In a previous article I argued that the money-out-of-thin-air meme does not provide a solution to our banking and monetary problems. Unfortunately, this meme has been accepted uncritically by people who don’t know much about finance. Where did they get this idea you ask? I believe it was sold to them. By whom? Probably by the parties who stand to benefit from it. Since the suggested remedies for this invented problem tend toward controlling the money supply I would guess these parties have something to do with financial markets.
Among those currently propping up this lie can be found so-called experts in the field of finance. Their expertise is based on the fact that they have worked in that field; their trustworthiness is based on the fact that they claim to have been converted to the progressive cause. They have seen the light, so to speak. One of these financial experts is a woman who once worked for five of the banks involved in the 2008 financial crisis. Her story goes something like this:
A young, attractive female bank employee becomes disillusioned and decides to quit her job. She immediately begins to write books exposing her former employers. Her books are wildly successful. She soon becomes the toast of the town, jet-setting around the world for research, speaking engagements and book tours, and incidentally, taking meetings with presidents, prime ministers and various people of consequence. In the process she manages to pull a globalist’s perspective out of her hat, with which she seamlessly fits everything together. Add to this unlikely scenario the fact that she is one of the leading promoters of the money-out-of-thin-air meme, and you might begin to suspect, as I do, that she is a banker in progressive clothing. I suspect she may be setting us up for the next financial coup.
On June 10 the people of Switzerland will vote on the Sovereign Money Initiative. This initiative is wrong-headed at best and attempted robbery at worst. But to people who believe that our banking problems can be solved by controlling the amount of money created by banks, it might look like the solution. I tried to refute that view by explaining that uncontrolled capital flows are the problem. Controlling capital is not the same thing as controlling money. Historically, capital controls have allowed politicians to work for the good of the people on policies promoting full employment and higher wages. Monetary controls have inevitably led to austerity.
An analysis of the proposed initiative was written by Philippe Bacchetta and published in the Swiss Journal of Economics and Statistics in January of this year. For anyone interested in the technical details of this analysis, Bacchetta includes historical charts and calculations. (And for an additional discussion of this issue, the Real News Channel on YouTube has published a series of three videos. The link to the third video is provided below.) However, what I would like to focus on here is Bacchetta’s discussion of money creation. To summarize his argument, the idea that money creation comes largely from the granting of credit by commercial banks is a mistake. The close relationship between money and credit is not verified at the macroeconomic level.
Bacchetta’s analysis begins with a brief description of the initiative. The Swiss initiative for monetary reform would limit the issuance of sovereign money, including banknotes and scriptural money from non-banks, to the Swiss National Bank (SNB). (Scriptural money means sight deposits included in the M1 category of money. Sight deposits are deposits that can be withdrawn immediately without notice or penalty. M1 is an aggregate that originally meant currency plus demand deposits in commercial banks.) The reform would imply that all sight deposits in Swiss francs would be transferred outside commercial banks’ balance sheets and would be deposited at the SNB. The SNB would control the quantity of these sight deposits. The initiative also proposes that the SNB distributes funds to the state or directly to households. These funds would come from the existing sight deposits the SNB receives and from new money creation.
The initiative has been compared to a full reserve requirement, but Bacchetta argues that it goes much beyond that, and it would impose severe constraints on monetary policy. Therefore, it would weaken financial stability rather than reinforce it. It would also decrease trust in the Swiss monetary system. That said, it’s not surprising to learn that several arguments which claim to support the initiative are inconsistent with empirical evidence or economic logic.
It is first useful to mention the debate about the role of banks in the creation of money. One can distinguish between two perspectives. On the one hand, banks can create deposits when granting loans. This is well explained in textbooks when explaining the money multiplier (even if the money multiplier examples are unrealistic). On the other hand, banks serve as intermediaries between deposits and loans. As explained for example by Tobin (1963), these two perspectives are totally consistent. In equilibrium, the amount of deposits created by banks has to be equal to the amount desired by depositors. And the central bank can influence this equilibrium.
However, there is a group of people that only accepts the first perspective and rejects the second one, which is obviously incorrect…. It is therefore claimed that banks create money ‘out of thin air’ (aus dem nichts) and claimed or given the impression that banks can freely decide how many loans and deposits to issue. In this context, the sovereign money supporters find this freedom unacceptable and consequently believe that the central bank should control sight deposits. But this belief is based on the incorrect view of ‘monetary mysticism.’
Before turning to an example and to empirical evidence to clarify the issue, two comments are worth making at this stage. First, the above discussion only talks about credit and deposits. If these are the only items on banks’ balance sheets, there should be a full correlation between these two variables. But there are other assets and liabilities on commercial banks’ balance sheets, which naturally weakens the link between loans and deposits. For example, loans can be matched by non-deposit liabilities or by a decline in other assets. The second comment is about the Bank of England article by McLeay et al. (2014). Even though this article is supposed to clarify the issues related to money creation, its ambiguous wording is actually creating more confusion. The article is very much in the line of Tobin (1963) that integrates the two perspectives on money creation mentioned above. However, the way the first pages of the article are written initially gives the impression that only banks determine the amount of deposits through their loans. This is the reason why supporters of monetary mysticism cite McLeay et al. (2014) as supporting their view. But this is not the basic message of that article.
Bacchetta goes on to say that while it is true that a bank can increase the quantity of deposits when it provides a loan, this is only true of the initiation of the loan.
Assume I want to buy a house and I ask a mortgage loan from my bank. When my bank grants me the loan, the funds are available on my checking account. So in this initial operation, my bank indeed increases money. Then, I transfer immediately the funds to the seller of the house, who has an account in another bank and will see an increase in her checking account. If the seller keeps the funds in the checking account, her bank can use the funds to make a loan, as it happens in textbook examples of the money multiplier. But assume that the seller does not want to keep these funds in her checking account, as it bears a low interest, and transfers them to interest-bearing instruments of her bank (e.g., time deposits, bank bonds, savings account). Then at the end of the day, my mortgage loan has no impact on the quantity of checking accounts and on M1, as my loan is matched by an increase in interest-yielding assets of the seller. In other terms, there is no obvious link between credit and sight deposits even when considering a single loan…
As illustrated by the previous example, in general, money is not generated by credit. This is confirmed by macroeconomic data. As mentioned in the Introduction, Schularick and Taylor (2012) document a decoupling between broad money and credit since World War II. This is also true for M1 and credit for Switzerland.