Thursday, March 13, 2014

When a bank makes a loan, does it create money?

Bank of England staff (Messers McLeay, Radio and Thomas) have just published an article entitled Money Creation in the Modern Economy. The article claims that the textbook view of banks (i.e. that they accept savers' money and lend that on to borrowers) is flawed. Rather, so they claim, banks extend loans first, which in turn creates deposits.
The article itself gets near to contradicting itself when it says that when a bank extends a loan, that will lead “..other things equal, to increased inflationary pressure..”. And that in turn means the central bank has to raise interest rates, which lo and behold, will cut lending. Ergo, if the economy is at capacity, a bank cannot make a loan worth $X unless someone has saved up $X. Thus the textbooks, which the article criticises, do have a point.
That apart, the article is decent bit of work.

On p.1 the BoE article says “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money”. And on p.2 they say, “This article explains how, 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.”
And in much the same vein, the article says “The reality of how money is created today differs from the description found in some economics textbooks. Rather than banks receiving deposits when households  save and then lending them out, bank lending create deposits.”     
However, the article itself casts doubt on the above “money creation” idea. On page 7 the article rightly says that the above new money created by new lending can be immediately destroyed if the recipient of the new money uses that money to repay a debt owed to a commercial bank.
Alternatively, and as the article puts it, the new money “may continue to be passed between different households and companies each of whom may, in turn, increase their spending. This process — sometimes referred to as the ‘hot potato’ effect — can lead, other things equal, to increased inflationary pressure on the economy.” Again, quite right.
Now if the latter inflationary effect does materialise, obviously government and/or central bank will attempt to negate that inflationary effect. For example, the CB might raise interest rates which is supposed to reduce borrowing and lending. Indeed, if the latter reduction exactly equalled to above alleged new money creation, then there’d be no net inflationary effect and no net money creation!
To summarise, if an economy is at capacity and a commercial bank extends a loan worth £X, that will not be inflationary if someone else brings about an equal and opposite “anti-inflationary” effect by saving up £X. In effect, then, the “economics textbooks” which the article criticises, are not entirely wrong. That is, assuming an economy is at capacity and in equilibrium, then as the textbooks claim, if non-bank entity saves £X, that enables some other non-bank entity to borrow £X.

However, commercial banks do create money.
But that’s not to say that the notion that commercial banks create money is completely invalid. In particular, if commercial banks set up  in what had hitherto been a barter economy, those banks’ initial activity would consist of accepting collateral from those wanting a stock of money, and crediting the accounts of the latter individuals.
So long as those individuals simply wanted a float of £Y (with the actual balance in their accounts rising above £Y as often as it fell below £Y), then no long term lending would take place. And that activity obviously constitutes money creation.
Likewise, given real economic growth, and assuming the private sector’s desire for “floats” rather than genuine loans expands in line with real economic growth, then commercial banks would create money in line with that economic growth.

Another flaw.
Another flaw in the idea that extending loans creates money is as follows (or perhaps this is just another way of making the points made in the above paragraphs)
A loan is the transfer of wealth from one entity to another, the intention of both parties being that the wealth is returned at some point, and with the initial recipient of the wealth normally paying interest to the donor.
Now in the above mentioned “creation of floats” scenario, banks do not transfer wealth to so called borrowers. Reason is (to repeat) that assuming we’re talking about genuine floats, the actual balance in “float owners’” accounts will rise above the above mentioned £Y as often as it falls below.
In contrast, in the case of a genuine loan intermediated by commercial banks, and assuming the economy is at capacity, then a bank cannot extend a loan worth £Z unless someone saves £Z, as explained above. And in that case, clearly no money creation takes place.
Ergo, extending loans does not create money.

Is commercial banking inherently inflationary?
A separate and interesting question is that as to whether in the absence of a gold standard and absent the above mentioned control of inflation exercised by central banks and governments, the money creation activities of commercial banks would lead to excess inflation. I haven’t got my head round that one yet!


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