Banking and money creation (part 2)
Previously, in Part One, I looked at where the money comes from for bank loans and mortgages. Here, I describe one of the many restrictions on the amounts that banks can loan: a bank is not just restricted by the amount of deposits it has and the amount it can borrow wholesale. Finally, I’ll comment on the “Fractional Reserve Banking” that gets circulated in YouTube videos and other silliness.
What are the constraints on how much money banks lend out?
Bank loans are not only limited by the money the banks have raised from savers and from the wholesale market. There are additional constraints on how much any bank can lend out: the Basel rules – we’re currently on Basel II, and Basel III is under negotiation right now.
This question brings us to Capital Adequacy Ratios – the belle of the Basle. (Basel is the German version of the name, Basle the French version – and it’s pronounced Barl. Belle of the Basle. Oh, suit yourselves).
Basel rules are dense, tedious, and differ in specific implementation by country, so I’ll use made-up numbers just to illustrate one aspect of what they mean: Capital Adequacy Ratios are just one part of Basel rules; there are also leverage ratios and liquidity rules, but let’s look just at one of the Capital Adequacy Ratios for now.
Right, a quick warning: there’s some unavoidable jargon ahead. I’m going to refer to Tier 1 Capital, and Risk-Weighted Assets. I’ll explain each of those first, then talk about how the Basel rules relate the ratio of them to how much a bank can lend out.
Tier 1 Capital : these are the most robust reserves a bank has – the least touchable part of its reserves. When shares are bought from the bank, then that part of the price that represents the face value of the shares, contributes to Tier 1 capital. When a bank earns profit, but retains some of it to the next year, rather than distributing all of it in dividends, then the retained profit also contributes to Tier 1 capital.
Risk-weighted assets : not all assets are equally risky – some assets are riskier than others. When a bank lends to another bank, that’s less risky (on average) than lending a mortgage to someone. And a mortgage is less risky for the bank than an unsecured loan: the bank can always repossess the mortgaged house, and recover (most of) its loan, whereas recovering unsecured loans tends to be less successful. “Risk-weighted assets” is a way of adding up all bank’s assets, in a way that reflects these different levels of risk. Notes and coins are treated as zero-risk assets, so have a risk-weighting of 0. Mortgages are treated as middle-risk, and may have a risk-weighting of 0.5. Unsecured loans may have a risk weighting of 1.
In order to ensure that each bank maintains some level of stability, its Tier 1 capital must be at least 4% of its Risk-weighted assets.
So, for every £4 in Tier 1 Capital, its risk weighted assets can be £100 at most. £100 of risk-weighted assets might consist of:
| Asset | Amount | weight | risk-weighted amount |
|---|---|---|---|
| cash | £200 | 0.0 | 0 |
| mortgages | £100 | 0.5 | £50 |
| unsecured loans | £50 | 1.0 | £50 |
| Total | £350 | £100 |
In this example, £350 of assets represent £100 of risk-weighted assets.
Hence, the size of a bank’s Tier 1 Capital, and the different proportions of its loan book that go to other banks, to mortgages and to unsecured loans, limits how much a bank can lend out.
So given these constraints, why did things get so bad in 2007?
After 1998, banks were able to stretch the rules, by selling off packages of loans in various types of special-purpose vehicle. Furthermore, investors became quite indiscriminate in their support for banks, even for Northern Rock, which had a basket-case balance sheet long before the meltdown happened.
Markets occasionally do engage in collective madness. We’ve come through this one so far remarkably unscathed, given the scale of the meltdown. Credit where credit’s due: when it went down, Gordon Brown and Shriti Vadera pulled off a magnificent escape act for the world. However, one of the consequences of the meltdown has been a plague of Austrian-School and other fringe (pseudo-)economists banging on about money creation. This too shall pass.
Did you see some animation that claimed to blow the lid on how banks really work?
Fractional Reserve Banking is a messy term used with a whole bunch of different meanings. However, in the youtube videos that get circulated, that particular meaning is a nonsense, and bears very little relation to how banking works.
It confuses the minimum reserve ratio (which applied to deposits, not loans) with ratios on the size of the loan book (which are very complicated, and one aspect of them is illustrated above). It makes a series of predictions that have been shown to be untrue: e.g. that expansions in broad money proceed from expansions in narrow money, whereas in reality, they typically precede them; that the money multiplier is a constant; or that Britain would explode in hyperinflation after quantitative easing.
