Credit, money and cash – continued

There is a lively debate in the comment section of this blog on QE, credit creation, the difference between credit and cash, and so forth.  Thank you to all those commenting.   Understanding how money is created is fundamental to an understanding of this financial crisis.

As a response to one of the commenters I inserted a few paragraphs from my book…But thought it might be more appropriate to insert it here.  So herewith – on one condition: that you all buy ‘The Coming First World Debt Crisis’ Palgrave, 2006.

From Chapter Two of ‘The Coming First World Debt Crisis’…

Bank money does not exist as a result of economic activity. Instead, bank money creates economic activity.

As long as fifty years ago, the economist Joseph Schumpeter noted that

” it proved extraordinarily difficult for economists to recognise that bank loans and bank investments do create deposits…And even in 1930, when the large majority had been converted and accepted the doctrine as a matter of course, Keynes rightly felt it necessary to re-expound and to defend the doctrine at some length…and some of the most important aspects cannot be said to be fully understood even now.”

Schumpeter, History of Economic Analysis. Allen and Unwin. 1954

……..many of us still assume that bank loans represent a gift from someone who, unlike ourselves, has taken the trouble to deny themselves a portion of their income and to deposit this in a piggy-bank or savings account. Most mainstream economists still believe that banks have “savings” – either theirs, or those of others – and extend these savings to others as credit – charging interest. This is not the case. The money for a bank loan does not exist until we, the customers, apply for credit.
In other words, far from the bank starting with a deposit, and then lending out money, the bank starts with our application for a loan, the asset against which we guarantee repayment, such as our house, and the promise we make to repay with interest. A clerk then enters the number into a ledger.

Having agreed the loan, the commercial bank then applies to the central bank which provides – on demand – the necessary cash element of the loan.

This cash element (notes and coins) is the small proportion of the loan that will be tangible to the borrower.  The rest is bank money, which is intangible.  Once the commercial bank has obtained the cash from the central bank we the borrowers, then obligingly re-deposit both the bank money (the undrawn part of the loan) and the cash, which together make up the sum of the loan, in either our own, or in other banks – creating deposits. Even if we spend the cash, the recipient of our cash will deposit it.

The Central Bank in issuing the cash, charges a rate of interest to the commercial bank. The commercial bank pays this in due course, adds its own interest, and passes both charges on to the borrower.

Cash on demand
While an increasing amount of transactions can be carried out without cash, there are many that still depend on cash, like coins for parking meters, so we, bank customers, want to hold a portion, albeit (in the UK) only a small proportion, of our money as cash .

A bank is therefore obliged to offer cash to its customers according to demand, depending on their credit standing or overdraft limit.  As a consequence banks have to hold a ratio of deposits in the bank, as cash. This is known as the cash ratio or ‘reserve requirement’.  This tends to be a small fraction of total deposits. In any case, as noted above, any cash issued and spent (mostly in retail transactions) very quickly returns to the banking system as deposits.

This being the case, a popular illusion nevertheless persists: that banks can only lend on the basis of reserve requirements. In other words, to lend £1000, banks need a reserve requirement of £100 in their vaults.  The reality is exactly the opposite. Reserves are created to support lending. The Bank of England (for example) provides cash to British commercial banks, based on public demand for that cash. Cash is created by the central bank only once borrowers apply for loans from the banks and central banks place no limit on the cash made available to banks. Because the central bank provides cash on demand, there is therefore no limit to the cash, bank money or credit that can be created by commercial banks.

However, there is a cost to commercial banks in applying for cash (as we explain below); they pay interest to the central bank for this cash (and promptly pass on the cost to the customer). There is however, no cost in the creation of bank money, or free money – the proportion of the loan that is intangible, that is not cash.

The decline of cash and the rise of credit

In the UK in 1982 the ratio of coins and notes to bank deposits was 1:14. At the end of 2005 the ratio had more than doubled, to 1:34. Put differently: in 1982 there was about £10.5 billion in circulation as notes and coins. Retail and wholesale deposits amounted to almost 14 times as much: £144 billion.  By 2005 there was only £38 billion circulating in notes and coins, and almost 34 times as much – £1,289 billion – held in banks as retail and wholesale deposits (Office for National Statistics, May 2006). So for every £1 circulating in cash in 2005, £34 took the intangible form of bank deposits.

These historic numbers demonstrate that the ratio of cash to bank money is not a constant: cash declines over time as confidence in bank money grows, and we make ever-greater use of e.g. credit cards, bank transfers and internet banking.

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8 comments to Credit, money and cash – continued

  • the.Duke.of.URL

    Ann, perhaps you could say a little about the reserves that are being considered as a ‘hedge’ against potential defaults on their

    loans by banks in the future.

  • This is very good, as far as it goes, though I believe the explanation could be even simpler, showing how

    inititial capital into a bank can be multiplied by many times the legally required “reserve ratio”.

    But I believe it needs to be expanded

    to show that the money and banking system described, used the world over, requires ever increasing levels of debt. But debt cannot increase without

    limit forever. Nothing can.

    This means our present system is unsustainable. Economic activity must eventually freeze up into just the kind

    of world-wide credit crunch we are seeing now, with defaulting borrowers and failing banks, once total public and private debt reaches its limit.

    It is disturbing to see the “experts” agreeing that if only we had operated with adequate regulations, the system would have proven stable.

    The assumption of the underlying stability of our present money and banking system is accepted by almost everyone, and until the world wakes up

    and sees it as false, nothing we do to fix the economy will work.

    Once the nature of the present system is understood, the need to decrease

    total debt will become apparent. Then will come the really hard choices, since none of the alternative solutions are attractive: very high taxation

    and redistribution; very high inflation; widespread debt forgiveness; or nullification of debts due to social collapse.

