Lars P. Syll — How money is created

David Graeber and the Bank of England.

Lars P. Syll’s Blog
How money is created
Lars P. Syll | Professor, Malmo University

Bill Mitchell — Central bank propaganda from the US

Most regular readers and those who understand MMT already know this, but it is a good summary of the correct versus the erroneous notion of banking operations.

Bill Mitchell – billy blog
Central bank propaganda from the US
Bill Mitchell | Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at University of Newcastle, NSW, Australia

Don't 'bank' on that econ textbook

If I had a dollar for every time an economist says something wrong about the modern economy, I'd be able to buy up an entire economics department (a-la Koch brothers).

In many of my previous posts in this blog, I've detailed how economists chronically misunderstand debt, deficits, interest rates, inflation, and trade. But so far I've ignored what is probably the biggest gaping hole of knowledge in the economics profession: the retail banking system. There is almost a laughable difference between the way economists explain banking, and the way that people who actually work in banking know how the system operates.

Economists remain wedded to very outdated, stylized views of banking that ceased to exist a long time ago. The overly simplistic money multiplier is perhaps the most inaccurate of these views. You've probably heard an economist describe banks as special kinds of private businesses that take money from savers/depositors, and recycle that money back into the economy through lending. This is called 'fractional reserve banking', which, like competent leadership of the Washington Redskins, has not existed for decades.

Banks have a very important role in the US economy. The government has empowered them with the ability to make loans based on creditworthiness and public need. In the simplest terms, modern US banks are credit allocation utilities, and serve as our conduits into the federal government's payment system.  Our modern economy would not exist without either of these facilities, especially the payments system. If you have ever used cash, check, debit, or ACH to acquire a good or service, then you have used the federal government's payment system. This payment system consists of wires between banks, which allows the deposits of difference banks to clear at par (face value). For example, if a customer of Bank A writes a $100 check to a customer of Bank B, then $100 is debited from Bank A's dollar account at the Federal Reserve, and credited to Bank B's dollar account at the Federal Reserve. Just like we have tubes and wires for water, sewer, cable, phone and internet, banks are tubes and wires for money. And just as competition among utilities leads to bad outcomes (duplicative infrastructure and poor service), competition among bankers for lower and lower lending standards leads to other bad outcomes (financial crises).

When it comes to lending, this is the arrangement: The federal government allows licensed banks to create an infinite amount of money out of thin air, and charge interest on it. The federal government also allows the liabilities created by individual banks to clear at par with each other, via the interbank payment system (Fedwire), and insures these liabilities (through the FDIC). Depending on the temperament of the bankers, and the state of the economy, banking can be a very easy and profitable enterprise. For example, in the old days of basic S&L banking, people used to joke about the "3-5-3 rule." Bankers would take in deposits at 3% interest, make mortgages at 5% interest, and be on the golf course by 3pm.

In exchange for these privileges, banks have to comply with the regulations that the federal government writes for them. These regulations can be roughly grouped into three categories: prudential (protecting the safety and soundness of the banks themselves), consumer protection (protects consumers from being ripped off by banks, mainly through disclosure requirements), and a group of rules called the 'Bank Secrecy Act', which prevent money laundering, and allow government agencies to monitor and track potential terrorists.

When a US bank makes a loan, the loan officer simply keystrokes a new deposit into an account. So when banks lend, they create their own liabilities, which themselves are not US dollars. This bank money is denominated in US dollars, and is cleared by US dollars, but it is not US dollars. This is crucial to understanding the banking system. Only the US government can create a US dollar, which is its own distinct liability. Banks cannot create US dollars, since dollars are not their liabilities. Banks create bank money, which are their own liabilities. So while bank lending does create new money, it does not create new US dollars. Only deficit spending from the US federal government can create new US dollars. Therefore, the amount of US dollars in the world does not change as the result of bank lending. When a bank orders cash to fill its ATM, its dollar account at the Federal Reserve is debited by the same amount of cash as it receives. The size of this Federal Reserve account is not affected by lending. This is the same account that is used to maintain reserve requirements and make payments to other banks on behalf customers.

For example, if you get a $250,000 home loan at Wells Fargo, you receive $250,000 in your Wells Fargo checking account. This money is your asset, and the bank's liability. In exchange, the bank creates the mortgage, which is their asset and your liability. This is called dual-entry accounting, and is the best way to understand modern banking. When you pay off the mortgage, this process happens in reverse. The deposits created by the loan are destroyed, and the mortgage disappears. Both your and the bank's liability vanish once the mortgage is paid off in full.

Banks are not part of the private sector, since they could not exist without the Federal Reserve System and deposit insurance provided by the FDIC (to say nothing about how the Fed and Treasury rescued the banking system in 1933, 1991, and  2008/9 -plus every time the FDIC puts a failing bank into conservatorship). Banks also do not recycle your deposits into loans. In modern times, banks are infinitely funded, and only rely on deposits as one source of liquidity. This bloody brilliant paper and a video from the Bank of England (the central bank of the UK) confirms exactly what I am saying here.

