. Bank Created Credit | London Progressive Journal
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Bank Created Credit

Tue 25th Mar 2014

For those of us who have argued for a long time that orthodox monetary policy is fundamentally misconceived, a significant milestone was achieved this week. In an important paper published in the Bank of England Quarterly Bulletin*, three Bank of England economists have acknowledged that the overwhelmingly greatest proportion of money in the economy is created by the banks out of nothing.

This finding comes as no surprise to that growing number of economists and others who have recognised, as a consequence of simple observation, that this is the case. But it will no doubt be hotly denied, in the face of all common sense and evidence, by those (including bankers themselves) who, for reasons of self-interest or sheer ignorance, continue to adhere to the classical view that banks are simply intermediaries between lenders and borrowers.

The great British public is itself the victim of the confusion and obfuscation that has surrounded this issue for generations. Most people, if asked, will tell you that what the banks do is to lend out to borrowers the money that is deposited with them by savers. On this analysis, there is nothing particularly special about banks; they simply charge for the service they provide in bringing savers and borrowers together.

The truth, however, now conceded by the central bank, is very different. The banks enjoy a most spectacular and surprising monopoly power. They alone are able to create new money - vast quantities of it - by the stroke of a pen or, in modern terms, by pushing a key on a computer keyboard.

When a bank lends you money, it simply makes a book entry that credits you with an agreed sum; that sum represents nothing but the bank’s willingness to lend. The debt you thereby owe the bank does not represent in any sense money that was actually deposited with the bank or the capital held by the bank. Nevertheless, when it arrives in your account, and you use it to spend or invest, the overall money supply is increased by that amount.

The only attempt to regulate the volume of new money created by the banks comes through raising or lowering interest rates - a power exercised not by government but sub-contracted to - you’ve guessed it - another bank.

This means that, in practice, the only limit on bank lending is their willingness to lend to applicant borrowers at whatever the current rate of interest may be. The size of the market which provides the huge profits enjoyed by the banks is, in other words, decided by the banks themselves and their assessment of, and willingness to accept, the degree of risk involved.

There will, in the search for the ever higher profits to be made from lending more and more of the money which they themselves create, always be the temptation to lend more than is prudent in their own interests or desirable in the wider interest - and that is how the global financial crisis came about.

The astonishing feature of this monopoly power enjoyed by private companies seeking profits for their shareholders is that their decisions as to how much and for what purpose money should be created, made with virtually no external control or influence to restrain them, constitute by far the single greatest (and potentially distortional) influence on our economy.

The Bank of England paper has now laid all of this out for public inspection. The authors do not quite have the required courage of their convictions, since they attempt to downplay the significance of their conclusions by using the operations of a single bank to illustrate the process of credit creation, and thereby fail to register the immense scale, when looking at the banking system as a whole, of what they are describing. Even so, the policy implications of what they say are immense.

Our macro-economic policy is at present virtually limited to attempting to control the money supply as a means of regulating inflation. But since the volume of money is a function of bank lending and reflects nothing more than the banks’ search for profits at whatever the current interest rate may be, it follows that the whole thrust of current policy is entirely misplaced.

The banks, in deciding for themselves how much, to whom and for what purpose they will lend, will always give priority to lending for house purchase since it requires by far the least effort, and is the most secure and profitable form of lending. Can we be surprised that, as a result, those wishing to borrow for business investment are at the tail end of the queue while house prices - inflated by the volume of new money going into the housing market - go on rising inexorably?

It is bank-created credit that provides the major stimulus to asset inflation in the housing market, with all of its deleterious economic and social costs, while at the same time diverting essential investment capital away from where it is really needed - in the productive sector of the economy. If we wish to restrain inflation, why do we not target the most obvious cause, rather than burden the whole economy with deflationary interest rate hikes? And if we want a stronger real economy, why allow the banks the exclusive power to decide that the new money should go to housing rather than productive investment?

Our current monetary policy is based, in other words, on a complete misunderstanding of the role of money and its impact on economic activity. Our economy is awash with money, but it is neither the economically neutral phenomenon - interesting only because of its impact on inflation - that classical theory describes, nor does it provide the stimulus to new productive investment in the real economy that it could and should do.

Monetary policy need not be just a rather ineffectual tool for controlling inflation. It has the capacity instead to be a major stimulant and facilitator of real productive investment if we understand and use it properly. The banks’ monopoly of the power to create money prevents us from doing just that.

*Money Creation in the Modern Economy, by Michael McLeay, Amar Radla and Ryland Thomas.

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