The article's authors claim that there are some popular misconceptions about how money creation works, and the central bank's control over that process. They seem to want to clear things up for us. Some people have had strong reactions to the article, and Simon Wren-Lewis links to some of that. It's a confused article, so it's really not surprising that it's lead to confused reactions.
As the authors cite Tobin's Commercial Banks as Creators of "Money," and refer to it extensively, it's useful to start there. Tobin's paper, written in 1963, is one of my favorite papers in monetary economics. You can guess where Tobin is going from the scare quotes in the title. Here are Tobin's conclusions:
For the arguments in the article, Tobin's point 4 is particularly important. Tobin thought it best that we think of commercial banks as financial intermediaries and, as such, to analyze their role in terms of normal economics. Indeed, people lose their grip on reality when they start thinking of central banking, and "money" creation, as some kind of hocus-pocus.
So, McLeay, Radia, and Thomas (MRT) begin their article by clearing up two "misconceptions." The first one is:
...that banks act simply as intermediaries, lending out the deposits that savers place with them.Well, that's a really bad start, as that's not a misconception, but a very useful way to begin thinking about what a bank does. A bank is indeed a financial intermediary - it borrows from one set of people and lends to another set of people. The second "misconception":
...is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.I'm on board with that. The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system - such as what exists in Canada, the UK, or New Zealand - where there are no reserve requirements, and they won't be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.
But, though MRT recognize that the money multiplier story may not be illuminating, that traditional story is actually part of their anti-misconception for "misconception" #1. The authors state:
...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.Well, in the money multiplier stories I heard, that actually seemed to be important. In the traditional textbook account, the central bank conducts an open market operation by purchasing government debt with reserves. Banks have more reserves, which they cannot collectively rid themselves of, but they start lending more, as they have reserves in excess of their reserve requirements. When a bank makes a loan, it simply gives the borrower a deposit at the bank. The borrower will presumably spend the funds in the deposit account, but the deposit balance stays in the banking system, and the multiplier process continues until the reserve requirement binds.
That's essentially the story that MRT are telling, but without the initial reserve injection. I think Tobin would object just as strongly to what MRT are saying as to the money multiplier story that he wrote about in 1963. Here's why. Lending by a bank does not somehow create the deposit liabilities that support that lending. For example, suppose bank 1 makes a loan for $20,000, and credits $20,000 to the borrower's deposit account. Then, the borrower purchases a car for $20,000, and when the transaction clears the borrower's deposit account at bank 1 is debited $20,000, and the deposit account of the car dealer at bank 2 is credited $20,000. Bank 1 also receives a debit of $20,000 to its reserve account, and Bank 2 receives a credit of $20,000 to its reserve account. Now, suppose that the car dealer withdraws the $20,000 from its deposit account in cash. Now, bank 2 is in the same position as before - there is no net change in its deposit liabilities or its reserve account balance. At bank 1, liabilities are no different than initially, but the composition of assets has changed. Reserves are now $20,000 lower, and loans are $20,000 higher. But, suppose that the car dealer who sold the borrower the car had taken out a loan from bank 1 in order to finance the car as inventory. Further, suppose the car dealer pays off the loan - with $20,000 in cash. So loans fall by $20,000 and reserves rise by $20,000 at bank 1. So now the banking system looks exactly the same as initially.
I just made up a series of transactions, but that story makes as much sense as what MRT describe as a "money creation" process. The story simply is not helpful. It would be much more useful to tell a story for lay people that focuses on the bank as a financial intermediary, with deposits and loans determined jointly by the behavior of depositors, borrowers, and banks. Basically, it's a general equilibrium problem, and we have to get this across in a way that people will understand. Making up stories about transactions and balance sheets doesn't help.
Then, once people understand something about financial intermediation and asset transformation, it's more straightforward to tackle central banking and what that is about. Basically, the central bank is just another financial intermediary, that competes with private sector intermediaries. To the extent its actions matter, that's because the central bank has some special advantages or powers in providing intermediation services.
MRT go further astray when they discuss how monetary policy works. Again, it seems their intention is to clear up a misconception:
Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices — setting interest rates.And again, they don't get it right. My understanding of the Bank of England's operating strategy is that the Bank sets the Bank Rate, which is the counterpart of the U.S. discount rate, and also the interest rate on reserves. Correct me if I'm wrong, but this is a channel system with no channel - effectively the overnight rate, the central bank lending rate, and the interest rate on reserves, are identical. So, in pre-financial crisis times, the overnight rate target was the Bank Rate, and the Bank of England would hit its target through intervention in the repo market. So, pre-financial crisis, the Bank did not literally "set" the overnight rate. It achieved a particular market outcome through a standard type of intervention, which would literally adjust the quantity of outside money to hit the target. So, the Bank of England seemed to have been doing what its economists said it was not doing.
Post financial crisis, you can see the state of the Bank of England's balance sheet here. As in the U.S., the central bank's balance sheet has grown, as has the stock of reserves. It therefore appears that (and this may not be quite correct, as I had trouble finding detailed Bank of England balance sheet information - please help me out if you know where to find it), as in the U.S., the interest rate on reserves determines the overnight rate, and repo market intervention (at the margin) is irrelevant. So, the current environment comes somewhat closer to what MRT are describing, though their view of bank behavior leaves a lot to be desired.
My last complaint is about MRT's analysis of the effects of QE (quantitative easing). The example they give again involves balance sheet entries. You can find this in the section beginning on page 8 of the article. It turns out they want us to think of QE as a central bank action that "creates broad money directly." What a funny idea. In the example, illustrated on Figure 3 on page 11, the Bank of England purchases government debt from a pension fund, which has no reserve account. The effect of the central bank action is to reduce the pension fund's holdings of government debt, and increase the pensions fund's bank deposits. In turn, the pension fund's bank sees an increase in its deposit liabilities and an increase in its reserve balances. Then the claim is that the pension fund proceeds to readjust its portfolio, which it is now apparently unhappy with, so QE has some effect.
Well, hold on. By this logic, if the Bank of England purchased T-bills from the pension fund, this would have the same effect. But MRT's argument is based on being in a liquidity trap. So, they have to show why it makes a difference that the asset purchases are of long-maturity government debt rather than short maturity government debt. Further, suppose that the pension fund has a reserve account, so that the asset purchase is a swap of reserves for government debt. Surely that can't make a difference to the ultimate effect of the purchase, but clearly MRT think it's critical that inside money increase as a result of the purchase in order for it to have an effect.
If you find that weird, then you'll also find "Quantitative Easing Explained," from the Bank of England's website, just as weird:
This policy of asset purchases is often known as 'Quantitative Easing'. It does not involve printing more banknotes. Furthermore, the asset purchase programme is not about giving money to banks. Rather, the policy is designed to circumvent the banking system. The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds to stimulate spending and keep inflation on track to meet the government’s target.Central bankers in the U.S. typically use market-segmentation stories as arguments for why QE works. But in those stories, there is segmentation in the market for government debt - by maturity. The Bank of England is telling us that there are two key segments to the financial market - banks and non-banks. The banking sector is not integrated with the non-banking sector perhaps, as MRT seem to want to argue, because banks have reserve accounts and non-banks do not. That's wrongheaded. Either you knew this before the financial crisis (for example by reading Tobin's 1963 paper), or you learned it during the financial crisis: It's foolish to draw a line between financial intermediaries that are "banks" and those that are not; indeed it can get us into big trouble.