So because many descriptions of Fractional Reserve Banking use assumptions that are demonstrably wrong, and make wrong predictions, they’re useless descriptions of how banking works.
In conclusion
Sensibly-regulated banks can do a very good job of mediating between short-term savers and long-term borrowers. The world is now moving back to that paradigm of stricter regulation, with tighter controls on lending and better management of bank liquidity. There are some who would go further, and attempt to destroy the entire banking sector, chasing something they call monetary reform but which is an attempt to drag economics back to the Dark Ages: it’s hard to see who’d benefit, other than loan sharks. So, the next time someone starts banging on about monetary reform, just walk away – they’re not worth it. Well, when they start telling you how the reserve ratio means that banks can create money at will, you could always remind them that the minimum reserve ratio was abolished in Britain in 1981. That usually stops them in their tracks for a minute or two, while they think up some new bluff and bluster.
Banking is complicated. And in 2007, it blew itself up pretty badly, after 20+ years of increasingly light-touch and limited-touch regulation. Throughout that time, Greens were some of the few voices that said that banks needed firm regulation, in the interest of the whole economy. As with environmental protection and human liberties, the other parties have finally come around to agreeing with us. It would have been better for the economy, for people, and for the world, if we’d been proven wrong.
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Andrew wrote: “ M4 measures how much money is out there, and is a very broad measure of it: it includes all the money in all current accounts. And it doesn’t count as negative money the amount in loan accounts. So, at the moment you receive your £100 loan, the bank puts £100 in your current account, and a matching debt of £100 in your loan account. M4 adds up all the money in current accounts (plus cash, plus some other things), but it doesn’t include the amount in loan accounts as negatives, so the amount of money in circulation as measured by M4 has increased.”
Precisely! In no way can the ‘negatives’ be counted as ‘money’; they are debts – and interest-bearing. But the ‘£100 in your current account’ IS new money entering circulation – and it has not come from any pre-existing source.
He also wrote: “when I lend money to someone, that doesn’t count as increasing the statistical measure of “broad money”. When a bank lends money to someone, it does increase that statistical measure.” – Precisely; and that ‘statistical measure’ is the money supply!
However, he also wrote: “for every saver, there’s a borrower on the other end of the transaction, and they must by definition have exactly equal interest rates. Whether or not one (or both) of the parties is a bank doesn’t change this fundamental equality.” This is nonsense. Just look at the interest rates paid by banks to their depositors, and those charged by banks to borrowers; and also remember that on current accounts, banks pay no interest, or virtually none.
Banks have, since the start, been usurping from the State the privilege of money-creation, despite periodic efforts to stop them, e.g. the 1844 Bank Charter Act, which outlawed banknotes except for those of the Bank of England – which caused the growth of the cheque system in its place!
When the State creates money, it spends it into circulation, gaining for itself (on behalf of its citizens)the seigniorage, and it enters circulation without creating any debt. When the currency was almost all coinage, the problems of keeping enough in circulation to meet society’s needs for medium-of-exchange encouraged the development of alternatives, but while the banks’ alternative, “credits’, does add – grossly – to the amount of State-created notes and coins, it also adds – grossly – to the amount of debt, and unjustly enriches the banks (and the ‘finance industry’ built on it).
The proposed alternative is to have in circulation enough money to meet society’s needs for medium-of-exchange, placed into circulation in the same way as our notes and coins, i.e. spent by the State, not created by banks.
Banks would then do what Andrew claims they now do: manage savings, and lend them on to borrowers; but with far fewer borrowers, since the needed money would have been put into circulation by other means!
Andrew: study the history of money. I recommend Stephen Zarlenga, ‘The Lost Science of Money: The Mythology of Money — the Story of Power’. Survey from ancient times to the present, highlighting the deliberate mystification about the nature of money for exploitation of the system. American Monetary Institute, 2002 ISBN 1-930748- 03-5 (See the web site, http://www.monetary.org/lostscienceofmoney)
Also look at the Positive Money site and its draft Bank of England Act
oo that face should be 8
You’re right, excuse me, the bank would lend out £90 of the depositor’s £100 if there was a 10% fractional reserve. Can’t this system still lead to the creation of money though, because when the borrower spends the £90 it will be put into someone else’s account as a deposit, £81 of which can be lent out…and so on…
The ideas of high powered money and the multiplier effect, which I remember reading in first yr macroeconomic text books acknowledge the way banks can create money.
