David Barmes – Banks Really are Magic Money Trees

Most people, probably 99%, believe that banks are intermediaries between savers and investors. They aren’t.

David Barmes is carrying out Positive Money’s latest research on Escaping Growth Dependency

Cross-posted from Positive Money

Banks really are magic money trees. We disagree with Thomas Hale’s assessment that such a description is misleading (Are banks really magic money trees?, 20 November 2019). Rather, it’s a useful frame that offers some crucial insights into the role they play in the economy.

Banks’ ability to create money via simple accounting entries has vast macroeconomic consequences. The constraints on their power are often overstated. The failure of mainstream economics to fully appreciate that power stopped it anticipating the 2008 crisis, and is a continuing barrier to building a banking system that serves society’s interests.

As the primary creators of money in our economy, banks have a significant impact on levels of financial instability, inequality, innovation, employment, and overall economic activity. The potential negative consequences of this were clearly demonstrated by the 2008 crisis, as banks inflated a colossal asset bubble by creating too much money for speculation in real estate and financial markets. Once the excessive growth of private debt started to prove unsustainable, they restricted credit creation, the system crashed, and the wider economy ended up suffering the consequences. Governments’ failure to provide adequate stimulus only deepened this suffering.

It would of course be wrong to claim that banks’ money creation powers are entirely without limits. [Whether this is necessarily implied by the ‘magic money tree’ frame, we’ll leave the reader to decide]. But the constraints that exist in theory are much weaker when applied in practice.

Hale considers the constraints outlined in the 2014 Bank of England report, ‘Money Creation in the Modern Economy’. He rightly identifies that although the need for individual banks to access reserves might represent a theoretical brake on lending, this is not an issue in the real world.

Banks’ lending decisions are made based on profit expectations, not reserves. As a result, banks tend to expand lending simultaneously, given that the circumstances that lead to higher profit expectations apply to all banks. In this situation, the banking system’s lending is not constrained by the prospect of lower profitability in the way that an individual bank’s lending would be if it were to attempt to expand its balance sheet more rapidly than other banks.

The Bank of England unequivocally states that reserves are not a binding constraint on lending. The Bundesbank is also clear on this issue: “a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal.”

Hale lists two other limits mentioned in the Bank of England report. The first is monetary policy, which he says “can change the incentives of commercial banks to make loans.” But monetary policy has a relatively weak and indirect effect on levels of lending and investment. The Bank’s policies have both failed to restrict lending pre-crisis and failed to stimulate lending in the years since.

The other limit that the report mentions is the behaviour of companies and households, but this section is actually about what households and companies do with newly-created money – it does not outline any constraint on lending. Nonetheless, of course, there must be a demand for loans from households and companies in order for banks to make loans, but this does not contradict the fact the banks can meet this demand at will.

Lastly, Hale adds capital requirements as a further limit. Capital requirements are indeed important, but they need to be far higher in order to have any significant effect. Even then, as Lord Adair Turner (ex-Chairman of the Financial Services Authority) argues, “capital requirements do not place an absolute constraint on credit growth, since bank equity can grow whether central bank/regulators want it to or not”. Any potential constraining impact of capital requirements can also be diminished through securitisation.

Hale suggests that labeling banks as ‘magic money trees’ offers nothing new to mainstream economics. He claims that the point that bank lending creates deposits “is now generally agreed upon” by economists.

Unfortunately, misconceptions about bank lending are present as ever in the vast majority of economics textbooks (e.g. Mankiw’s famous Macroeconomics), and have been repeatedly promoted by Paul Krugman in the Wall Street Journal. As our most recent response to this ongoing status quo, Positive Money is collaborating on a campaign with 50+ organisations and individuals to rethink the role of banks in economics education.

