Can commercial banks create money out of thin air?

If the title of this posting is Googled there will be many hits suggesting that banks are able to do just this.

For instance according to Michael Kumhof Deputy Division Chief, Modeling Unit, Research Department, International Monetary Fund “The key function of banks is money creation, not intermediation.”

Some banks are also able to issue their own banknotes (or bills in the US). For instance Scottish banknotes, designated in £ sterling,  can be issued by several of their commercial banks and are readily accepted there.  But, maybe less so in England!  Normally UK banknotes are issued by the Bank of England. The Bank of England is the reserve bank of the UK,  part of the UK government and the issuer of the £ sterling currency.

When commercial banks issue loans they credit the bank accounts of the borrower and but they don’t debit their own reserves. The bank has the asset to the amount of the loan, and the borrower assumes the liability of repayment.

Of course, there are rules, which vary from country to country, which govern the lending practices, and ability to print banknotes, of the commercial banks. There is often, but not always, a requirement for the commercial bank to maintain a certain level of reserves. However, subject to these rules, the commercial banks can borrow as they need to provide commercial loans. They borrow at a low rate of interest, either from the reserve bank or their depositors, and lend out at a higher rate. The difference between the two rates provides the banks with their profit margin and also acts as an insurance against a default on the loan.

But if they feel they don’t need to borrow anything they don’t. They just write out an IOU which we all tend to think of as if it were the same as a government IOU.

Government, or their reserve banks, set interest rates as a matter of policy to regulate lending. The conventional, but erroneous, wisdom,  is that money can be created by the Reserve bank,  in printed  form or by keystroke,  and lent out via  the commercial banks  to regulate the level of activity in an economy.   It is is not considered that this should be done to directly fund additional government spending though. That needs to be done via the process of printing or creating treasury bonds. Somehow, for reasons which don’t appear to be quite logical, the economic mainstream don’t consider printing bonds to be the same as printing money.

Swapping money for bonds, or vice versa, doesn’t really change anything much at all , as has been recently seen through the so-called process of Quantitative Easing so maybe something of a rethink is called for on this point.

However, regardless of any inconsistency, the process works reasonably well in normal times but less well when interest rates are deliberately reduced to ultra low levels. The control knob can’t be turned any further.

Does this mean the commercial banks,  too,  are also acting as currency issuers rather than users? Are the Scottish banks assuming the role of a currency issuer when they print banknotes?

No, they aren’t.  Apart from being able to borrow directly from the reserve bank, individuals can do the same thing. They can issue IOUs as they please which in principle can be traded by a third party. Casinos can issue £5 chips, which are their IOUs, for use on , say, a roulette table. They, too, in principle could be traded on an open market. Of course, if the casino were considered a credit risk the chips would lose their value. Scottish banknotes could lose their value too if the issuing bank was considered to be in risk of default. Similarly, any bank customer with a bank account full of newly created credits would need to have all payments cleared using those credits. It is possible that they would be refused, by another bank, if the issuing bank were considered to be at risk of default.

It’s the financial viability of the issuing institution which guarantees any written IOU. Conventional theories involving banking multipliers are bunk! That’s not how it works.

So, in conclusion,  the “thin air” expression is somewhat misleading. Commercial banks aren’t doing anything special at all. The only issuer of a currency is the government, or governments in the case of the Euro,  via their Reserve bank. Everyone else is a user, and cannot , unless they are in the counterfeiting business, create their own extra units of that currency.

Further reading:
http://neweconomicperspectives.org/2013/06/do-banks-create-money-from-thin-air.html

29/11/2013

PS This posting has generated more heat than any other with 23 comments so far. I think I now understand the  problem better than I first did, so I’d like to thank everyone for their contributions. It seems to me that there needs to be a recognition that what we see in our bank accounts, at the commercial banks, isn’t quite the same thing as money. The figures actually do refer to bank IOUs which can of course be always swapped for government printed banknotes, which are certainly money,  providing the bank is solvent.
Similarly what the bank creates isn’t quite money. They generate their own IOUs or asset/liability pairs in the same way as anyone else can.  Should they be prevented from doing this? I’d have to say no. Anyone has the right to issue an IOU.  But, that of course is a political and not an economic question.

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63 responses to “Can commercial banks create money out of thin air?

  1. Pingback: Can commercial banks create money out of thin a...

  2. Banks don’t add a cent to the money supply, except for every savings and checking account in existence.

  3. Peter,
    The spending vs lending money into existence is an interesting point. According to Randall Wray in his recent book “Modern Money Theory” none other than Milton Friedman was once in favour of spending all new money into existence using the principle of 100% reserve banking to prevent any new money being lent into existence – as it now is.

  4. Peter Martin, so you think that Michael Kumhof, Martin Rees, Adair Turner, Mervyn King and Richard Werner, to mention just five prominent people at the top of their individual games, are wrong in their understanding?

