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.
The biggest problem with Tobin's New View was that even as he recognized that checking account dollars issued by a private bank are the liability of that bank, he denied that Fed dollars are the liability of the fed. One wonders why Federal Reserve Notes appear on the liabilitiy side of the Fed's balance sheet, or why the Fed conducts open market sales of bonds.ReplyDelete
Yes, Tobin's view of the world was static, and he thought at the level of demand and supply functions. You can see that in #4 above, where he's talking about "Marshall's scissors." He certainly did not think deeply in terms of the Fed as an intermediary, that the way the Fed's liabilities are backed would matter, etc. People have tried to use Tobin's thinking (3-asset model, for example) to think about QE, which doesn't get you anywhere.Delete
Nick Rowe insists that the special distinguishing feature of a central bank, as opposed to regular banks, is "asymmetric redeemability". Regular banks promise to redeem in terms of CB notes, the central bank makes no promises contingent on other notes. But if a CB was targetting an exchange rate with another country's currency, it would become like a regular bank.ReplyDelete
Nick's response to the BoE paper is here.
"Regular banks promise to redeem in terms of CB notes..."Delete
Not quite correct. At each point in time, a deposit contract (perfectly divisible) gives me three options: (i) leave the deposit in the bank; (ii) exchange the deposit for currency; (iii) transfer the deposit claim to someone else (by debit card or check).
"...the central bank makes no promises contingent on other notes."
Not quite correct either. A deposit with the central bank (reserves) is actually quite similar to a retail bank deposit. Just as with the bank deposit, a bank with a reserve account can exchange it for currency, or transfer it to someone else. The set of institutions to which funds can be transferred is, of course, limited by the set of financial institutions holding reserve accounts. Currency, however, is quite different from a bank deposit, as it's not related to any explicit promises. But there are implicit or explicit promises made by the central bank that are critical to its future real payoffs. That's the interesting part.
Professor you have give a new vision about money. Now, I know that your way it's the wrong path to understand the economy. Thank you!ReplyDelete
Thanks for a very nice and interesting post!ReplyDelete
To say that banks create money out of thin air may have elements of truth in it, it may still be a misleading way of thinking about banking. Maybe the BoE-paper did not explicitly claim that banks create money out of thin air, it somehow had that flavor. You explained it in a very good way in this passage:
"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."
I actually agree with a lot of this, although I think you're being a little hard on the BoE. The way they describe monetary policy as rate setting seems to me to be pretty reasonable, at least as far as sterling monetary policy goes. Lending (repo) and deposits are provided at the set rates in whatever quantity is required. There is no sense in which either rate is simply a target. In fact, I'm not sure how you could target both a lending rate and a separate deposit rate with one intervention tool.ReplyDelete
This may come down to semantics, but the BoE definitely sees it as rate-setting. The following is from a speech by Paul Tucker when the system was overhauled in 2004. (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb040306.pdf)
"In terms of the overriding objective of stabilising ultra-short interest rates at the MPC’s rate, the key is to ensure that we are both the marginal supplier and taker of ‘reserves’. In theory, there are two possible ways of achieving this. One is to use OMOs to adjust the quantity of reserves to bring about the desired short-term interest rate, implicitly or explicitly drawing on an identified demand schedule. Neither in the past nor in the current review have we even briefly entertained the notion that this is realistic.
The alternative way for the central bank to establish itself as the rate-setter is to be prepared to supply (or absorb) whatever liquidity the market demands at its chosen rate(s). The most precise way of doing this is through so-called ‘standing facilities’ in which the central bank lends (secured) whatever is demanded at a fixed rate or takes on deposit whatever is supplied at a fixed rate."
Maybe this is just semantics. Most central banks intervene in markets for short term credit in some fashion to peg an overnight nominal interest rate. The way they do this differs somewhat according to institutional features - the nature of overnight markets, the number of market participants, etc. There is nothing fundamentally different about Bank of England monetary policy. They choose a market price, and then vary the quantity so that is the market price. In their case, the institutional setup is such that they can effectively fix the price.Delete
In teaching students, I don't think we want to tell them that the Bank of England "sets interest rates." That's not actually what they are doing. What if the Bank decides to fix the quantity, and let the price vary? Then the student will not understand what is going on, or how to predict what the consequences would be.
