow to 10 times the amount of cash in the economy. If the Bank of England then increases the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to 20 times the amount of cash in the economy.
   Alternatively, the Bank of England could change how much cash there was in the economy in the first place. If it printed another £1000 and put that into the economy, and the reserve ratio is still 10%, then the theory says that the money supply will increase by a total of £10,000, after the banks have gone through the process of repeatedly re-lending that money. This process is described as altering the amount of ‘base money’ in the economy.
3. Thirdly, it implies the money supply can never get out of control, unless the central bank wants it to.

Unfortunately, the money multiplier model of banking is completely wrong. Professor Charles Goodhart of the London School of Economics and an advisor to the Bank of England for over 30 years described this model (in 1984) as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.” Why is this?

Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is simply not true. In actual fact when banks lend they create deposits:

This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.

Piti Distayat and Claudio Bori, Bank for International Settlements (2009)

Nor do banks need reserves in order to make loans. As Alan Holmes, who was senior Vice President of the Federal Reserve Bank of New York at the time remarked:

In the real world, banks extend credit, creating deposits in the process , and look for the reserves later.

Alan Holmes, then Senior Vice President, Federal Reserve Bank of New York (1969)

The vice president of the ECB had something similar to say:

It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.

Vitor Constancio, vice president of the ECB (2011)

Of course, this is just two men’s opinion, albeit men who should know what they are talking about. Thankfully empirical work has been carried out on this subject by Nobel prize winners Finn Kydland and Ed Prescott of the Federal Reserve bank of Minneapolis, who find that:

There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.

Nobel prize winners Finn Kydland and Ed Prescott , Federal Reserve bank of Minneapolis (1990)

What they are saying here confirms Alan Holmes quote above. Central bankers not only reject the money multiplier story due to their understanding of how banks operate, but also because of the empirical evidence.

There are also other reasons why the money multiplier is not a good model of how banks actually operate. For example, there’s no reserve ratio in the UK anymore, and there hasn’t been for a long time. While reserve ratios might be useful for other reasons, it is almost impossible for the central bank to use reserve ratios (or limit reserves held by banks in other ways) to restrict credit creation by banks. There are several reasons for this, not least because “banks extend credit, creating deposits in the process, and look for the reserves later”.

Of course, the central bank could choose not to provide a bank with extra reserves when requested. However, if the bank in question had extended credit and requested reserves in order to make a payment on behalf of a borrower, by not providing the reserves the central bank could create a problem for the bank in question.

For example, in a banking system with a reserve ratio the denial of reserves to a bank (which causes their reserves to fall below the regulated amount) will result in one of three outcomes:

1. The bank may attempt to borrow the reserves from another bank. However this is likely to place upward pressure on the interest rate at which banks lend reserves to each other on the interbank market. If the central bank wishes to maintain this rate then in all likelihood it will have to provide further reserves to the banking system – undermining its efforts to restrain lending through restricting reserves.
2. The central bank may allow the bank to break the rules, and operate with a reserve ratio of less than the required amount.
3. The central bank may deny the bank the ability to make payments until its reserve ratio increases up to the required amount. If the bank is also unable to borrow the reserves either from the central bank or other banks this could create a liquidity crisis, as the bank in question will not be able to make the payment. This could then potentially lead to a solvency crisis and/or a financial crisis.

Therefore if the Central bank wants to restrict private bank money creation supply by using reserve ratios or by restricting the amount of reserves availability to private banks, it must be willing to either allow large fluctuations in the interest rate or alternatively intermittent liquidity crises. Due to the potential for liquidity crises to turn into solvency crises, and because a solvency issue at one bank can cause a cascade of bankruptcies throughout the entire banking system, the central bank are unlikely to pursue the second option. Indeed, it goes against one of the central bank’s core functions – its mandate to protect financial stability.

NEXT: Part 8 - How banks become insolvent

 

[Dovahkiin]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I take issue with the fact that your post boils down a complex phenomenon as if it were a simple push-button. The reality is that money is created only when the general population, through direct or indirect agreement or tacit agreement, agrees that it is created.

It really is quite simple. Money creation will indeed stop if banks stop lending, along with the government not running a deficit. Luckily, we run a net deficit with banks loaning. Unfortunately, no one seems to care about private sector debt build up.

 

[Rustic]

Start with some cotton rags and some green ink ...

The overwhelming majority of money is electronic. You refer to physical currency, which only exists because of the government.

All IOUs

 

[Dovahkiin]

Start with some cotton rags and some green ink ...

The overwhelming majority of money is electronic. You refer to physical currency, which only exists because of the government.

All IOUs

You are indeed correct!