For an example of a ‘full reserve’ system in which lending could still occur, see the proposal written by Positive Money and the New Economics Foundation.
http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf (Investment accounts – page 8)
It does create money, but there’s no problem with that. It’s just a function of what we count as money.
So the total money supply if I deposit £100, £90 of which then gets lent to you is £190, my desposit account balance plus the $90 of cash you have. But the money supply has only increased because we didn’t count the £90 of debt you also have. No value has been created, but we have satisfied your desire to borrow money and mine to save money.
The bank performs a pooling and tranching function to match lenders (effectively what I’m doing when I deposit) with borrowers, which is a useful social function.
Under full reserve systems that can’t happen (well not as easily), and lots of money will sit around in bank accounts not doing anything while other people find it harder to get loans. Plus, because the banks make money by borrowing short term and lending longer term, switching to full reserve means that deposit account no longer generate any income by themselves for the bank. Thus the bank will have to charge for the services, like standing orders, cheques etc., it provides to depositors.
Of course, there are ways to make full reserve still allow lending overall, but they unnecessarily complicate the system and make it more expensive, without making it any more secure. (I’m writing a series of posts on financial reform in which I’ll go into that in more detail soon.)
PS, I actually met Adam Ramsey, not Andrew, sorry
Dear Andrew,
Will’s housemate, Marloes, here. I met you very briefly in my garden the other night, and Jim recommended these blog posts as I am very interested in banking, and reform.
(Lets put the issue of whether Fractional Reserve Banking is desirable to one side.)
My immediate reaction is that I’m troubled by your description of bank lending. You have simply excluded the feature of ‘fractional reserve banking’ from your exposition of how the banking system works. FRB is not a whacky theory as you seem to imply (perhaps people develop fruity theories from it); it is name for a particular feature of the banking system. As the Independent Commission on Banking (ICB) wrote in their recent Interim Report, it is the “fractional reserve banking model that underpins the present banking system.” (p 101)
Interestingly, you happily describe the Basel accords, and ideas of capital requirements. Fractional reserve banking follows directly from these rules!
You write in the first post that “When a bank lends out £100, it has to have received that £100 from savers and investors in the first place.” This would be the case under FULL reserve banking. But if we take on the 10% capital requirement recommended by the ICB in its latest report, then banks would only need to receive £10 from savers/ unrisky-investors to lend out £100.
Here here James Beecher!
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Hi Marloes,
I’m afraid that’s not quite right about fractional/full reserve banking.
Andrew is entirely correct when he says that to lend £100 a bank needs to have received £100 from savers and investors.
Under a 10% fractional reserve system if I deposit £100 in a bank the bank can lend £90 of that to someone else but must keep £10 as a reserve. Under a full reserve system the bank would have to keep all £100 in its vault and could not lend anything. Either way the bank has to have receieved £100 from somewhere in order to lend it out, it can’t just create it from nowhere, much as some people misunderstand otherwise.
What we have in the UK, though, even if the ICB interim proposals are adopted, is a 0% reserve system. The issue of capital requirements are not quite the same. In the UK there is no requirement to keep any percentage of deposits, but there are capital and liquidity rules. That capital, however, need not come from deposits.
Richard, the statement “interest rates are always lower for savers than for borrowers” is nonsensical: for every saver, there’s a borrower on the other end of the transaction, and they must by definition have exactly equal interest rates. Whether or not one (or both) of the parties is a bank doesn’t change this fundamental equality.
One of the ways in which banks make a profit is that they tend to lend long-term and tend to borrow short-term. The rising yield curve means that long-term interest rates are higher than short-term interest rates. So, by borrowing short-term to lend long-term, banks make a profit on that difference.
If you or I lend long-term and borrow short-term, we can also make more on our lending than we do on our borrowing. For example, every month, I use my credit card to borrow money from the bank. I never pay any interest, because I pay the full amount off every month. By using the credit card, this allows me to keep a few hundred quid extra in a notice savings account, which earns interest. So, I earn more on my savings, than I pay on my debt. So your statement: “interest rates are always lower for savers than for borrowers” is demonstrated to be false.
And as for there being a monopoly on lending, well that’s demonstrably wrong too. There are dozens of lending organisations – banks, building societies, credit unions, payday loan companies. There are barriers to entry over which the incumbents have very limited influence; and there’s a very competitive market place.