As members of the Federal Reserve System, banks can always get the reserves they need to meet reserve requirements, from the federal funds market, the discount window, or overdrafts. Since the Fed itself mandates these reserve requirements, the Fed also always provides the reserves necessary for these requirements to be met. Since we are no longer under a gold standard, the Fed does not have to worry about its liabilities (reserves/dollars) being called in for gold, and can therefore flexibly create/lend these reserves as necessary to meet the requirements it imposes. As the requirer and monopoly issuer of these reserves, the Fed always provides them in infinite amounts, but at certain and variable prices which are voted on by the Federal Open Market Committee. This price of these reserves is what people usually refer to as 'interest rates.'

Note that reserve requirements are entirely different from capital requirements. Reserve requirements are about setting monetary policy. Capital requirements are prudential measures intended to maintain the safety and soundness of the banking system.

At its core, retail banking is a simple activity, with best practices that are well known and established. Like other utilities, it should be a boring and marginally profitable enterprise. The US used to have such a simple, sound banking system in the five decades after the Great Depression. Then, when a fever of deregulation took over in the 1980's, banking was unleashed into the wild, rapacious, and highly profitable business of rent extraction that it is today.

If you've reached the end of this blog, congratulations! You now have a better understanding of the banking system than many economists. Now feel free to use that overpriced textbook as kindling or to even out a wobbly chair.

Yves Smith — Steve Keen: The ECB’s Eurozone Medicine is Nonsense

Yves here. While the impetus for Steve Keen’s post is the ECB’s latest pretense that it can and is doing something to combat deflation, he provides an excellent and short debunking of two widespread misconceptions about money and banking. The first myth is the money multiplier and the second is that reserves are the basis for bank lending.

Naked Capitalism
Steve Keen: The ECB’s Eurozone Medicine is Nonsense
Yves Smith

circuit — On the (ir)relevance of the money multiplier model: The Fed view

Documented summary of the Fed's position as stated by a number of officials versus the conventional economics textbooks' account.

Fictional Reserve Barking
On the (ir)relevance of the money multiplier model: The Fed view
circuit

Ramanan — Jackson Hole Symposium Starts With The Money Multiplier

Robert Hallfrom Stanford University in the first talk titled The Natural Rate of Interest, Financial Crises and the Zero Lower Bound:

… Every economic principles book describes how, when banks collectively hold excess reserves, the banks expand the economy by lending them out. The process stops only when the demand for deposits rises to the point that the excess reserves become required reserves and banks are in equilibrium. That process remains at the heart of our explanation of the primary channel of expansionary monetary policy …

The Case for Concerted Action
Jackson Hole Symposium Starts With The Money Multiplier
Ramanan

Really.

Randy Wray — Banks Don’t Lend Reserves! Who Knew? MMT, That’s Who!

OK so it took almost four decades but finally the mainstream is waking up to the fact that banks do not “lend out” reserves (except to one another in the fed funds market). The whole “deposit multiplier” story that was taught in every American money and banking textbook is wrong. Always has been wrong.
(Just an aside: the mistake was largely an American deal. British students got to use Charles Goodhart’s text, which always got it right. But generations of Americans as well as foreigners who studied in America were misled by our textbooks.)

If our policymakers who art in Washington understood this, we would not have got QE. Or all the hyperinflation hyperventilating by those who fear that the trillions of dollars of excess reserves will get “lent out” and cause prices to go to the stratosphere.
Banks do not “use” reserves as the raw material for loan-making. Rather, they lend out their own deposits, which are created by keystrokes. Post Keynesians have been saying this since a seminal piece by Basil Moore was published in 1979 (and it is easy to find early precursors all the way back to the dawn of time–as I demonstrated in my 1990 book, Money and Credit in Capitalist Economies).

Economonitor — Great Leap Forward
Banks Don’t Lend Reserves! Who Knew? MMT, That’s Who!
L. Randall Wray | Professor of Economics, UMKC

Paul Sheard — Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves

"Although the "money multiplier" view of central banking and credit creation is the dominant one, largely I would posit because its pedagogical attractiveness makes it a "dominant meme," other schools of thought have long existed in economics and have come to the fore more recently in the guise of "modern monetary theory (MMT)." See, for instance, Wynne Godley and Marc Lavoie, 2007: Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth (Palgrave Macmillan); L. Randall Wray, 1998: Understanding Modern Money: The Key to Full Employment and Price Stability (Edgar Elgar); L. Randall Wray, 2012: Modern Monetary Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (Palgrave Macmillan)". — endnotes, p. 12

Standard and Poor's — Ratings Direct
Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves
Paul Sheard | Chief Global Economist and Head of Global Economics and Research, New York
(h/t y in the comments)

John Carney — An outdated monetary policy model stirs fears of Fed policy

John Carney debunks the myths about reserves, money supply, bank lending, and inflation. Will will the people who need to hear it, like Rick Santelli and the Zero Hedgies, read it?