    But some

    combination of one or more of these is what inevitably will happen.

  • C. Rasjid

    Hello Ann,

    What you explains is “fiat (paper) money fractional reserve banking”, the monetary system the whole world has adopted

    unquestioningly, and only this system succeeds in the magical transmutation of “thin air” into “real money”.

    On the contrary, a gold

    standard with 100% reserve backing do not allow any “creation of money”. Gold supports itself. Here, there is no need for “Bankers” and bankers

    only lend whatever depositors deposit with them – not an ounce more may they lend. With a pure Gold Standard, “nothing created, nothing destroyed”.

    Can a gold standard ever work in this era? Who knows? – that this is not the only option that the world must adopt before this financial

    destruction ends. God created Gold in His Omniscience.

    The current credit crunch is the antithesis of creating money – what Paul Krugman

    could have
    termed “Revenge of Money Creation”. The US banks simply withdraw loans if there is a chance of default and no sweet talk can make

    them lend – better be safe than sorry. The total money supply M1 (coins + notes + demand deposit) of the banking system shrinks equal to the amount

    of “good loans” recovered to the relief of those lucky banks – and this process feeds on itself. Bankers know they cannot do anything about the

    situation as they don’t make the laws.

    Your post has : “Bank money does not exist as a result of economic activity. Instead, bank money

    creates economic activity” – this is the current mainstream economics which may
    be the reason why we face what we face now.

    I vaguely

    read economics like these somewhere :

    The fundamental characteristics of money are :
    1) store of value representing economic labour.

    2) medium of exchange.

    “bank money does not exist as a result of economic activity” – take the bank accounts (money) in the US banking

    system at any instant and ignore how it originated. This “quantity of money” represents the the reward for past labour (economic activity) of all

    Americans and has been “touched” by toils and sweat – all enmeshed together – money, labour, toil, sweat. Sugar cannot be separated from its

    sweetness. I doubt Economics if money is viewed as an abstract construct “free” of man’s labour to earn it – I like my $1000 in my bank account

    and am distrustful if someone can “create” an equal amount through his keyboard.

    “Instead, bank money creates economic activity” –

    this may be flawed. Any theory of economics based on this premise may bring more harm than good. Man had been working (economic activity) even

    before money was invented. Here money only transacts a deal between the cobbler and the farmer – wheat for a pair of shoes. Shoes and wheat fulfill

    real needs in man’s life. If the invention of money cause any “new” economic activities, then those may be harmful. Man’s economic activities

    should be towards his proper rightful needs and not dictated by anything else – not by the invention of money.

    Rasjid

  • ann

    C. Rasjiid, I am not describing fractional reserve banking at all….In fact the system for creating money does not require

    reserves at all…

    That is my point.

  • C. Rasjid

    Ann’s reply to Rasjid:

    My mistake here – assumed US banking style is universal.

    Any fiat money has to be first

    “manufactured” and then distributed for use. Only commodity money (Gold) cannot be created.

    US banks at 10% reserves requirement
    (money

    in Fed branches, etc) can create money tenfold. At 100% reserves, only the central bank can create (or destroy) money and auction them to best

    bidders. Rasjid

  • A E Pfeiffer

    There are people. There is stuff. People need stuff.

    Money in its current form has failed as a distribution mechanism. Its relationship

    with reality has been breaking down for decades because of people’s reliance on credit and the need to pay interest, and the economy’s need for

    growth in order to finance that interest. The current crisis came to a head because of speculation, which caused panic in the financial services

    industry when it was realised just how far the speculative bubble had “decoupled” from the real economy of people and stuff.

    A possible way

    out of this recession would be for mechanisms like local currencies and LETS schemes to come into their own. They both by-pass traditional money in

    getting stuff to people. They don’t charge interest and they’re not traded on the speculative financial markets. At the moment it’s money (not

    people, not stuff) that’s the problem. The current mess might be a way of understanding that and beginning to do something about it.

    And

    we’d better, because sooner or later our economy is going to run into the “brick wall” of the physical constraints of a finite environment. We’re

    going to run out of vital resources and places to dump our waste products and pollution. We could use the recession as a way of gradually moving

    away from an unsustainable economy that relies on credit to finance industries that use up finite resources to produce more and more things we don

    ‘t need just so that we can pay off the loans we took out to buy the things in the first place. We could create a less frantic money-grabbing

    society and a more sustainable future for the economy and the environment.

    We could, couldn’t we?

  • The US had better worry – their free lunch is coming to an end. Back in 1971 the US defaulted on the Gold

    Standard. Since then we have been in freefall with no floor under the system. Now the Chinese are about to call the shots.

    http://www.ft.com/cms/s/0/7851925a-17a2-11de-8c9d-0000779fd2ac.html
    China calls for new reserve currency to replace dollar
    By Jamil

    Anderlini in Beijing
    Published: March 23 2009 12:16 | Last updated: March 23 2009 14:22
    China’s central bank on Monday proposed replacing the

    US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

  • T Perret

    Rasjid – saw your article on FEASTA, couldn’t comment there, not a member.

    Regarding your Fixed Money Supply Real Gold Standard:

    As

    far as I can see, gold is needed only if you want to change the amount of money. This is how I see it:

    Freeze the amount of fiat money, and

    you will get a fixed point. Then everything else will adjust.

    Just like the share capital in a company is fixed, which is the reason you can

    measure the value of each share at each moment.

    Do the same with money. No bubbles. And the whole community gets a part of the benefits of

    development in technology etc. without destroying the incentive for business. Everybody wins. Except the financial institutions of today. But hey,

    they havent’t contributed with anything except misery and bubbles.

    Can you see it? Am I wrong?

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