This obsession with which loans go into the statistical measure of M4, and which do not, seems bizarre to me. You do realise that banks can only lend out money that they’ve had lent to them, right? I know that many members of the “Monetary Reform Policy Group” don’t understand this, and it appears that Rupert Read doesn’t, but I take it that given you’re studying for a PhD in economics, you do grasp this basic concept. Don’t you?
AT: “To suggest the disparity between rich and poor is fundamentally due to the ability or necessitated by the ability of banks to create money (but not wealth) is disingenuous at best”.
RL: Causation of the rich poor gap, like everything in the economic system, is multifactorial, so I would not claim that it is “fundamentally” down to the ability of the banks to create money.
However, it is undeniable that within the system, those with surplus funds find that their funds can expand, and those with a need for funding must pay to obtain them. This is clearly a driver of the rich-poor gap.
What I find difficult to understand is that so many progressives who are critical of “capitalism” in general, nevertheless support the right of financial mega-corporations to have a monopoly of money creation by lending at interest.
were you suggesting I just listed people who supported monetary reform? you didn’t respond to any of my arguments… ho hum…
“For interest, for a loan of £100k @ 5% over 25 yrs, the borrower will pay back £168k. This represents a flow of money from the less well off to the more well off. Cumulatively, this will increase the divergence between rich and poor – the rich-poor gap, which as we all know (Spirit Level) is bad for society.”
Further to this perfectly reasonable point (which you don’t seem to have responded to in any meaningful sense), the green addition to this is that monetary systems based around interest thus demand a greater use of resources. Ultimately, we have to use more in order to pay more to banks.
Anyway, as I said before, the people in favour of FRB-banking-with-regulation might want to consider another phenomenon, well known in finance, that of “circumventory innovation”. In other words, the more you regulate, the more you push banks into innovating into areas that aren’t regulated.
In short, good luck with this whole “we can have a stable banking system through strong regulation” argument. It’s only going to land us in more doo-doo. Thanks for being an apologist of the next crash. 😉
One last question – when is all this money that banks are “lending” going to be paid back? Can it ever all be paid back?
(Welcome to the next financial crisis everyone!)
You did list a number of people you claimed support your arguments, without making the arguments themselves. I could say that Adair Turner, John Kay, Paul Krugman, Joseph Stiglitz, Mervyn King, etc. etc. disagree with your proposals but that would be pointless without addressing the actual arguments. My point was, however, meant to be a general comment to all involved not a personal attack. Sorry if you took it that way.
On the substantive point, that is a very simplistic analysis of how banking works. If you do away with fractional reserve banking as you describe it, only people who already have capital in large quantities can lend it, at present the deposits of many people can be pooled and lent to others (though this is itself a simplistic analysis, see the original articles). So it is not necessarily a payment to the rich from the poor. You also overlook the ability to tax those payments. To suggest the disparity between rich and poor is fundamentally due to the ability or necessitated by the ability of banks to create money (but not wealth) is disingenuous at best.
I have to say, as well, that I find the accusation that I am an apologist for the next crash frankly offensive. You clearly have no knowledge of my politics. I want a massive reallocation of power and economic reform, I just reject magical solutions where there is no real understanding of the effects. My preferences for a radically democratised economy aside, we did have a very stable financial system for thirty years after world war 2. Until the financial sector was de-regulated; so please back up the assertion that regulation is “only going to land us in more doo-doo” with some evidence. For someone who asked for substantive responses to their arguments you offer no logical or empirical evidence for your assertions.
On your final question, I don’t quite follow. Any individual loan will be paid back at some point, unless the debtor goes bankrupt. When depends on the terms and conditions of the loan. Of all loans, they will never be paid back, as new loans will be issued. That’s a good thing. It means wealth is being invested and not just sitting idle in accounts. A transition to an ecologically sustainable economy will require huge investment in new infrastructure and technology, your solutions to the financial crisis will make that almost impossible by tying up capital in unproductive deposits.
Andrew. I find your comment against me exceedingly unreasonable. Because my comment responded to you at exactly the level at which you operated. You did not treat any of YOUR targets of criticism remotely seriously: instead, you took aim at a cartoon.
I am an academic. I am very familiar with giving citations etc etc etc. . If you look at my published work on money, e.g., you will find plenty.
When _you_ write an article that deserves proper citations etc. in response to it, then you’ll get them.
Until then, kindly refrain from calling me a troll.
Because your entire pair of articles consisted of little but thinly-veiled trolling against monetary reform.
