banks don't lend money, they create it: deobfuscating monetary and banking terminology

AARHUS UNIVERSITET

Banks don’t lend money, they create it: Deobfuscating monetary and banking terminology

7th Critical Finance Studies ConferenceCBS, Copenhagen, August 20-21, 2015

Ib RavnResearch Program on Organization and Learning, Department of Education, Aarhus University, Denmark

Ib [email protected] AARHUS UNIVERSITY

Problems• What does a bank do when it lends?• Three theories of bank lending

(Werner, 2014). Which is true? Or when?• Why does ‘lending’ and so much

other monetary and banking terminology seem like obfuscation?

My argument1. How banks create money (account money).2. The three theories of bank lending fit three different monetary and banking

systems.3. Some money and banking terms that need to be deobfuscated

– and a few hypotheses as to why they haven’t been already.

1. The problems and my argument

To obfuscate: To deliberately make more confusing in order to conceal the truth.


• Bank of England paper, Money Creation in the Modern Economy: ”Banks do not act simply as intermediaries, lending out deposits that savers place with them” (McLeay et al., 2014, p. 14).

• Hugo Frey Jensen, (Deputy) Governor, Danmarks Nationalbank: "Banks create deposits, and thus money when providing loans” (Jensen, 2013, p. 1).

• Example: I take a loan of 800,000 DKK. The loan officer enters this amount into my current account (a bank liability) and opens a loan account in my name, entering the 800,000 as my debt to the bank (a bank asset). The bank’s balance has been extended. No transfer of funds. No intermediation.

• Michael Kumhof, Senior Research Advisor, Bank of England: “…whenever a bank makes a new loan to a non-bank customer X, it creates a new loan entry in the name of customer X on the asset side of its balance sheet, and it simultaneously creates a new and equal-sized deposit entry, also in the name of customer X, on the liability side of its balance sheet. The bank therefore creates its own funding, deposits, in the act of lending.” (Jakab & Kumhof, 2015, p. 3).

2. Banks create money when they ‘lend’


• When loan has been made, the borrower spends it = payment, a transfer to another account. Doesn’t that require the bank to cough up the money?

• No, because millions of payments -- the national payment system (in DK: Nets). Clearing (Norman et al., 2011). Only small net amounts are transacted. A payment system facilitates money creation.

• The money supply (M1) is mostly sum of bank deposits. M1 increases as loans are created and shrinks as loans are repaid.Thus, bank lending is money creation.

• Consequence: In good times, banks over-lend and feed bubbles in fixed assets, driving boom-and-bust rollercoaster.

• Unchecked bank lending (money creation) is the main cause of the business cycle (Werner, 2005).

3. Lending + clearing => money creation


• Crazy terminology. What lawn mower do you create in the act of lending it?

• And does it cease to exist when you return it?

• Why has this and many other misleading banking terms persisted?

• To justify the charging of interest? (Savers must be compensated for theunavailability of their funds, right?)

4. The term ‘lending’ obfuscates


1. The financial intermediation theory: A bank gathers deposits and lends them.

2. The fractional reserve theory of banking: A bank retains a fraction of any deposit and lends the main part, again and again.

3. The credit creation theory: Bank creates new (account) money by bookkeeping (adding digits to customer accounts).

• Werner (2014) finds overwhelming evidence for no. 3.

• I’ll argue they are suitable for three different banking systems (Weberian types)

5. Three theories of bank lending (Werner, 2014)

Money. Jens Overgaard Bjerre

Money. Jens Overgaard Bjerre


• Theory: A bank intermediates savers’ money by lending it to borrowers.• This was true when and where banks accept gold and valuables (like a

painting) for safekeeping (de Soto, 2012).• The gold coins were lent, with or

without depositor’s knowledge.• This theory has survived later

developments in banking and remains popular theory of banks.

• Theory 1 is true for that type of bank (historically very rare).

