Friday, October 7, 2011

What proportion of the money supply is created by commercial banks?

I like the ideas in this paper authored by Prof.R.A.Werner, Positive Money and the New Economics Foundation. But I’ve got a technical quibble about the proportion of the money supply that is created by commercial banks.

Pos Money and NEF argue that because about 3% of the money supply is physical cash (£20 notes, etc), therefor about 97% must be commercial bank created money.

That point would be valid if physical cash was the only form of monetary base. But it’s not: there is also book keeping entry type monetary base: i.e. bank reserves.

NEF claim that “central bank reserves do not actually circulate in the economy” which is their reason for not counting reserves as part of the money supply. I beg to differ, and for the following reasons.

Suppose I have government debt which reaches maturity tomorrow. I’ll get a cheque from the central bank tomorrow for the relevant amount, which I then deposit at my commercial bank. And the latter than presents the cheque to the central bank, which then credits the account of the commercial bank in the books of the central bank.

I can then transfer £Y of my recently boosted bank balance to person X. And the central bank, as part of it’s role in helping commercial banks settle up between themselves, will transfer £Y from my commercial bank’s account at the central bank to the account (in the central bank’s books) of the commercial bank where X keeps his money.

Now the above transfer is no different to the transfer of commercial bank created money between two individuals (and hence between their commercial banks). Put another way, when I get monetary base as a result of my government debt maturing, I then in effect have money stored at the central bank. As to transferring this money to someone else, it just happens (because of institutional arrangements) that commercial banks act as “go betweens” when it comes to transferring this money. But effectively, the chunk of monetary base concerned is part of the money supply “circulating in the economy”.

But that doesn’t detract from any of the basic points made by Pos Money or NEF. It’s just that I think their 97% figure is a bit out. Since bank reserves are roughly 3% of total money supply (far as I can see – which is not very far) I am saying the figure should be about 94%. Though at the moment, bank reserves are somewhat bloated, so the figure will currently be less than 94%


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