If you haven’t read/seen Mervyn King’s speech, then really you need to start all over again.
I’m sorry Rupert, but you were asked to provide specific critiques and references, that seems entirely reasonable. Andrew did respond in a somewhat flippant manner, but given he had previously asked you for those same sources and you had not done so I can see why he felt that way. That said, it would, of course, be better if we all stuck to our arguments and didn’t let this become personal.
I have read Mervyn King’s speech and I think all that can really be said with certainty about it is that he thinks our current system of banking (in general, not specifically fractional reserve) is in need of reform. He gives a number of different suggestions ranging from Basel III, to Paul Volker’s plan to seperate retail and investment banking, to John Kay’s proposals to seperate deposit taking from lending to Lawrence Kotlikoff’s suggestions that would basically abolish banks in any way we now understand them. Interestingly, he certainly doesn’t sound like he wants to end growth, but to achieve more stable growth. Other economists disagree with some of those suggestions, Adair Turner, for example, suggests that Kotlikoff’s system of mutual funds could be more unstable than our current system and be prone to just as large booms and busts. I certainly don’t think that one speech discredits what Andrew has written, indeed most of these two articles merely tries to explain the current system, not offer suggestions for it’s improvement.
Sorry, re-reading I see that I sounded a bit brusque with the “jump in” phrase. No offence.
Alasdair
The market share changes after the first investment because A has bought machinery that allows him to produce more goods more quickly and more cheaply.
There is another, unrelated, aspect of lending that is perhaps more easy to understand.
Debt is a power relationship with a positive feedback. The lender has spare money, the borrower does not. So he borrows, and has to pay back interest as well as the original principal.
For interest, for a loan of £100k @ 5% over 25 yrs, the borrower will pay back £168k. This represents a flow of money from the less well off to the more well off. Cumulatively, this will increase the divergence between rich and poor – the rich-poor gap, which as we all know (Spirit Level) is bad for society.
Before anyone jumps in, I am not proposing that we need state sponsored 0% interest mortgages. I’m just pointing out that lending is an imbalanced power relationship.
AT: “Once both companies have made these changes we are at a new equilibrium but with better/cheaper products. A clear improvement”.
RL: er…no. Not if the products are high volume short-life, planned obsolescent. Because that increases throughput of materials.
Do you agree that we need to reduce throughput of materials?
But you’re ignoring my point, why did the market share change after the first investment?
I do agree about the need to reduce our resource use, but your example has nothing to do with that.
“because many descriptions of Fractional Reserve Banking use assumptions that are demonstrably wrong, and make wrong predictions, they’re useless descriptions of how banking works.”
I bet you really felt good with this blow to FRB understandings of how money works. No actual references to these assumptions being made by people, no mention of any of the numerous green economists (or others) arguing along these lines. In an inversion of the law that “just because you read it in the paper doesn’t make it true”, “just because you saw it in a youtube video doesn’t make it false”.
“There are some who would go further, and attempt to destroy the entire banking sector, chasing something they call monetary reform but which is an attempt to drag economics back to the Dark Ages: it’s hard to see who’d benefit, other than loan sharks”
You seem to have completely failed to engage with arguments for monetary reform. Why would these drag economics back to the Dark Ages? There is no reason to argue this. Why would they benefit loan sharks? There is no reason why banks offering interest-free or very low interest rates would push people into the arms of those offering very high interest rates.
“So, the next time someone starts banging on about monetary reform, just walk away – they’re not worth it. Well, when they start telling you how the reserve ratio means that banks can create money at will, you could always remind them that the minimum reserve ratio was abolished in Britain in 1981”
Right – ‘the next time someone makes an argument, as opposed to a list of attakcs, don’t listen to them’ – that’s surely the arguement of someone who feels they are on stable ground in their arguments. Pitiful. What does it matter that the minimum reserve ratio was abolished in 1981 in Britain? Since then, and before, UK banks HAVE been lending at will. The only thing stopping them is the fear their loans won’t be repaid – hence the credit crisis. Why else are those with no interest or need (such as myself) asked repeatedly if we’d like credit cards, even from building societies? So that banks can make a profit purely on the interest margin? But why would they only be interested in this if they can effectively print money?
I really can’t see how anyone with an interest in alternative politics and economics can have waded through the Basel stuff and come out unable to grasp that money creation might be an important part of banking.