"... I don't think we want to tell them that the Bank of England "sets interest rates." That's not actually what they are doing."Delete
Well, they're not setting all interest rates. But the MPC decides what the bank rate will be for the period until the next meeting. They don't make any decision on what the quantity of reserves will be. It seems to me that turning that around and saying they're not setting rates, they're setting something else is obscuring what the actual practice is. Especially as if they did fix the quantity, say, and let the price vary, it would have very different consequences, notably much greater volatility in overnight rates.
All of that could be part of the story that gets written up in an article like this. Part of what you want people to understand is the mechanism by which the Bank pegs the Bank Rate.Delete
"Part of what you want people to understand is the mechanism by which the Bank pegs the Bank Rate"Delete
Isn't that explained in the Paul Tucker quote above?
"The alternative way for the central bank to establish itself as the rate-setter is to be prepared to supply (or absorb) whatever liquidity the market demands at its chosen rate(s). The most precise way of doing this is through so-called ‘standing facilities’ in which the central bank lends (secured) whatever is demanded at a fixed rate or takes on deposit whatever is supplied at a fixed rate."
In the world described in the BoE paper:ReplyDelete
- Whenever a bank creates a loan it creates new credit money
- Whenever a loan is repaid it destroys credit money
- Whenever someone converts bank deposits of cash the amount of bank reserves diminishes.
They couch this in terms that are endogenous-money friendly but (if you exclude CB monetary policy) what they describe would be equally true of a model where banks are pure intermediaries. You could describe the process of a loan being repaid to a bank and then a new loan being created (either by the same banks or a different bank who obtains any needed reserves on the interbank market) purely in "loanable funds" terms. All the flows would be exactly the same - the only difference would be the terminology used.
People who talk about "endogenous money" use the "loan create deposits" meme to imply that banks somehow have the unlimited ability to expand the money supply to meet the needs of the economy. But in a world with a fixed base this would not be true. In such a world if the demand for money stayed constant and the demand for loans increased then the ability of the banking system to increase the supply of credit money would be limited.
You really need a CB targeting the interest rate to get this kind of elasticity. If increased demand for loans puts pressure on interest rates then the CB will increase the size of the base and allow the money supply to grow via extra lending. (Of course if this puts its inflation target at risk it will soon adjust the target interest rate and stop the expansion)
- The endogenous money language used in the BoE report probably hinders as much as helps in understanding how banking works, though I don't see it as actually wrong.
- Much of the money supply elasticity that endogenous money likes to focus on is actually provided by boring old CB policy and not by anything intrinsically "endogenous" about the money creation process by banks itself.
"But in a world with a fixed base this would not be true."Delete
Maybe, but that's clearly not the world we inhabit.
"Much of the money supply elasticity that endogenous money likes to focus on is actually provided by boring old CB policy and not by anything intrinsically "endogenous" about the money creation process by banks itself."
The CB provides additional reserves in response to prior credit expansion by banks. Banks expand credit, and then the CB expands reserves, if necessary, after the fact. So the process of money creation starts with banks making loans to 'credit worthy' borrowers who demand the loans. It doesn't start with the central bank injecting a fixed quantity of reserves which the banks can then 'lend out' and 'multiply up' into more deposits.
"Banks expand credit, and then the CB expands reserves, if necessary, after the fact"Delete
I think this is only true if the "if necessary" is taken to mean "necessary to maintain the target interest rate" and not "necessary to allow the banking system to work efficiently".
Day-to-day banks act as intermediaries and need to be able to attract fund to back their lending. An endogenous increase in lending would be driven by an increased desire to keep money in the bank and/or an increased desire to borrow.
If the CB sees it targeted rate under threat (which could happen if demand for loans increased and desire to keep money in the bank stay the same) it will increase base money so that banks can attract more funds.
