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BoE dismisses misconceptions about money creation

BoE dismisses misconceptions about money creation – Editor

In a recent blog [1], Prof Bill Mitchell (Charles Darwin University) informed his readers about an article which appeared in the Bank of England (BoE) Quarterly Bulletin 2014/Q1 – Money creation in the modern economy – which “explains how the majority of money in the modern economy is created by commercial banks making loans.” This paper challenges several of the basic assumptions made in many mainstream economics textbooks:

“ Money creation in practice differs from some popular misconceptions – banks

do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.

The reality of how money is created today differs from the description found in some economics textbooks:

      • Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
      • In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. “

The BoE paper then discusses two misconceptions about money creation.

Banks do not lend out the public’s deposits

First, the BoE says that “The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood”.

We learn that “banks do not act simply as intermediaries, lending out deposits that savers place with them”, which means that household saving creates the deposits.

The reality is very different: “ … when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does no by itself increase the deposits or ‘funds available’ for banks to lend.

… in reality in the modern economy, commercial banks are the creators of deposit money … rather than bank lending out deposits that are placed with them, the act of lending creates deposits – the reverse of the sequence typically described in the textbooks. “

The BoE paper details the process:

  1. The central bank has assets equal to its liabilities (bank reserves held with it and currency on issue). This is called base money.
  2. A commercial bank makes a loan and creates a new deposit.
  3. The bank now has more assets (the new loan) but matching higher liabilities (the new deposit).
  4. Borrowers have more assets (the new deposit) but higher liabilities (the new loan).
  5. New broad money has been created because deposits have risen.
  6. No new net financial assets have been created (“both sides of the commercial banking sector’s balance sheet increase as new money and loans are created”).
  7. The new money has been created “without – in the first instance … any change in the amount of central bank… ‘base money’. “
  8. The banks will as a consequence of the higher deposits “want, or are required, to hold more central bank money in order to meet withdrawals by the public or make payments to other banks”. That is, the bank will need to increase its ‘reserves’ held at the central bank to facilitate the payments system.
  9. But “reserves are … supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheet”.
  10. And … “In no way does the aggregate quantity of reserves directly constrain the amount of bank lending or deposit creation”.

Banks do not lend out their reserves to the public

The BoE paper also observes that: “ … description of money creation contrasts with the notion that banks can

only lend out pre-existing money … Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not a bank asset that could be lent out. “

Second, “a related misconception is that banks can lend out their reserves”: “ Reserves can only be lent between banks, since consumers do not have access to reserves accounts at the Bank of England. “

What this is also telling us is that in the modern world we have a dual monetary system, in which two forms of money tag along with each other but do not actually mix. These two forms of money are (a) the money supply, consisting of deposits and currency in circulation, being money which is accessible to the public, and (b) banking reserves, being a form of money which is only access- ible to banking institutions. Reserves never cross over the line into the real (non-bank) economy.

The full picture

This BoE description of money creation by banks is fine, except that:

  1. it does not mention that although bank credit money mostly arises from bank lending, banks also create new credit money when they spend into the real economy (e.g. to pay dividends to shareholders, interest to depositors, government tax and other fees, salaries and overheads, contractors’ fees, etc);
  2. the article does not address the complementary matter of money destruction (cancellation) by banks.

Moreover, money creation is a much larger subject than the creation of bank credit money. To get a full picture, one must integrate the description of bank money creation with money creation and destruction by the state (i.e. arising from a conjunction of the activities of the Treasury and Central Bank).

[1] http://bilbo.economicoutlook.net/blog/?p=28435

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