 

[Confounding]

in fact, I favor cracking down on the banks.

Elaborate?

 

[Toddsterpatriot]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

No, they don't. What makes you think banks lend out deposits and multiply up central bank money?
Here's an authority on the question:
http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)

No, they don't.

Yes, they do.

What makes you think banks lend out deposits

Let's walk through it.

Dovahkiin goes to the bank to borrow $10,000 to buy a car. They have no deposits, because they create a deposit with your loan. You write a check against that deposit account and give it to the car dealer. You drive off with your new car. The dealer deposits the check and it bounces. The dealer sues you and takes back the car. You sue the bank.

Toddsterpatriot goes to the bank to borrow $10,000 to buy a car. They have $100,000 in deposits, because they like their checks to actually clear. My loan creates a deposit and I write a check against that deposit account and give it to the car dealer. I drive off with my new car. The dealer deposits the check and it clears.

Which bank is more likely to be in business next week?

 

[Dovahkiin]

in fact, I favor cracking down on the banks.

Elaborate?

I'm sure you've heard the calls to "break up the big banks." Can't say I disagree. Also, we can look at the recent recession as to why we need to crack down on risky behavior.
And.. the US shadow banking system isn't subject to the same regulatory oversight.
Then, we have the subprime loans..
The government did play a part in this though.

 

[Dovahkiin]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

No, they don't. What makes you think banks lend out deposits and multiply up central bank money?
Here's an authority on the question:
http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)

No, they don't.

Yes, they do.

What makes you think banks lend out deposits

Let's walk through it.

Dovahkiin goes to the bank to borrow $10,000 to buy a car. They have no deposits, because they create a deposit with your loan. You write a check against that deposit account and give it to the car dealer. You drive off with your new car. The dealer deposits the check and it bounces. The dealer sues you and takes back the car. You sue the bank.

Toddsterpatriot goes to the bank to borrow $10,000 to buy a car. They have $100,000 in deposits, because they like their checks to actually clear. My loan creates a deposit and I write a check against that deposit account and give it to the car dealer. I drive off with my new car. The dealer deposits the check and it clears.

Which bank is more likely to be in business next week?

That has nothing to do with banks LENDING OUT DEPOSITS. Banks do not lend out deposits, your example doesn't show that at all. Anyways, your example actually shows that loans create deposits.

 

[Toddsterpatriot]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

The Money Multiplier...and Other Myths about Banking - Positive Money

The money multiplier model of banking has several implications:

1. Firstly, this model implies that banks have to wait until someone puts money into a bank before they can start making loans. This implies that banks just react passively to what customers do, and that they wait for people with savings to come along before they start lending.
2. Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio or the amount of ‘base money’ – cash – at the bottom of the pyramid.
   For example, if the Bank of England sets a legal reserve ratio and this reserve ratio is 10%, then the total money supply can grow to 10 times the amount of cash in the economy. If the Bank of England then increases the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to 20 times the amount of cash in the economy.
   Alternatively, the Bank of England could change how much cash there was in the economy in the first place. If it printed another £1000 and put that into the economy, and the reserve ratio is still 10%, then the theory says that the money supply will increase by a total of £10,000, after the banks have gone through the process of repeatedly re-lending that money. This process is described as altering the amount of ‘base money’ in the economy.
3. Thirdly, it implies the money supply can never get out of control, unless the central bank wants it to.

Unfortunately, the money multiplier model of banking is completely wrong. Professor Charles Goodhart of the London School of Economics and an advisor to the Bank of England for over 30 years described this model (in 1984) as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.” Why is this?

Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is simply not true. In actual fact when banks lend they create deposits:

This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.

Piti Distayat and Claudio Bori, Bank for International Settlements (2009)

Nor do banks need reserves in order to make loans. As Alan Holmes, who was senior Vice President of the Federal Reserve Bank of New York at the time remarked:

In the real world, banks extend credit, creating deposits in the process , and look for the reserves later.

Alan Holmes, then Senior Vice President, Federal Reserve Bank of New York (1969)

The vice president of the ECB had something similar to say:

It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.

Vitor Constancio, vice president of the ECB (2011)

Of course, this is just two men’s opinion, albeit men who should know what they are talking about. Thankfully empirical work has been carried out on this subject by Nobel prize winners Finn Kydland and Ed Prescott of the Federal Reserve bank of Minneapolis, who find that:

There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.

Nobel prize winners Finn Kydland and Ed Prescott , Federal Reserve bank of Minneapolis (1990)

What they are saying here confirms Alan Holmes quote above. Central bankers not only reject the money multiplier story due to their understanding of how banks operate, but also because of the empirical evidence.