While CB policy undoubtedly helps banks manager interest rate risk I do not think a successful bank would ever lend on the assumption that the CB will provide needed reserves after the fact, which is sort of implied in the above statement.
"Day-to-day banks act as intermediaries and need to be able to attract fund to back their lending."Delete
Say a bank makes a loan, and creates a deposit in the process, thereby expanding the broad money supply. Essentially all the bank has to do then is manage to pay a lower rate of interest on the deposit than it receives on the loan. So in that sense the bank is an intermediary between the deposit holder and the borrower. However the bank created the 'money' in the process of making the loan, rather than getting money from the depositor and then lending it out to the borrower.
"I think this is only true if the "if necessary" is taken to mean "necessary to maintain the target interest rate" and not "necessary to allow the banking system to work efficiently"."Delete
In general, though it might be a bit of both - as the interest rate target is also related to what is considered to be necessary to maintain financial stability. Also a bank might borrow directly from the CB, in which case the CB would be supporting the bank directly rather than setting an interbank lending rate.
"If the CB sees it targeted rate under threat (which could happen if demand for loans increased and desire to keep money in the bank stay the same) it will increase base money so that banks can attract more funds."
By "desire to keep money in the bank stay the same" do you mean people as a whole want to withdraw more money as currency? In that case the CB would normally buy bonds and issue more currency, maintaining its target interest rate. I'm not sure how that relates to the banks 'attracting more funds' though.
"I do not think a successful bank would ever lend on the assumption that the CB will provide needed reserves after the fact."
Agreed, but they also won't check to see if they currently have enough reserves to 'lend out'. What would be relevant is the assessment of the loan itself and the bank's capital position. Banks do of course also estimate how much cash they think they will need to meet customer withdrawals in the near future, but that doesn't tend to change much, and they can get more cash quite quickly if they need to. Management of reserves required for interbank settlement or regulatory reasons is separate from the loan decision itself.
For someone who doesn't seem to advertise a considerable amount, why the devil is your post confined to such a narrow column? I'll be sending my bill for Carpal Tunnel Syndrome due to all this scrolling. Tl;Dr - please make this easier to readReplyDelete
You're the first one to complain about this, so it never occurred to me that I could fix this. Come to think of it, it's been bugging me too. Like a constant background noise you just get used to.Delete
you can change the settings in the blogger 'design' or 'layout' section, if I remember correctly.Delete
"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."ReplyDelete
In general this is correct. But you might have heard about this recent event sometimes labeled Little Depression or Great Recessions which catapulted a large part of the world out of equilibrium (and a quick glance at the unemployment numbers shows that we are still out of equilibrium).
QE is obviously not so useful in such a case (unless you have some decent intuition about out-of-equilibrium dynamics) and given that most people who predicted the bursting of the bubble on the housing markets made some basic stock flow analysis and did take a look at balance sheets it is also obvious that balance sheets matter a lot while we are not in the tranquil world of the Great Moderation anymore.
spelling error: "GE (general equilibrium) is obviously not so useful"Delete
logic error: "nothing you see is known to be out of equilibrium" Please learn something before you speak.Delete
"Nothing you see is known to be out of equilibrium"Delete
Total nonsense. Even the Walrasian story involves a story in which the economy converges towards equilibrium. You are in dire need of actually reading some Econ 101 and then some Walras and Arrow.
Incorrect. There is no way to know if a pair of price,quantity is in or out of equilibrium. You are a very dim person, and I'm happy you're unemployed.Delete
"...catapulted a large part of the world out of equilibrium"Delete
Equilibrium is not an observation about the state of the world. Part of an economic model is the equilibrium concept, and that model in turn can be used to think about what is going on in the world. And every model has an equilibrium concept - New Keynesian models, new monetarist models, old-fashioned IS-LM models. Whatever. So your statement neither describes the state of the world nor any model one would use to think about the Great Recession.
It depends on your view:.Delete
View 1: Right now there is an excess supply on the output and labour market (I am all ears for your story about 40% - 50% youth unemployment in Spain or Greece that does not work without involve involuntary unemployment). So the labour market is clearly not in equilibrium.
