What The Textbooks Get Wrong About Money And Banking

I’ve now, in three posts, given a basic (but reasonably complete) overview of how money creation actually happens in the real world.

But what you’ve read here is not what you would read in mainstream economic textbooks.  Don’t take my word for it – the Bank of England paper I’ve been quoting states this six times.  It wasn’t always like this.  At the Positive Money conference in 2013, Professor Victoria Chick described how in the late ‘50s and early ‘60s economics courses taught money creation accurately.  Similarly, the 1963 paper by James Tobin I referred to 2 weeks ago, “Commercial Banks as Creators of Money”, opens with a description of a typical University professor teaching money creation, and the description he gives is correct.  But economics lost its way in the late ‘60s (for one account of how this happened watch all of the video of Professor Chick – it’s very interesting, and if you increase the video speed in the youtube settings it only takes 9 minutes).

Before we consider what impact this process of money creation has on the economy, and why it matters so much, it’s worth reviewing what errors of thinking a mainstream economics education will lead you into.  My purpose here is not to poke fun at or berate mainstream economics.  One of the most distressing elements of reading economics article and blogs is the tone of utter disdain that economists will use about other ideas and directly about each other.  From the ultra orthodox to the most heterodox, mainstream to radical, economics writing seems to be suffused with smug arrogance that everyone assumes they are right and everyone else is an idiot.  I am determined not to allow this blog become like that (which is a challenge, because some economists really are idiots).

But striving to be balanced, moderate and even restrained does not mean we should not point out and reject descriptions of real-world phenomena that are simply incorrect – the role of banking in money creation is not a matter of opinion, it is a matter of verifiable fact.  Rather, it is important to be explicit when this occurs so that you will then understand the errors that you routinely see repeated in the media, by journalists, economists and politicians.

And the first point to be made about mainstream economics is that it treats money as unimportant, and leaves the financial sector out of most of its economic models.  So most of what I have been writing about in the last few weeks, and will write about in future months, is simply missing from economics curricula.  This is perhaps the most calamitous mistake.

But a standard textbook would typically give a basic overview of money and banking – stating that this works according to “fractional reserve banking”, as described in this post.  And they will say that Central Banks create reserves (remember how I said all banks have reserve accounts with the Central Bank) and then banks create the money in the economy by making loans and “multiplying up” these reserves.  The Central Bank then controls the quantity of money in the economy by controlling the quantity of reserves and reserve ratios.  The only part of this description that bears any relation to reality is the bit about banks creating money by making loans.

First of all, Central Banks do not seek to control the quantity of money by controlling the level of reserves and reserve requirements.  The Bank of England is unequivocal that this is not what they do (page 2 column 2, page 8 column 1, and page 12 final paragraph).  The UK does not even have a reserve requirement.  What Central Banks actually do, and how monetary policy works, will have to wait for a future series of posts.

Even more importantly, the model presented by textbooks is that banks make loans by lending out the savings of other customers.  You may well have heard of this before and believe this is how the system works.  The notion is that deposits are needed for banks to make loans, and that saving is therefore a good thing because savings are needed as a source for bank loans.

The reality, explained over the last 3 weeks, is that banks make money out of nothing every time they make a loan.  When that loan is spent it will become a deposit for someone else – so it is loans that create deposits, not the other way around.

It’s useful to picture this system as a whole.  As Lloyds bank makes loans to its customers, they will then spend those funds (by some form of electronic payment, not by withdrawing cash!). That loan becomes a deposit for someone else.  Lloyds then has to transfer Central Bank reserve into the reserve accounts of the banks of the people receiving those payments, and could run out of reserves pretty quickly, except of course it will also have customers receiving payments from people who have received loans from their banks.  So across the system as a whole this all balances out (as I’ve explained in great detail over the last 2 weeks).

But the key point here is that every loan becomes a deposit for someone else – loans create deposits, not the other way around.  As the above cited Bank of England paper states on its first page:

“The reality of how money is created today differs from the description found in some economics textbooks:  Rather than banks receiving deposits and then lending them out, bank lending creates deposits.”

So banks do not need deposits to make loans (though they do need to subsequently receive deposits to balance out the payments their customers are making).

The full significance of this may be lost on you right now (we’ll look at this over the next two weeks), but the point to focus on this week is that economics textbooks are completely wrong.  The implication is that most economics graduates are not just uninformed, they actively believe something about the economy that is the opposite of reality.  They believe that deposits create loans, and saving is a good thing because it provides the funds needed for banks to make loans (saving may be a good thing, but if so it has nothing to do with providing funding for bank loans).

As I hope I have just made unequivocably clear, as incontrovertible fact, there doesn’t need to be a single penny in any savings account for a bank to make a loan.  Everyone in the economy could be spending money as quickly as it hits their bank account, and there would be no limitation on how much banks can loan out.  They just need to keep pace with the rate at which their customers receive payments from others, a rate determined by the loans made by other banks.  And if any bank gives out more in loans than they receive in deposits, they can fall back on interbank lending.

And don’t forget that when they make loans banks create new money.  Private banks control the money supply.

What is in standard textbooks is wrong, and hence every economist – unless they have discovered the truth in the course of their career – actively believes, the opposite to reality.  And they then base their recommendations (e.g. to Government) on this wholly erroneous view of how money and banking works.

The organisation Positive Money commissioned a survey of MPs in 2014 on the process of money creation.  They found that only 12% understood how money is created in the modern economy.  And these people will tell us at elections that we can trust them with our economy.

I’ll just leave you with that to think about for this week.