Home > Uncategorized > Bundesbank corrects textbook mistakes on money creation, rejects 100%-money

Bundesbank corrects textbook mistakes on money creation, rejects 100%-money

from Norbert Häring

In the April-edition of their monthly report, the Bundesbank has belatedly joined the Bank of England in explicitly stating that the treatment of banks and money creation in most textbooks is wrong: banks are not intermediaries; they create money ex-nihilo. This helps the Bundesbank to reject criticism that central banks are currently “printing” too much money. At the same time, the Bundesbank rejects the proposal of 100%-money, i.e. bank deposits fully backed by central bank money.

So far, the Bundesbank has only published an English summary of the article “How money is created”, originally written in German (and a French summary). Once the article is available in full translation, I will write a bit more about the (mostly faulty) arguments of the Bundesbank against 100%-money.

The most important sentences regarding money creation are already there in the summary, though:

The majority of the money supply is made up of book money, which is created through transactions between banks and domestic customers. Sight deposits are an example of book money: sight deposits are created when a bank grants a credit or purchases an asset and credits the corresponding amount to the customer’s bank account in return. This means that banks can create book money just by making an accounting entry. This refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant credit using funds placed with them previously as deposits by other customers.

  1. May 11, 2017 at 10:09 pm

    “sight deposits are created when a bank grants a credit or purchases an asset and credits the corresponding amount to the customer’s bank account in return.”

    But this transaction can put the bank afoul of its lending requirements, though. It seems to me that the math you need to use when banks are near their reserve requirements and the math you use when banks are far from their reserve requirements are completely different ideas. Context is hugely important in this discussion.

    • May 12, 2017 at 1:03 am

      Is it not the case that banks can always get reserves when needed by borrowing from other banks or from the lender of last resort, the central bank that always provides reserves to maintain the integrity of the payment system?

      • May 12, 2017 at 4:02 pm

        That’s a good point. I still feel like there has to be such a thing as a “financially unsound” bank or the credit unions and similar that “play by the rules” are facing unfair competition from the multinationals. Does the old joke, “you can borrow money as long as you don’t need it” not apply to banks?

    • Risk Analyst
      May 12, 2017 at 1:24 am

      Not sure if you are referring to Germany or the US, but for the US banking system there are excess reserves of over two trillion dollars due to the earlier quantitative easing program. The required reserves, currently at about 130 million or so, will not be a constraint for a very long time.

      • Risk Analyst
        May 12, 2017 at 1:27 am

        Correction: Obviously I meant to write 130 billion, not 130 million.

  2. May 12, 2017 at 2:54 am

    The context is that commercial banks have created >95% of money supply (yes it varies from country to country) without reserves requirements holding them back!

    • Helge Nome
      May 12, 2017 at 6:17 am

      As I understand it, the main constraint on bank lending comes from perceived risk in making a loan. If reserves are needed to support a loan, they can easily be borrowed, at a low cost, from the central bank.
      That is to say, if bank A credits the account of customer Joe $1million and customer Joe writes a cheque on that account for $1million to Charlie who deposits the cheque in his account with bank B, an amount of $1million in bank A’s account at the central bank will be debited from its account and credited to bank B’s account with the central bank, as part of the overnight transaction cycle.
      If bank A happens to be short of “central bank money” (which is separate from money circulating in the general economy), it can easily borrow the amount needed in order for bank B to get the $1million deposited into its central bank account.
      Now, if Charlie begins writing cheques on his account with bank B, bank B has the reserves in its central bank account to honour those cheques as they end up in the inbox of other banks.
      And so on.

      • May 12, 2017 at 6:35 am

        I’d say that’s a pretty good take – I’d also add (having worked in bank credit) that the risk of taking on loans is invariably more a micro than macro factor – yes, banks want to balance their books according to perceived riskiness (deployment of balance sheet) and they monitor sectoral bad debt targets but if you want to assess the effectiveness of their Risk Management systems then look at sub-prime, S&L, Knickerbocker etc. The fat tail of many things going wrong at once doesn’t seem to be significantly better managed today despite the technology and historic precedents. Profit motive seems to trump RM every time. So, yes you’re right that risk of default is the biggest impediment but clearly it doesn’t act as a sufficient deterrent to aggregate risk.

  3. Charles Layne
    May 12, 2017 at 3:26 am

    I have never heard or read the simple fact that every successful bank loan results in removal of money from the economy and does not add money to the economy. That fact dictates policy that must be followed by the central bank, the buying of a national debt which is necessary for the existence of a central bank and continued operation of banks..

  4. May 12, 2017 at 5:05 am

    “I will write a bit more about the (mostly faulty) arguments of the Bundesbank against 100%-money.”

    The argument against 100% money is simple. Changing the name of something doesn’t alter the function of it.

    Changing deposits to bonds will no more stop credit creation than forcing government to move from a ways and means account to Gilts or Treasuries. It’s a complete misunderstanding of the way credit works.

    To constrain banks you have to proscribe what assets they can hold – as Minsky explained.

    • May 12, 2017 at 5:11 pm

      “The argument against 100% money is simple. Changing the name of something doesn’t alter the function of it.”

      So in other words, I shouldn’t feel bad about not completely understanding what is meant by “bank deposits fully backed by central bank money” because the people proposing this idea don’t understand what they mean either?