6. (1) The intermediation theory fits a warehouse bank


• Theory: A fraction of every deposit is kept as a ‘reserve’, before on-lending, in case the depositor comes for it (Mankiw, 2009, p. 549)

• Theory invented for a gold-type banking system, where deposit slips circulate as money (bank notes) and depositaries write fake deposit slips, passing them off as loans (Ravn, 2014). Reserves are banks’ and nations’ safeguards against bank runs.

• “Reserve” only makes sense here (not in warehouse bank: no new money, thus no need for reserves).

• In the 1700-1900’s this theory was a fair fit (if we ignore account money)

7. (2) The fractional reserve theory fits a bank with reserves


1. Theory: A bank credits the borrower’s account with the deposit and enters a corresponding asset (the value of the loan) on the other side of the ledger. No funds transferred. Deposit is created from scratch.

2. Suitable for a banking and monetary system where all money is account money (no gold or cash) (Jakab & Kumhof, 2015)

3. Bookkeepers discovered they could ”lend” by adding numbers to borrower’s account, without honestly subtracting same numbers from some other account. Because, when amounts are transferred between accounts, they tend to clear. In the clearing of matching loans lies money creation.

4. As loans are not given as cash/gold today, this theory fits current banking system.

8. (3) Credit creation theory fits pure account-money bank


• Suitable to historically different banking systems. • Past economists confused about bank lending? • “Keynes… did little to enhance clarity in this debate, as it is possible to cite

him in support of each of the three hypotheses, through which he seems to have moved sequentially” (Werner, 2014, p. 12).

• British banks in 1925 were a combination of warehouse banks, gold-reserve banks, and account-money banks.

• Theory 3 holds today (Werner, 2014; Benes & Kumhof, 2012). Our banking system is evermore account-based. For the other banking systems: the other theories are fine.

• Using theory 1 concepts today is misleading and self-serving:- It justifies interest (“Lender forgoes use of his money”. No)- It hides banks’ enormous power to create money and control the money supply- It portrays banks as humble servants of society’s needs when pursuing own profits

9. The three theories evaluated


Finansrådets hjemmeside: ”Banker skaber kontakt mellem de, der vil låne penge, og de, der ønsker at spare op. Bankernes unikke rolle som ‘pengeformidlere’ skaber blandt andet værdi ved at gøre det nemmere og billigere at låne og spare op. …[B]ankerne leder pengene i samfundet derhen, hvor de gør størst gavn…. http://www.finansraadet.dk/Tal--Fakta/Pages/bankernes-betydning-i-samfundet/bankerne-og-vaekst/uddybning-om-ind--og-udlaan.aspx

Translation: The Danish Bankers Association website:“Banks establish contact between those who want to borrow money and those who wish to save. The banks’ unique role as ‘money intermediators’ creates value by making it easier and cheaper to borrow and save. …[T]he banks channel the money in society to where it does the most good….

10. Example: Theory 1 used for public communication


11. Theory 1 terms that obfuscate

1. Lending, loan. Warehouse terms conceal that banks create money

2. Loanable funds; funding. Suggest lent money derives from ‘funds’

3. Make a deposit. Nothing is deposited. It’s all numbers. No gold; rarely cash.

4. Repayment of a loan. No such thing. You don’t ‘repay’ freshly created money.

5. Business cycle – as if the boom-bust economy is normal, not

preventable.

• Create money: ”I’d like you create £200,000 for a new home for us.”

• Money creation. Unethical to pretend otherwise. Truth in advertising? Illegal?

• Coordinate numbers. “Would you jiggle some numbers in my accounts?”

• Destruction. “Let me destroy £500 a month. Erase it from my account.”

• Money bubbles – to underscore the money-created origins of boom-bust


1. Ignorance: When early trading houses allowed customers to go into debt and still trade, they didn’t know they were creating money.

