Tuesday, November 29, 2011

Positive Money and what proportion of the money supply is created by commercial banks.

Positive Money advocates full reserve banking. So do I. So I support Pos Mon both financially and with my time. But I disagree with them on a couple of points.

What proportion of money is created by commercial banks?

Pos Mon (and the New Economics Foundation) claim that 97% of money is created by private banks rather than the Bank of England. This figure is based on the fact that 3% of money is physical cash (£20 notes etc).

If monetary base came only in the form of the above cash, then the argument would be valid. But the reality is that a significant portion comes in the form of book keeping entries, or (as is the case nowadays) entries in computers. As far as I can see this amounts to about another 3% during normal times. In contrast, during the current recession, the monetary base in the UK and elsewhere has been significantly expanded.

For example, in the US the base as a proportion of M2 rose from about 12% at the end of 2000 to 27% in Oct 2011. For the figures, see here and here.

The “book keeping entry” portion of the monetary base is not of course strictly speaking in circulation. But nor can it be said to be private bank created.
The process by which this portion of the monetary base comes into existence (using QE for the purposes of illustration) is thus. The Bank of England (BoE) creates money and buys Gilts from X – (person or institution). The latter gets a cheque for the value of the bonds sold. The cheque is deposited at X’s commercial bank and X’s account at the commercial bank is credited. And the commercial bank presents the cheque to the BoE, who credit the commercial bank’s account in the BoE’s books.

The net result is that the money supply is expanded, NOT as a result of any private bank’s money creation activities, but as a result of the BoE’s money creation activities. And the only reason X is not a direct holder of monetary base is that the BoE does not create accounts in its books for anyone apart from very large institutions, like commercial banks. But in effect, X holds monetary base: it’s just that a commercial bank acts as agent for X at the BoE.

Are we reliant on debt for our money supply?

Another claim made by Pos Mon is that we are reliant on debt (owed to banks) for our money supply. The above 97% figure would certainly seem to support this view.

On the other hand, given a about of deleveraging, such as we have had recently, and a consequent contraction of privately created money, it is clear that central banks step in and make up for the contraction of privately created money with an expansion of central bank money (monetary base).

This phenomenon is nicely illustrated by the 2nd chart on page 2 of this Credit Suisse paper.

So are we really “reliant” on privately created money for our money supply? I suggest not. I suggest that what is going on is as follows.

The typical household with a mortgage will be in debt to the mortgage provider to the tune of very roughly £20,000 to £60,000 with only perhaps £1,000 or so in the bank. In other words the average household with a mortgage sees fit to have an amount of debt which is large compared to the amount of debt free money it chooses to hold.

Those households with £20 – 60,000 of debt will of course be balanced by other households or institutions with equally large amounts of cash to spare.
Incurring debt so as to get a roof over one’s head is largely a VOLUNTARY choice, since the alternative and debt free method of getting a roof over one’s head is to rent. Indeed, this ties up with law of reflux and the real bills doctrine which state that each private sector entity incurs the amount of debt it WANTS, or regards as appropriate, or regards as best suiting its needs.

To summarise, commercial banks provide what might be called a “debt transfer” service. Those debts are widely regarded as “good” because they are backed by respected institutions: large banks. Thus these debts are a form of money.

AS IT HAPPENS, these debts provide the economy with nearly as much money as it wants or needs. But if the population were particularly keen on incurring NO DEBT, the money supply would not shrivel up: the central bank would just step in and issue the amount of money required to keep the economy ticking over.

Do we “rent” our money supply?

Pos Mon, or at least a proportion of Pos Mon minded folk, promote the idea that because people pay interest on debt, and because that debt is a form of money, that therefor we “rent” our medium of exchange. I disagree.

The rent paid here is the rent paid by debtors to creditors. If the creditor is NOT A BANK, chances are that the debt does NOT become a form of money. Money is anything widely accepted in payment for goods and services. For example, where firm A supplies firm B with goods, a debt is than owed by B to A. And part of the agreement between the two may involve interest to be paid by B to A if B is late in paying for the goods. But this debt is not a form of money because it is not easily transferable: it is not widely accepted in payment for goods and services.

And borrowing, lending, debts, etc would continue after the introduction of full reserve, as Pos Mon admits. Put another way, if you have money in your bank account, you are, to that extent, a creditor. But you don’t pay “rent” for the privilege of possessing this money do you? Quite the reverse: other than during the very low interest rates that currently obtain as a result of the credit crunch, you probably get some interest. I.e. the bank PAYS YOU!!!!

Conclusion: debtors normally pay interest to creditors, but posessors of the money created by commercial banks do not pay rent to such banks for the privilege of being supplied with a medium of exchange.


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