The difference between the system that the Bank of England explains and the one described by most economists is not just a “linguistic disagreement” as Hale suggests. It is a very real disagreement about the role of reserves in the banking system, and the way in which banks make lending decisions. And it is the disagreement that meant the majority of mainstream economists didn’t predict the 2008 financial crisis, unlike heterodox economists such as Wynne Godley, Ann Pettifor and Steve Keen.

Mainstream economic models further display the extent to which most economists fail to understand that banks don’t lend out or ‘multiply up’ reserves. Even after the crisis that they failed to predict, most DSGE models (dominant in neoclassical economics), either assume no banks at all, or assume that banks need deposits to lend. Consequently, they still fail to accurately model banks and capture their far-reaching impact on the economy.

Compared to the flawed image of banks as ‘intermediaries’ between savers and borrowers, conveying banks as ‘magic money trees’ more effectively captures the power they have in the monetary system and questions the inherent nature of money. This, in turn, effectively opens up discussion on banks’ role in the economy at large.

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1 Comment

  1. This is Positive Money’s latest research. What does it tell us, those of us who are thinking about international high finance, banking, mainstream economics and mainstream economists, about Positive Money and David Barmes? Personally, I think the purpose of this article is to maintain certain myths by means of certain assertions and by implication. For instance, the notion that there was some pivotal disagreement which led to the majority of mainstream economists not predicting the global financial crisis is very misleading. It would appear to the uninformed lay person that, as has been claimed consistently since 2008, the majority of mainstream economists did not know what was going on in that regard. Articles which appear of a dissenting and/or revelatory nature regarding policy and practice to do with high finance, economics and almost all government policies invariably lead lay people astray. Before and after the GFC there have been many dissenting economists and other aware commentators who have explained what was going on-As ever there have been explanations for strange behaviour on the part of the authorities, regulatory bodies and those institutions in question regulated. Mainstream economists and many a dissenting and/or heterodox expert commentator, not to mention the veritable plague of think-tanks and other such taxpayer and consumer- funded busybodies, have long been and still are engaged in the arts of justifying certain policies and most, if not almost all, practices in that regard, while fooling the public as to what the authorities, regulatory bodies and financial-economic institutions are aiming for.
    Finance, economics, commerce and politics are essentially one and the same as far as the globally oriented corporations and the nationally-based high-finance, economics, commercial and political cadre supporting the Establishment is concerned. The only purpose is to maintain and build on the power-base already in hand. The competition within this monolithic oligarchic body of national and international elites is to be vying for advantage and advance within the hierarchy of this Establishment phenomenon. Dissenters there are, but cannot be said to be in competition with the Establishment. There is a monopoly in power running the affairs in the western democracies. I used to say government had been hijacked, but the term state capture serves equally well.
    Although in theory government in the western democracies is meant to serve the nation-state and its citizenry, the demo, the people, and there is never no end to the sentiments and good intentions expressed by the commentariat in that regard, the fact is that politics is not the field of democratic political comtending it is made out to be. The game is rigged, of course, as has been noted time and again, and increasingly so of late, but the heterodox and dissenting opinionators are more often than not in the business of casting yet another veil, or two or three, over what goes on, as they “reveal” what can no longer creditably denied and as they attack the orthodoxies with sleights of hand, confounding the issues as they go, or simply massage public opinion by repeating and reinforcing popular sentiments.
    The nostrums put about are often incredible, impossible, impractical or prohibitively expensive, or a combination of any or all of these. The object being to justify a certain position with the view of gaining or maintaining a sinecure in an academic or some similar occupation. By and by, however, even the plebs, the lay observers, the citizens who follow the affairs of state from the outside and handicapped by the dearth of inside knowledge and time and/or opportunity to acquire such, are gaining an intuitive understanding of the way they are being shafted by the Establishment. What started as a few snowballs being thrown from a high vantage point will at some stage develop into a series of cascading avalanches, taking the impostors, who have been taking the public-at-large for a long and slow ride up the garden path and around the maze of misinformation and misleading narrative, on a short and fast ride into ignominious obliviation.

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