This perspective is useful if you are policy-orientated, focus on employment and the failure of the usual price mechanism that makes excess demand/supply disappear.
View 2: There is a continuum are multiple equilibria and right now we are in one of the worst ones because of the timid policies of central banks and governments worldwide. This view is useful if you are doing theory (multiple equilibria stories are a bit harder to teach laymen than the notion of involuntary unemployment as excess supply) and want to emphasize that a recession is a gigantic market failure.
Of course I know very well that you do not agree with either of these perspectives and thus basically with the very basic of macroeconomics since Keynes and Friedman (I might also mention that Smith and Mill already wrote that what we call today Say's law does only hold in a barter economy) ... but you being engaged in fringe economics is your problem and not mine.
I forgot to point out that besides the excess supply on the good and labour market and the underemployment equilibrium perspective (also forgot to point out that the latter makes more sense if you think that the situation will persist) there have been some brilliant first steps at disequilibrium research back in the days (I am only familiar with Malinvaud's "Theory of Unemployment Reconsidered") which provide in my opinion more insight into the issue than contemporary mainstream models.Delete
"in my opinion more insight into the issue than contemporary mainstream models"Delete
Your opinion is as valuable as the paper it is printed on. Oh, it's not printed on paper? Exactly.
Anger management issues, little troll? Unable to talk about the issue at hand because you have no idea about economics?Delete
I'm not going to get into a discussion about military tactics with the crazy guy on the corner who thinks he's Napoleon.Delete
Great point about treating the financial system as an integrated whole, rather than cherry-picking bits of it for public support and throwing the rest to the wolves. And a great point about the money multiplier. It really isn't a helpful concept - particularly as it seems to be astonishingly badly taught.
I disagree with you on other matters though.
Firstly, about banks as intermediaries: I think the Bank was trying to correct the prevalent view that banks are merely passive intermediaries. They certainly aren't, and I personally welcome the Bank's attempt to explain the rather more active role that banks play in the financial system.
Secondly: it is is technically correct to say that banks don't "lend out" deposits but create new ones when they lend. Whether you think this is economically relevant is a different matter, but it is correct. How lending is all too often taught in economics (and, sadly, banking) courses is not correct. In correcting it so publicly the Bank has done everyone a favour. That doesn't mean that old models have no value, but perhaps people will be a little more careful about their use.
And finally, on monetary policy: I think you need to distinguish between US and UK approaches. The Bank is not incorrect to describe itself as "setting" the base rate. That is exactly what it does. It fixes the rate, then uses open market operations to keep other market rates broadly in line. This is different from the Fed, which alllows the Fed Funds rate to float and uses open market operations to keep it close to target.
banks don't 'lend out' bank deposits because bank deposits are bank liabilities, not bank assets.Delete
Well said, thanks Frances!Delete
"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."ReplyDelete
Do you have a favorite reference?
Actually, no. Sometime I'll write this down and post it.Delete
"lending out deposits"ReplyDelete
I'd suggest reading the redoubtable JKH on this, on this BOE paper, and on the various meanings we might attach to the term "intermediation."
He explains why intermediation can be an apt term to describe what banks do (carefully understood), while it is conceptually incoherent or at least confusing, in accounting terms, to assert that "banks lend deposits":
"which is a strange phrase on its own, with some epistemological head scratching associated with it"
He/she seems to really like the BOE paper. Maybe not so redoubtable.Delete
Martin Wolf obviously clueless about how monetary economies and and accounting work, as well. http://www.ft.com/intl/cms/s/0/46a1ce84-bf2a-11e3-a4af-00144feabdc0.html?ftcamp=published_links%2Frss%2Fcomment_columnists_martin-wolf%2Ffeed%2F%2Fproduct&siteedition=intl#axzz2yVktQsCQDelete
"Propagating Confusion " Spreading alarm & despondency also. Reading this article & comments makes me feel that, economically, I'm in an airplane, and the Pilot & 1st Officer are trying to read an upside-down map while arguing about those little red flashing lights & the blaring klaxon.ReplyDelete
I'm afraid banks really can fund their own loans "out of thin air." They could even fund their own capital out of thin air--although regulators would frown on this.