CNBC NetNet

An outdated monetary policy model stirs fears of Fed policy
John Carney | Senior Editor

Stubborn Mule — Wall of Liquidity

Sean Carmody debunks the myths of "cash on the sidelines" and the "wall of liquidity."


Wall of Liquidity
Stubborn Mule

circuit — Does the endogenous nature of money weaken the case for NGDP targeting?

Conclusion

The point of this post is simple: the arguments concerning the endogenous nature of money and the irrelevance of the textbook multiplier do very little to challenge the case in favor of NGDP targeting (or inflation targeting, for that matter) and the general theoretical construct used by market monetarists. As I've shown, the case for NGDP targeting can be made (at least theoretically) using a quantity theory approach that is consistent with the endogenous nature of money.

Therefore, from a debating standpoint, those who support a functional finance approach to economic policy would be better served by focusing their efforts on challenging notions such as the natural rate of interest and in demonstrating the inadequacies of an approach to monetary policy whose monetary transmission mechanism relies largely on the portfolio balancing effect. While the issue of the natural rate is largely a theoretical problem (Does it exist? Can it be measured?), the question of the portfolio balance effect is essentially an empirical issue (Is the portfolio rebalancing effect substantial? Can the central bank control it for policy purposes?)

As for the bloggers and economists who think that post-Keynesians and MMT economists are wrong about the endogenous nature of money and its implications for central bank operations, I would suggest they review the work of Robert Hetzel. His take on these matters is in line with the post-Keynesian/MMT view.

Fictional Reserve Banking
Does the endogenous nature of money weaken the case for NGDP targeting?
circuit

Joshua Wojnilower — Quote of the Week... Fed: Money multiplier mistaken

Fed paper admits the money multiplier is flat out wrong.

Bubbles and Busts
Quote of the Week...
Joshua Wojnilower

Peter Stella — Level of bank reserves at a central bank not linked to loan growth

Scott Fullwiler tweets, "Peter Stella, former IMF; yet another of the few that understand the money multiplier is wrong h/t @edwardnh[arrison]

Read it at The Financial Times | Letters
Level of bank reserves at a central bank not linked to loan growth
From Dr Peter Stella | Former chief of the monetary and foreign exchange operations and central banking divisions at the IMF

Scott Sumner — Do you believe in the money multiplier?

The Money Illusion
Do you believe in the money multiplier?
by Scott Sumner

Fullwiler thrusts at the heart, Krugman attempts to parry and riposte

Read it at New Economic Perspectives
Krugman’s Flashing Neon Sign
by Scott Fullwiler | Assoc. Prof., Wartburg College

Read it at The New York Times | The Conscience of a Liberal
Things I Should Not Be Wasting Time On
by Paul Krugman | Professor, Princeton University

This has legs. New Keynesian Krugman is in for the battle of life now with the Post Keynesian monetary economists on his case. This is an old feud among Keynesians going back to John Hicks and Paul Samuelson's "bastardization" of Keynes in PK eyes, and now it is payback time. Expect more heat as the proponents of endogeneity attempt to administer the coup de grace to monetarism's exogenous quantity theory. But the monetarists are not going down without putting up a fierce fight.

UPDATE: Scott informs me that he has responded to Krugman's riposte at the beginning of the post cited above. Here it is for convenience.

Update: Paul Krugman has posted a reply to this post that is a straw man. He and Nick Rowe are viewing this all through the lens of the old Monetarist/Keynesian debates in which there was a choice b/n interest rate targets and monetary aggregate targets; the Monetarist critique assumed the Keynesians were going to keep interest rates at the same level forever and not change them. Once John Taylor came up with his “rule,” everyone agreed an interest rate target could work.

What we are talking about here is operational tactics–the CB can only target an interest rate. It cannot target a reserve balances or the monetary base directly. But that is different from strategy–that is, WHERE the CB puts its target and WHEN it chooses to change the target. There is NOTHING in anything I’ve ever said or anything any PK’er, MMT’er, etc., has ever said that suggests the CB can’t set the target wherever it wants whenever it wants. The point is that whatever the target is, THAT is what its daily operations defend directly, not a monetary aggregate, not the monetary base, not reserve balances. There is nothing in anything I’ve said that would preclude the CB from running a Taylor’s Rule type strategy, for instance, that responds at any point in time endogenously to the state of the economy. That is, the target rate is an exogenous control variable (i.e., it is necessarily set by the CB) that it sets endogenously in response to economic events.