There are also other reasons why the money multiplier is not a good model of how banks actually operate. For example, there’s no reserve ratio in the UK anymore, and there hasn’t been for a long time. While reserve ratios might be useful for other reasons, it is almost impossible for the central bank to use reserve ratios (or limit reserves held by banks in other ways) to restrict credit creation by banks. There are several reasons for this, not least because “banks extend credit, creating deposits in the process, and look for the reserves later”.

Of course, the central bank could choose not to provide a bank with extra reserves when requested. However, if the bank in question had extended credit and requested reserves in order to make a payment on behalf of a borrower, by not providing the reserves the central bank could create a problem for the bank in question.

For example, in a banking system with a reserve ratio the denial of reserves to a bank (which causes their reserves to fall below the regulated amount) will result in one of three outcomes:

1. The bank may attempt to borrow the reserves from another bank. However this is likely to place upward pressure on the interest rate at which banks lend reserves to each other on the interbank market. If the central bank wishes to maintain this rate then in all likelihood it will have to provide further reserves to the banking system – undermining its efforts to restrain lending through restricting reserves.
2. The central bank may allow the bank to break the rules, and operate with a reserve ratio of less than the required amount.
3. The central bank may deny the bank the ability to make payments until its reserve ratio increases up to the required amount. If the bank is also unable to borrow the reserves either from the central bank or other banks this could create a liquidity crisis, as the bank in question will not be able to make the payment. This could then potentially lead to a solvency crisis and/or a financial crisis.

Therefore if the Central bank wants to restrict private bank money creation supply by using reserve ratios or by restricting the amount of reserves availability to private banks, it must be willing to either allow large fluctuations in the interest rate or alternatively intermittent liquidity crises. Due to the potential for liquidity crises to turn into solvency crises, and because a solvency issue at one bank can cause a cascade of bankruptcies throughout the entire banking system, the central bank are unlikely to pursue the second option. Indeed, it goes against one of the central bank’s core functions – its mandate to protect financial stability.

NEXT: Part 8 - How banks become insolvent

Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is simply not true. In actual fact when banks lend they create deposits:

The banks don't need the deposits before they loan, but they need the deposits in order to clear the loan check.
The fact that your loan "creates a deposit" means fuck all when the check bounces.

 

[Toddsterpatriot]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

No, they don't. What makes you think banks lend out deposits and multiply up central bank money?
Here's an authority on the question:
http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)

No, they don't.

Yes, they do.

What makes you think banks lend out deposits

Let's walk through it.

Dovahkiin goes to the bank to borrow $10,000 to buy a car. They have no deposits, because they create a deposit with your loan. You write a check against that deposit account and give it to the car dealer. You drive off with your new car. The dealer deposits the check and it bounces. The dealer sues you and takes back the car. You sue the bank.

Toddsterpatriot goes to the bank to borrow $10,000 to buy a car. They have $100,000 in deposits, because they like their checks to actually clear. My loan creates a deposit and I write a check against that deposit account and give it to the car dealer. I drive off with my new car. The dealer deposits the check and it clears.

Which bank is more likely to be in business next week?

That has nothing to do with banks LENDING OUT DEPOSITS. Banks do not lend out deposits, your example doesn't show that at all.

Banks do not lend out deposits

How long does the lending bank remain in business with $0 deposits?

 

[Dovahkiin]

Most americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.

I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.

http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

I expect many posters to take an issue with my assertion that Loans create deposits.

Yes, loans create deposits.

Banks do not lend out deposits or multiply up central bank money.

But of course they do.

No, they don't. What makes you think banks lend out deposits and multiply up central bank money?
Here's an authority on the question:
http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)

No, they don't.

Yes, they do.

What makes you think banks lend out deposits

Let's walk through it.

Dovahkiin goes to the bank to borrow $10,000 to buy a car. They have no deposits, because they create a deposit with your loan. You write a check against that deposit account and give it to the car dealer. You drive off with your new car. The dealer deposits the check and it bounces. The dealer sues you and takes back the car. You sue the bank.

Toddsterpatriot goes to the bank to borrow $10,000 to buy a car. They have $100,000 in deposits, because they like their checks to actually clear. My loan creates a deposit and I write a check against that deposit account and give it to the car dealer. I drive off with my new car. The dealer deposits the check and it clears.

Which bank is more likely to be in business next week?

That has nothing to do with banks LENDING OUT DEPOSITS. Banks do not lend out deposits, your example doesn't show that at all.

Banks do not lend out deposits

How long does the lending bank remain in business with $0 deposits?

It doesn't, because a bank that isn't lending doesn't have anyone going to it for loans.
This should be common sense.