Again, we can make another rule: “Just because someone in the Austrian School says something doesn’t mean it is ALWAYS wrong, even though it is likely to be”. There are lots of dodgy tory free market types who understand the role of banks in creating money, and they come to weird conclusions about this. But there are also lots of green economists (who I’m pretty sure won’t be happy at being characterised as ” fringe (pseudo-)economists banging on about money creation”. If you consider yourself a genuine greenie you might like to consider the thoughts of the Green Party’s economics spokesperson (and PhD economist) Molly Scott Cato (http://steadystate.org/learn/leeds2010/workshops/money-and-the-financial-system/) – an advocate of monetary reform. Or you could try Mary Mellor (she’s an Emeritus Professor, but hey, I’m sure you can still dismiss her somehow). Her book The Future of Money (www.plutobooks.com/display.asp?K=9780745329949) makes the argument for monetary reform clear by comparing current methods of money creation with those in history. You can read a synopsis of her work here: http://www.redpepper.org.uk/The-future-of-money/
To be honest, it’s not arguing with you – “there are none so blind as those who cannot see” – but the idea that a bit of regulation can sort our banking system out is ridiculous. The whole point about basel 1 and basel 2 is that they made no demonstrable difference – we still had the banking collapse.
Off balance sheet lending through securitisation etc was PART of this, and certainly exarcabated it – but lending mortgages that can’t be paid off (creating money in electronic form that won’t be ‘realised’) will always lead to a bust.
You need to reconsider your understanding of how banks do create money, why it’s a problem and why we can only solve it with radical monetary reform. If all you can do is bang on about regulation, you’re going to be left behind.
Mervyn King said “Of all the possible ways of organising baking, the one we have is the worst” – and he DID criticise FRB. Anyone with a passing interest in the making the banking system work will have come across this quote. Those who wish to shoot down radicals to make themselves seem clever, like you appear to be, maybe won’t have. You can get a copy of Mervyn King’s speech at the Positive Money site here: http://www.positivemoney.org.uk/
It might also help you to understand monetary reform, and the banking system too…
All the best, but serious – think more, dissmiss less.
Cheers,
James Beecher – PhD economics student
Can we please not just list people that agree with us, that gets us nowhere. There are certainly economists who don’t think we should go back to full reserve banking. There are some who do. Let’s stick to the arguments themselves.
AT: “If both companies have laid off workers their wage bills will have decreased. So without selling any more goods they’ll have higher profits, with which they can pay the interest”.
RL: You are assuming there that the wages saved are exactly equal to the repayment on the loan interest+capital. The layoffs are a side effect of increased productivity due to the new machinery obtained via the bank loan.
The point of buying machinery is not to achieve the same level of production than before, but to out-do the competition and take over the whole market.
AT: “if they laid off workers proportionally to their increase in productivity why do the market share change?”
I’m afraid you have misread what I wrote. The market share does not change once they have *both* taken out loans.
The point of the experiment is to show the Before and After (taking out a loan) scenario.
Before, 2 companies in competitive equilibrium.
After, 2 companies in competitive equilibrium, but now, because both are repaying the interest on a loan, they are forced to produce more goods to do so, which means more throughput of materials, which is not sustainable.
Incidentally, the layoffs represent an externalisation of their costs onto the taxpayer. The company is saving on wages, but society has an increased burden of benefits to pay.
Have you watched the Money as Debt video? It is very revealing, showing how the situation has evolved from the days when people gave their bags of gold to be stored on the Goldsmith banks or shelves.
I didn’t misread you Richard. I meant, why does one company’s market share change when they have made changes but the other has not? It must be because the products have got better or cheaper in some way. Once both companies have made these changes we are at a new equilibrium but with better/cheaper products. A clear improvement.
The difference in wage bills may be more or less than the interest payments but if it’s less it was simply a bad investment, those can happen. We have no reason to assume either from your example, however. To prove anything we would need a far more detailed situation with assumptions backed up by real data. Your example certainly doesn’t show that access to credit inevitable leads to higher resource use. Incidentally, do you really want to ban access to credit entirely? Or do you just want to ban charging interest? If neither your example is entirely meaningless.
Oops. I left the link out in the process of trying to see how to make a live link.
1 Money is being created. Scroll down to the graph here:http://greenerblog.blogspot.com/2010/11/will-market-virus-kill-global-economy.html
This debate is famous for getting enmired in confusion. Let us therefore approach it from the things we know.
