08.21.2014 2

If not debt, then where does money come from?

depositscreditm2By Robert Romano

On August 19, this author did a piece, “Yes, bank lending creates money” about a March 2014 bulletin from the Bank of England that suggested “Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example, to someone taking out a mortgage to buy a house, it does not typically do so by giving them… banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.”

The piece prompted many readers to ask just how a bank could possibly make loans up out of thin air.

Which is a good question. It’s more or less the same question I had: If loans do not come from reserves, and they do not come primarily from deposits, then where do they come from?

Yet, a better question might be, if not loans and new debt, then where does money come from?

2010 Fed study: ‘Reservable liabilities not sufficient to meet bank funding needs’

But first, doing due diligence I dug deeper into the Bank of England study’s footnotes which turned up another study from the Federal Reserve back in 2010, “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?”

In it, Associate Director of the Fed Board of Governors’ Division of Monetary Affairs Seth Carpenter and Koc University economics professor Selva Demiralp openly questioned whether deposits and reserves were sufficient to carry on commercial banks’ extensive loan portfolios: “the volume of reservable liabilities is simply not sufficient to meet the funding needs for bank loans at the aggregate level, and banks meet the rest of their funding needs by issuing managed liabilities.”

Managed liabilities, according to the Fed, include “large time deposits ($100,000 and over with maturities of less than one year), repurchase agreements against U.S. government and federal agency securities, Eurodollar borrowings, and federal funds borrowings from a nonmember institution.”

So, that should settle it, right? Whatever banks cannot fund via their own balance sheets, they borrow from elsewhere. Still, it does not tell us whether some new loans result in a net creation of money.

What anyone who doubts the Bank of England’s bulletin is going to get hung up on are how new loans lead to money creation. And with good reason. So, how does one show it in action?

Balance sheets do not settle question

The body of regulation that deals with how much banks can lend are their capital requirements, the minimal requirement to lend, set forth by Basel III, and then implemented by the Fed: “the rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5 percent and a common equity tier 1 capital conservation buffer of 2.5 percent of risk-weighted assets that will apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4 percent to 6 percent and includes a minimum leverage ratio of 4 percent for all banking organizations. In addition, for the largest, most internationally active banking organizations, the final rule includes a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures.”

But what does that mean to an actual bank’s balance sheet, say, Wells Fargo’s?

Most recently, according to Marketwatch, Wells Fargo has $181.5 billion of equity, and this backs up $1.6 trillion of assets, including net loans of $815.8 billion but also a few hundred billion of securities it bought. It also has $1.12 trillion of deposits and $229.7 billion of debt.

When Wells Fargo or any other bank experiences losses on its loan portfolio, then that comes out of the bank’s capital, per the Fed: “Capital acts as a financial cushion to absorb unexpected losses and is the difference between all of a firm’s assets and its liabilities. To remain solvent, the value of a firm’s assets must exceed its liabilities.”

So, the losses come out of the bank’s equity, but, how does one show that Wells’ loans did not originally come from its deposits? Looking at the balance sheet, there’s more than enough deposits to cover its loan portfolio. Then, a micro look at any given commercial bank’s balance sheet will still have one asking about the chicken and the egg. Which came first the deposits, or the loans? The balance sheet doesn’t tell us one way or another.

So, perhaps it is easier to show the money creation on a macro level? According to the Fed, at commercial banks, total assets are $14.8 trillion and total liabilities are $13.2 trillion, therefore, implied capital is something like $1.6 trillion. Although the Fed warns in a footnote that “This balancing item is not intended as a measure of equity capital for use in capital adequacy analysis.”

Nonetheless, with $7.7 trillion of loans and $10.1 trillion in deposits, even a macro look at all commercial banks balance sheets shows there would still be enough deposits to carry on the lending. Which came first, the loans or the deposits? Still hard to say.

But how does the money supply keep growing?

Yet, the amount of loans, deposits, and the money supply generally continues to grow on an annual basis. But how?

As the nation’s central bank, the only way the money supply can increase is if the Fed creates new money one way or another. And then, only either through asset purchases or loans. Or perhaps by increasing reserves.

Commercial bank credit grew from $4.6 trillion to $8.5 trillion from the beginning of 2000 to Aug. 2007 when the financial crisis began. Deposits at all commercial banks grew from about $3.4 to $6.4 trillion over the same period. M2 money stock grew from $4.6 trillion to $7.3 trillion.

Especially prior to quantitative easing, all the new money to carry on the new loans and make the new deposits had to come from somewhere.

So, where did all that money come from?

We can say for certain that it was not quantitative easing asset purchases that fueled the growth. Those had not started on a mass scale yet until the end of 2008.  The Fed’s balance sheet only expanded from $613 billion to $855.7 billion between 2000 and Aug. 2007. Reserves were flat, barely moving from $44.2 billion to just $44.9 billion. Not nearly enough to explain the expansion.

Nor was it foreign investment. The U.S. ran balance of payments deficits — which takes account of foreign investment, trade, and other factors — totaling $4.34 trillion during that time according to the U.S. Commerce Department.

And it wasn’t money that just happened to be stuffed in mattresses or thrown in wishing wells all these years, either.

Therefore, since all new money has to ultimately be generated by the central bank, and the only other thing the Fed can provide to banks besides asset purchases are loans, it could have only been credit from the central bank or the banks themselves or both that fueled the growth of new money.

Either way, the money had to be created from loans. What else could it have been?

The only remaining question then is perhaps the precise mechanism by which the new money was transmitted into the economy. But the only plausible explanation available for the growing money supply is new debt being issued and bank balance sheet expansion.

Robert Romano is the senior editor of Americans for Limited Government.

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