See here: http://www.cnbc.com/id/100497710
Similarly, when General Motors issues corporate bonds to finance the construction of a new plant, that's creating liabilities out of thin air. To state that banks are doing it too doesn't say anything interesting.Delete
Not all liabilities are the same. Everyone can create money; the problem is to get it accepted (Minsky).Delete
I apologize for my tardy response. I only recently came across MRT’s BoE paper and Mr. Williamson’s response to it. I would like to add some personal notes on misconception #1 – Does the act of lending create deposits?ReplyDelete
The abridged version is that lending creates deposits in situations having the following characteristics.
(1) Lending results in an interbank payment
(2) Bank 1 does not have sufficient reserve balances to settle the payment
(3) The interbank rate is above the discount rate, generating a discount window loan
And this situation can persist only so long as the above characteristics are preserved and the Bank is generating a sustainable net interest margin from such lending activity.
Mr. Williamson’s example uses a scenario where Bank 1 originates a $20,000 consumer loan. The loan is booked as $20k loan (asset) and $20k deposit (liability). This loan expands Bank 1’s balance sheet. The consumer uses the $20k loan to purchase a car from a car dealer who has an account with Bank 2. Since consumer and car dealer use different banks, a bank-to-bank transaction is necessary to settle payment. (Bank-to-bank transactions are settled in each Bank’s account at the central bank. Central bank accounts are commonly called “reserve accounts” and balances in these accounts are “reserves”). The example concludes with some accounting and concludes that the banking system looks exactly the same as initially. So far so good.
The example contains a key assumption: Bank 1 has sufficient balances in its reserve account to settle interbank payments. What would happen if Bank 1 did not have sufficient balances in its reserve account to settle the interbank payments? Well, Bank 1 would have to go to the interbank lending market and purchase sufficient reserves at the interbank rate to bring its reserve account positive. Ultimately reserves move from one reserve account to another and the banking system looks exactly the same as initially. So far so good.
The interbank lending rate is key to answering the question of whether lending creates deposits. Suppose the interbank rate for Bank 1 is higher than the central bank discount rate. (Let’s call this Example 1A). What is Bank 1 to do? Bank 1 will go to the central bank’s discount window (or standing facility if you prefer) to borrow reserves. Importantly, discount window borrowing results in increased reserve balances. The banking system is changed for the duration that the discount window lending is outstanding, which will be determined by Bank 1’s need to maintain a positive balance in its reserve account AND the discount rate is lower than the interbank rate. Thus, the act of lending creates deposits in situations where the loan generates interbank payments and Bank 1 does not have sufficient reserve balances to settle the payments.
Example 1A may be observed when there is upward pressure on the interbank rate and the central bank has yet to respond with either an open market operation or adjustments to one or more of its policy rates: the interest rate on reserves, the target rate, and the discount rate.
The persistence of Example 1A depends on the strength of the economic growth and on the strength of central bank’s policy response (which also might change the banking system, but that’s for another time). Let us define the “strength of economic growth” as a positive net interest margin for Bank 1. This is important because the deposit creation generated by unprofitable lending will eventually result in asset write downs that destroy deposits. Banks must remain profitable throughout the deposit expansion life cycle. Funds must be lent out (revenue) at a rate higher than the cost of funds (expenses) and the revenue must ultimately be realized.ReplyDelete
Example 1A glosses over the temporary nature of deposit expansion. The original loan will eventually be repaid, increasing Bank 1’s reserve account balances, which ends Bank 1’s need to access the central bank’s discount window for reserves. Reserves borrowed from the discount window will be returned to the central bank (destroyed), and the deposit grown will shrink to its original state. And…viola! The banking system looks exactly the same as initially. So everything is good….?
Great discussion in the original article and comments on MRT’s BoE article. I hoped I have contributed to this discussion by illustrating how lending can potentially create deposits when profitable lending results in interbank payments that have to be funded by discount window lending. Perhaps these examples can help inform ongoing discussions!