1 Money is being created. Scroll down to the graph here:
2 Banks create 97% of the new money in the UK, and they do this by lending at interest.
3 Although banks also borrow from depositors at interest, the interest rates are always lower for savers than for borrowers, and the amounts retained on deposits are in the order of one percent of the amounts lent out.
4 To pay back the interest means that the commercial borrower (e.g. a manufacturer)has to make a profit on the market.
5 This system of creating money is an important driver of economic growth.
To back this point, a thought experiment is needed:
Imagine 2 companies, A and B, which are in competition. They are in stable equilibrium, each having 50% of the market, and both are sound.
Now company A goes to the bank, borrows capital, and invests it in new machinery. His firm’s productivity goes up, so he is able to lay off workers, who go on to social security. His share of the market goes up, so he now has 75% of the market.
His competitor, company B, has no choice but to borrow, invest in new machinery, and lay off workers.
B is successful in this, so they are now back in equilibrium, with a 50-50 share of the market.
However, they are both now burdened with debt interest which reduces their profits, so they must increase output by invading other markets, or by producing goods with shorter working lives, or both.
So the system has “progressed” from equilibrium to equilibrium, but in the process hands have been laid off, the banks have secured a source of income, and A and B are marketing more goods more aggressively.
This is the essence of a book by Willem Hoogendijk, “The Economic Revolution”, Green Print/Jan van Arkel, London/Utrecht 1991
So, the way in which money is created by
The video Money as Debt which summarises the history of banking in a clear way can be found here: http://www.youtube.com/watch?v=vVkFb26u9g8 and is well worth a watch.
I hope this is helpful.
I don’t follow your thought experiment at all Richard.
If both companies have laid off workers their wage bills will have decreased. So without selling any more goods they’ll have higher profits, with which they can pay the interest.
Also, if they laid off workers proportionally to their increase in productivity why doe the market share change? Are the products now better, or cheaper? Either of which is a good thing for consumers surely? I think this sort of simplistic example doesn’t really teach us anything.
More basically, though, I think you get the argument the wrong way round, the companies borrow money in order to invest in order to grow. They don’t have to grow because they got into debt.
Again Rupert Read, you’ve brought no substance, just drive-by trolling. While I respect the blow you’ve struck against nominal determinism, it does nevertheless seem to be a waste of pixels.
If you’ve got something of substance to say, please say it. Which description by Mervyn King of FRB, which specific Mervyn King predictions, are you referring to: links and quotes please? Which specific part of what I’ve posted do you think it conflicts with?
As for the other people you name, well, James Robertson Justice is bloody marvellous, isn’t he? I love the Doctor … films, albeit sexist claptrap. (and yes, this is treating your comment with exactly the respect it deserves).
We need to nationalise (some of) the banks properly, along the lines of the motion I proposed to GPEW Conference last autumn, that was passed. And yes, of course we need better regulation.
But that is only the start. These two articles are not very convincing. They certainly don’t convince me that the in-depth arguments of the greatest green economists, Herman Daly and James Robertson, about why we need monetary reform, are wrong. Because: you simply haven’t taken those arguments on.
And some of your own arguments are weak in the extreme: “So because many descriptions of Fractional Reserve Banking use assumptions that are demonstrably wrong, and make wrong predictions, they’re useless descriptions of how banking works.” Fine; and what about the descriptions of FRB that use assumptions that are not wrong, and do not make wrong predictions??
Please explain to us where Robertson and Daly (and Scott-Cato, and Porritt, and even, latterly, Mervyn King, etc.) have gone wrong in their accounts of FRB, of bank money-creation, etc. etc.
Great article, issues that are so often talked about and little understood. Also good to see some de-bunking of the insane myths that fly around about fractional reserve banking.
My only worry is that in your conclusion you say “The world is now moving back to that paradigm of stricter regulation, with tighter controls on lending and better management of bank liquidity” as if that was all that was needed. Osbourne and others have been pushing this line that stress testing & higher basel iii capital requirements (not due until about 2018) mean our banking system will be magically fixed and that nothing else needs to be done. True, these will help but they do nothing to actually reduce risk in the banking sector.
Regulation of OTC derivative markets (e.g. credit default swaps, collateralized debt obligations) are urgently needed to reduce the risk of another total freeze up of credit markets. Banks using deposits & capital for speculation rather than lending to the real economy raises questions about separating high st & investment banking. We also now have much less competition in the banking sector than before the crash. Capital requirements aren’t a substitute for effective banking reform.