08.19.2014 0

Yes, bank lending does create money

Fed_lending

By Robert Romano

“Fractional reserve banking is a tautology. Banks aren’t in business, nor could they remain in business if they simply warehoused money. Instead, they borrow money from depositors seeking a return on their savings, and who don’t need access to their savings right away, only to lend the money borrowed to individuals who do need it right away.”

That was Forbes.com columnist John Tamny expressing the conventionally held view of where bank loans come from, very much in the George Bailey, savings and loan tradition. Depositors put money into savings, and the banks take that money and lend it back out into the economy.

But what if that’s not the way it really works or has worked for some time?

Enter Bank of England senior economist Ryland Thomas, along with colleagues Michael McLeay and Amar Radia, writing earlier this year, “Money creation in the modern economy.”

The Bank of England says it is not deposits that lead to loans, but quite the opposite: “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.”

Contrast that with Tamny’s description. “Credit can’t be multiplied. Period,” writes Tamny, adding, “For every individual who attains credit successfully, there must be a saver willing to give up near-term access to the economy’s resources.”

That might have been true at some point in financial history, but apparently no longer, if the Bank of England’s Thomas, McLeay, and Radia are to be believed. Somewhere along the line, the link between deposits and loans was seemingly severed.

In a video put out by the Bank of England, Thomas puts the conventional view of banking to bed, saying, “[W]hile this is nothing new, [bank lending] is sometimes overlooked as the main way in which money is created, and it runs contrary to the view sometimes put forward that banks can only lend out deposits that they already have.”

The significance of this Earth-shattering revelation was not lost on The Guardian’s David Graeber, who in March wrote, “everything we know is not just wrong — it’s backwards. When banks make loans, they create money. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognize as legal tender by its willingness to accept them in payment of taxes.”

So, are commercial banks so significantly different in London as opposed to Washington, D.C.? Are Thomas, McLeay, and Radia referencing the U.S. experience as well as the UK’s in “Money creation in the modern economy”?

It’s not entirely clear, but one assumes that they are. In the paper, the writers reference a 2007 speech by then Federal Reserve Chairman Ben Bernanke where even the connection between bank reserves and loans has been severed, not just deposits.

Then, Bernanke said, “Reserve requirements are lower and apply to a smaller share of deposits than in the past… Although the traditional bank-lending channel may still be operative in economies that remain relatively more bank-dependent, as recent research has found for some European countries… in the United States today it seems unlikely to be quantitatively important.”

So, if loans do not come from reserves, and they do not come primarily from deposits — something Bernanke also acknowledged in the 2007 speech when he said “banks and other intermediaries no longer depend exclusively on insured deposits for funding” — then where do they come from?

Good question. Is it nowhere? A security that is sold to provide the financing? A short-term loan from the Federal Reserve providing the cash to make the loan or buy the security? All of the above?

What is clear is that the issue would raise profound legal questions in the U.S., particularly since the power to create money is constitutionally granted to Congress under Article 1, Section 8. It might be hard to make the case that the national legislature ever explicitly delegated that power to private banks, but if it did — for example, under the Federal Reserve Act — then it is not commonly understood, as is evidenced by Tamny’s commentary on Forbes.com.

It would be a revolution in the way we have to think about the way the entire economy works, the way the financial system operates, and just how comfortable the borrowing public is with the idea that all the interest they’re paying may be on loans that the banks never risked any money on to begin with.

Say it ain’t so. Because if it is, this changes everything.

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

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