2. Gradual awareness of deception: E.g., goldsmiths writing fake deposit slips.

3. Deliberate silence for gain. Why call attention to a fraud by naming it so?

4. ‘Bankers’ responsibility’ to guard the public’s ‘trust’ (Nielsen, 1930, s. 59)

5. Scholars unaware. Money and banks virtually absent form economics. Neutral veil; can be ignored.Highly convenient for bankers. Shared interests?

Major failing:• Bankers practical – use extant concepts• But economists and finance scholars

should have updated theory (from no. 1 to 3) and reconceptualized ages ago. www.tinyurl.com/keen-krug

12. Possible reasons why no change in terminology


1. Lending and other terminology hidden behind a veil.Not veil of neutrality, but a veil of deception (Häring, 2013)

2. Three banking systems overlap, as do three models of lending.3. (1) The warehouse theory legitimizes the charging interest and glorifies

bank’s role (2) Banks seen as having gold reserves: fractional reserve banking(3) Best fit today: banks add to the money supply when lending = money creation

4. Responsibility of academics in (critical) finance: This really matters. Business cycles concentrate wealth at the top and deprive millions of their just share.

5. If we don’t understand this causal factor, bubbles will return. The nature of bank lending needs to be clear: banks’ money creation feeds bubbles and crises.

6. Help design a more equitable monetary system – which controls bank credit creation (Werner, 2005) or strips banks of their power to create money (Wolf, 2014; Jackson & Dyson, 2012; Sigurjónsson, 2015)

13. Conclusions


Benes, J., & Kumhof, M. (2012). The Chicago Plan revisited. IMF Working Paper WP/12/202.

De Soto, Jesús Huartes (2012). Money, bank credit, and economic cycles. 3rd edn. Auburn, AL: Ludwig van Mises Institute.

Häring, Norbert (2013). The veil of deception over money: How central bankers and text-books distort the nature of banking and central banking. Real-world economics re-view, 62: 2-18 (25 March).

Jackson, Andrew, & Dyson, Ben (2012). Modernising money. London: Positive Money.

Jakab, Zoltan, & Kumhof, Michael (2015). Banks are not intermediaries of loanable funds – and why this matters. Working paper No. 529, Bank of England, May.

Jensen, Hugo Frey (2014): Money at the bank is also good money. Danmarks Nationalbank, Press Release, Sept. 23, www.tinyurl.com/hugo-money

Mankiw, N. Gregory (2009). Macroeconomics. 7th edn. New York, NY: Worth Publishers.

McLeay, Michael, Radia, Amar, & Thomas, Ryland (2014b). Money creation in the modern economy. Bank of England Quarterly Bulletin, Q1, 14-27.

Nielsen, Axel (1930). Bankpolitik. Bd 2: Læren. København: Hagerups Forlag.

14. References (a)


Norman, B., Shaw, R., & Speight, G. (2011). The history of interbank settlement arrangements: exploring central banks’ role in the payment system. Working Paper No. 412, Bank of England, June.

Ravn, Ib (2014). Private bankers pengeskabelse – belyst ud fra en episode i 1600-tallet med Londons guldsmede. Samfundsøkonomen, nr. 2, april, 4-10. [Money creation by commercial banks, explained through an episode in the 1600’s with the goldsmiths of London]

Sigurjónsson, Frosti (2015). Monetary reform: a better monetary system for Iceland. A report commisioned by the prime minister of Iceland.

Werner, Richard A. (2005). New paradigm in macroeconomics: Solving the riddle of Jap-nese macroeconomic performance. Houndmills, UK: Palgrave Macmillan.

Werner, Richard A. (2014). Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, 1-19. A blogger’s fine summary here: www.kortlink.dk/frkv

Wolf, Martin (2014): Wolf, M. (2014). Strip private banks of their power to create money. Financial Times, 24. April.

15. References (b)

banks don't lend money, they create it: deobfuscating monetary and banking terminology

Economy & Finance