Wednesday, July 18, 2012

Tim Worstall does not understand money or banking.

Tim Worstall is normally clued up on economics. But not, so it seems, on the subject of money and banks. He says, “No, banks do not create money. The banking system as a whole creates credit. But individual banks do not create money. They just don’t.”

He needs to look up the definition of the word money in a dictionary. It is defined as something like, “Anything widely accepted in payment for goods or serves or in settlement of a debt.”

Now the fact of the matter is that when someone gets a loan from a private bank, the latter does not need to get the relevant money from anywhere: it can just credit the borrower’s account with a book keeping entry – or if you like, it can credit the borrower’s account with money ex nihilo.

And when the borrower draws a cheque on that account or does a credit or debit card transaction based on the account, the cheque or card transaction will be “widely accepted” in payment for goods and services. Ergo the bank has created money.

Here are some quotes on the subject.

"Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created -- brand new money." - Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

"When a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower."

- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

Northern Rock.

Worstall then claims that if private banks can create money “then Northern Rock would not have gone bust, would it?”

The answer to that is that there are an infinite number of grades or types of money: in particular, “Northern Rock money” is not as good as central bank money.

Indeed it was common in the 1800s and before for WEALTHY INDIVIDUALS AND FIRMS to issue a form of money: bills of exchange. The latter were simply I.O.U.s or promises to pay a certain sum on a particular future date. And they were passed from hand to hand in settlement of debts or in payment for goods and services. Ergo bills of exchange were a form of money. And issuers of bills of exchange who conducted their affairs in a competent manner had no problems, while the incompetents ended up doing a “Northern Rock”: going bust.

To summarise, private banks cannot issue a form of money which is as good as gold. They cannot produce a form of money which is as good as central bank money. But they can nevertheless issue a form of money.

Wholesale borrowing.

In the paragraph starting “What Rock actually did…” Worstall claims that Northern Rock funded itself via the wholesale money market: i.e. borrowing from other banks or other institutions.

True: to a large extent it did. But that does not prove that Northern Rock did not in addition create money. In fact for those of us who understand banks, it is obvious that a bank which DOES NOT expand faster than other banks will NOT NEED to borrow from the wholesale markets. While banks that ARE EXPANDING faster than others WILL NEED to borrow. Reason is thus.

When a bank “lends money into existence” as the saying goes, most of that money will be deposited at other banks. And the latter will want central bank money from the former bank in exchange for the former bank’s “funny money”: that’s done at the end of each working day in the books of the central bank. Now if a bank is expanding faster than other banks, it will need to borrow to cover what it owes other banks.

However, if every other bank is expanding at the same rate, the amount of money deposited at the first bank will be about equal to the amount of the first bank’s money deposited at OTHER BANKS. I.e. it all nets out, roughly speaking.

Conclusion: the fact that Northern Rock was borrowing significant amounts wholesale does not prove (a la Worstall) that Northern Rock was not creating money. It is just evidence that that Northern Rock was expanding faster than other banks, which indeed it was.


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