Saturday, 15 June 2013

Endogenous Money and "Out of Thin Air" Money



I often hear comments confusing the endogeneity of money with the idea that banks create money "out of thin air".  Although these two ideas are connected, that are not the same and one does not imply the other.

In particular, there seems to be a belief that an essential feature of money being endogenous is that banks can make loans without needing deposits first.  This is not correct.  Even if loans were only made out of previously deposited funds, monetary growth would still be determined in substantially the same way.

We can illustrate this with a little thought experiment.

Imagine that a law is passed under which banks are strictly prohibited from making loans by crediting deposits.  Any new credit must involve the bank handing over physical cash to the borrower.   People could still make payments by bank transfers from their current accounts, but not if it involved going overdrawn.  Instead, such people would have to borrow physical cash from the bank, then deposit it into their current account, before drawing on it.

In such an arrangement, it would be impossible for a bank to make a loan without having first taken a deposit (or received cash through some other means like stock issuance).  Does this mean that the loans are now constrained by deposits?  No, at least no more than it did before.

In the example above, the bank pays out cash in place of allowing an overdraft (using cash from a previous deposit).  The cash is then deposited back with the bank, so the borrower can make transfers from it.  This leaves everyone in exactly the same position as if the bank had simply credited the borrower's account.  The bank now has the cash again to make another loan, and then another, ad infinitum.

It makes no difference to this argument if the borrower deposits the cash with another bank.  The only way that cash will not flow back to the banks is if the non-bank public decides to start hoarding it and there's no reason to suppose that they will automatically do so in response to an increase in lending activity. 

This latter point is no different to the way things work in the real world, where banks make loans by crediting accounts.  The ability to do so without limit depends on the public retaining their new money in the form of bank deposits.  If the public suddenly decided to start hoarding cash, withdrawing the balance of their newly created deposits, banks would cease to be able to make new loans.

In our thought experiment, as well as in the real world, it is the interaction between banks and borrowers that is driving money creation.  Regardless of the actual mechanics of making loans, it does not require a spontaneous decision by depositors to increase savings for an expansion in the money supply to occur.  The endogenous nature of money does not depend on the fact that banks can make loans without having taken deposits first.

The reasons for the growth or otherwise of private money lie in the budget decisions of economic agents, not in payment mechanics.  Money growth is a result of the pressure created by when the equilibrium between non-banks wanting more debt and banks prepared to take on more risk implies a higher level of loans.  Even if deposits must proceed loans, that pressure is still there and balances will move towards the equilibrium position.

I have glossed over practical issues, because I don't think they affect the argument, but I should say something on these.  Obviously, having to make all loans in cash would raise some practical considerations.  It would also mean that the amount of cash holdings of banks and non-banks would probably need to be significantly larger than is currently the case.  If the monetary authorities attempted to constrain lending by restricting the supply of cash, this could potentially slow up the pace of money creation, even if it did not change the final equilibrium.  However, this is not very different from using monetary base control methods in the real world.

The way banks create money "out of thin air" is certainly a useful thing to understand, but in terms of considering the endogeneity of money, it is nothing more than a red herring.

7 comments:

  1. Instead of saying that thin air money creation is a “red herring”, I suggest it would be accurate to say that the thin air method of money creation is one way of creating money, while the lending of physical cash (which is then deposited and re-lent) is another.

    It’s a bit like saying that a ban on public transport would be a red herring in that almost everyone has a car nowadays. That would be a true statement in a sense. But I prefer the statement that public transport is one form of transport, and cars are another.

    The full reserve systems advocated by Positive Money, Laurence Kotlikoff and others actually recognises the above two separate ways that commercial banks create money. That is, under PM and K’s systems, any sums loaned out must be central bank created money. Second when a depositor opts to have their money loaned on by their bank, the depositor then loses access to cash. For example under K’s system, the depositor gets a stake in a unit trust in return for the cash they’ve given up.

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  2. Maybe.

    I used the term because I wanted to stress that there is more to endogenous money than the book entry "trick". It seems to come up quite a lot and I can see why it can seem surprising to some people, but I really don't think much rests on it. As you say, money can just as easily be created by cash circulation (and again it's the lending leg that creates money, since cash held by a bank isn't money).

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  3. This is a good point to be made, indeed. That being said, I find vocal opponents to this system (such as rothabrdians) to be focusing on the supposed immorality of this mecanism where the same token of currency appears both in a depositor's account and in a borrower's account at the same time. My question is then: is there a historical record of this phenomenon that would tell whether this mecanism spontaneously appeared among free bankers on a free market in response to individuals' demands (hence legitimizing it even for hard-core libertarians) or whether it was some sort of government/crony bankers invention popularized through legal coertion ?

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  4. I'm afraid I'm not very good on the history side of things, but I believe this arose quite naturally. All it requires is for the borrower to accept as loan proceeds the IOU of the lender, rather than the IOU of someone else. If the lender is a good credit, that shouldn't require coercion.

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  5. Thank you for you answer. This is my view as well because if banks were forced to be 100% reserves, they would be akin to cash warehouses, and one should pay them a fee just to deposit money in their vault. Provided you trust your bank, authorizing it to lend out an IOU of the same nominal value of your deposits grants you interest on your account: that sounds like a better deal, and I would not be surprised if people willingly engaged in such transactions, hence making endogenous money supply a creature of free markets. Furthermore, even if one considers such a system to be immoral, he/she can still hoard cash under the mattress, buy gold or simply buy treasuries, the issuer of currency then supporting all the risk tied to banks IOUs.

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    1. Jean: You are mistaken in the effect. It is not a free market choice in the sense that not all market participants can engage in the process of endogenous money creation any more. I as a market participant, cannot just get an excel spreadsheet out and create a balance sheet, then start lending to my friends directly via the CREST payments system. Even if I met all the Basel III capital adequacy rules. This is a state organised oligopoly.

      Imagine what would happen to society in general if by virtue of having £10,000 in actual cash, then going down to the Bank of England and depositing this into the inter-bank accounts, I could then simply lend my friend £400,000 for a home and charge him 5% p.a. on my original £10,000 (i.e. £500 p.a.). I don't think many people would use the banks... They would also find out extremely quickly just how inflationary this fundamental system really is. Or perhaps, my friend also does the same, we simply cancel the debt and keep the new deposits. Thereby increasing our total share of the whole money supply.

      As you can practically say, endogenous money cannot survive in a proper working free market society.

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    2. you'd be getting 20,000 per annum from your friend wouldn't you?

      other than that, thanks for getting so straight to the point!

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