    • Sanjay Mittal
      May 13, 2017 at 12:03 pm

      The flaw in Neil Wilson’s argument is that it is not the objective of 100% reserves to stop credit creation, as Neil would discover if he read the material on 100% reserves: particularly the material written by the various Nobel Laureate economists who have advocated 100% reserves. E.g. Milton Friedman, James Tobin and so on.

      • May 14, 2017 at 4:33 pm

        Don’t go anywhere near Milton Friedman if you want to understand credit creation – otherwise you’ll just get distracted by fallacious supply & demand arguments with banks reduced to simple, innocent intermediation. Nobel or not.

  5. Charles Layne
    May 12, 2017 at 4:26 pm

    The biggest single issue with banks is that they rent something (credit) for a limited time and rent is charged in the same units as that which is rented plus, when the rental period is over and the rent is paid, then the item that was rented is destroyed. Perform a gedanken experiment using that protocol on any other commodity and you will then understand a significant feature of banking.

    • Blissex
      May 12, 2017 at 6:19 pm

      «rent something (credit) for a limited time and rent is charged in the same units as that which is rented plus, when the rental period is over and the rent is paid, then the item that was rented is destroyed»

      That’s not how the “chartalist” money system works, and the explanations by the BoE and BB are not quite accurate. The key is H Minsky’s point that:

      http://www.amazon.com/Stabilizing-Unstable-Economy-Hyman-Minsky/dp/0071592997
      Both the monetarist and standard Keynesian approaches assume that money can be identified quite independently of institutional usages.
      But in truth, what is money is determined by the workings of the economy, and usually there is a hierarchy of monies, with special money instruments for different purposes.
      Money not only arises in the process of financing, but an economy has a number of different types of money: everyone can create money; the problem is to get it accepted.

      “Money” is created by buyers, not by banks; the role of banks is to *endorse* it. Consider the case of someone who wants to buy a car that costs $15,000 they could pay the seller with a “promise to pay” for $15,000, and that “promise to pay” is “money” issued by the buyer. But the seller won’t accept that “promise to pay” from the seller because they don’t know their reliability. The will however accept a cheque drawn on a bank for $15,000 because they know the bank’s reliability.
      Therefore what happens in between is that the buyer gives his “promise to pay” $20,000 to a bank (this is called “borrowing”) and gets in exchange a “promise to pay” $15,000 from the bank (this is called crediting his account with the bank with a loan), and this allows him to pay with a cheque drawn on the bank.

      The bank in effects accepts “money” issued by buyers and endorses it into “money” acceptable to most sellers, and gets a conversion fee plus late penalty fees (“interest”) from the buyer.
      Nothing in effect has been created or destroyed of substance, only accounting entries are added one way at some point, and added another way at a later point.

  6. May 13, 2017 at 1:31 pm

    Humans invented and continue to invent money. Then they invented and continue to invent how it can be used, by whom, and for what. Money is a device that allow humans to coordinate and act together, even if the particular humans involved don’t know one another, don’t want to know one another, and often don’t trust or like one another. In simple terms, money is a cultural artifact. Like most such artifacts humans struggle over its meaning, significance, and its value to them. What are the effects of making money merely entries in a book or data files in a digital memory? So long as people accept it as the artifact that allows them to accomplish the things listed above, the form of money is irrelevant. When people no longer accept it as such an artifact, improving its beauty, appeal, or supposed security will have no effect. Money is a cultural understanding. One of the first to cross over among diverse and different cultures on the way to a global culture. Unfortunately, in that cross over, and for the benefits it provided it also brought along a long list of those wanting to define and use money only to further individual wealth. As they say, everybody needs money but only a few make it an ontological artifact. That is, an artifact that defines every aspect of cultural life. It becomes the basis of individual identify, personal status, and political power. By so doing it subjugates the rest of culture. And thus makes life more difficult, confusing, and cruel. Right now money is killing the species that invented it.

  7. May 13, 2017 at 4:12 pm

    We were told in 1934. Give Frederick Soddy his just due? https://wordpress.com/post/bestsolutionsfl.wordpress.com/159

    • May 14, 2017 at 5:06 pm

      ******Excerpt from http://en.wikipedia.org/wiki/Frederick_Soddy

      “In four books written from 1921 to 1934, Soddy carried on a “quixotic campaign for a radical restructuring of global monetary relationships”[this quote needs a citation], offering a perspective on economics rooted in physics—the laws of thermodynamics, in particular—and was “roundly dismissed as a crank”[this quote needs a citation]. While most of his proposals – “to abandon the gold standard, let international exchange rates float, use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort” – are now conventional practice, his critique of fractional-reserve banking still “remains outside the bounds of conventional wisdom”[this quote needs a citation]. Soddy wrote that financial debts grew exponentially at compound interest…”

      Free download-
      http://archive.org/stream/roleofmoney032861mbp/roleofmoney032861mbp_djvu.txt

      • Craig
        May 15, 2017 at 1:24 am

        It can be mathematically proven that interest can be paid. However such mathematically abstract a conclusion is still economic and ethical duncery because the only way that it can be paid is if we are compelled to continually borrow….until private debts are unserviceable. This exposes the dominating and problematic business model (Finance) and the real problem we face which is that the rate of flow of total costs/prices in modern technologically advanced and capital intensive economies simultaneously exceeds the rate of flow of individual incomes, and this reality is enforced by the Banking/Financial paradigms of Loan and Debt Only. Integrate the new paradigm of Monetary Gifting intelligently into the digital economic and pricing systems and you’ll have both individual economic freedom and systemic free flowingness.

        wisdomicsblog.com

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