    Reply: Probably Yes. Its not the banks who create the money. The government does that. The banks are just conduits in the process.If banks could create money they’d never go broke!

    Methinks it’s time you got yourself a copy of “Modernising Money”, available on this website, and sat yourself down for a quiet read. Perhaps then you’d realise that what you’ve written is just BS.

    Reply: If you think I’m wrong you are welcome to explain why in your own words.

  5. The commercial banks as a group increased the money supply by 2.5 times between 1997 and 2007 by lending it into existence, and tripled house prices in the process as much of the money went into mortgages. The recession occurred because people and government were trying to pay down their debts, so taking money out of the economy. Quantitive Easing was seen as a way of maintaining the money supply, otherwise the recession would probably have been a lot worse. The extra money created in this ten year period did not come from deposits, or the central bank creating money, but from the commercial banking system. The increased lending created new deposits, and new money.
    “If banks could create money they would never go broke…” A bank has to lend to someone in order for money to be created, it cannot just create their own money. The banks collectively increased the money supply (see above), 1997 to 2007. Northern Rock went bust because it borrowed short off other banks and creditors like me, and lent long to too many bad borrowers. The system starts to collapse when the borrowers cannot repay. There are the reserve accounts at the bank of England which the banks use to settle up between themselves, and money which you and I use with our bank accounts. For a good overview of the system, see the Banking 101 videos on the Positive Money site, the banks are not just conduits of money, they can and do create it, although they have to have enough money in their reserve accounts to meet their immediate payment obligations, which is usually a small fraction of their loan book and deposits (hence the term fractional reserve banking).

    Reply: The fallacy in your argument is most apparent in saying “A bank has to lend to someone in order for money to be created, it cannot just create its {my correction} own money.”

    A bank can either create money or it can’t. Governments, I would expect we would both agree, can create as much of their own sovereign fiat money as they like and spend it on what they like. They can never involuntarily default on any loan in that currency. They can never go broke. They don’t need a third party to create money. So why should a bank?

  6. So why was Northern Rock bust, along with RBS, HBOS, Bradford and Bingley et al ? The commercial banking system as a whole creates money through the act of making loans.

  7. Simon,

    These banks went bust for the reasons well known. They had over extended themselves and acquired too many bad debts.

    If these banks could have created money as you suggest, their chairmen, to realise their shortfall, could have taken a leaf out of Terry Venables’s book and opened an account in the name of their dogs. Then they’d have lent the dog a huge sum of money and later transferred it back to the bank’s coffers with a pawprint on a cheque!

    Of course, it would never have worked like that even if it had been legal. The money you think is created in the lending process has ultimately to be borrowed from somewhere, and usually that somewhere is the government owned reserve bank (the BoE) who lend out money created by keystroke.They may well have been guilty of being far too lax in their previous lending generally but they aren’t going to lend out billions to a bank to save the shareholders.

    The government did decide to later bail out the banks but that’s a different story.

  8. I am sorry, but you are mistaken in thinking the commercial banks borrowed money from the central bank or elsewhere when the huge amount of money was created from 1997. The loans preceded the deposits which became new money. If all the banks increase their lending in step, then they can expect new deposits to return to them at roughly the same rate. A bank has to have enough in reserve to meet immediate obligations, and they are now required to hold more capital after the financial crisis, so in that sense the deposits do matter, but they are not expecting all their creditors to appear at once. Please educate yourself, because as another person has posted, your analysis is at odds with many notable people including Adair Turner and Mervyn King amongst others.

  9. Simon,

    I didn’t say that the “the commercial banks borrowed money from the central bank….” Not in the sense that they borrowed all of it, they may well have borrowed some of it, but ultimately the market knows that the money can be borrowed by the commercial bank from the central, or reserve bank, providing that the bank is financially solvent ie they don’t have too many bad debts etc.

    Correct me if I’m wrong but I think your argument is that , as banks are allowed to lend out more than they receive in deposits, they are ‘creating’ the surplus? The rules of fractional reserve banking do vary from country to country, but typically the banks would be allowed to lend out around a factor of around 10 more than they receive on deposit. Although in Canada, UK there are no rules on the levels of reserves a bank must keep, but there are still rules on capitalisation.
    http://en.wikipedia.org/wiki/Reserve_requirement

    In other words, they can take in £1000 then can then lend out £10,000, or even more, so where does the extra £9000 come from? Or where does the whole £10,000 come from if they keep the £1000 in their reserves?

    The answer is that they are the banks IOUs. They aren’t IOUs created by government. The loans themselves are assets to the bank and the liabilities of the borrower. In normal times there would only be a small percentage of the loans which would be termed bad, so they, in turn, can be used as collateral, for additional loans from the reserve bank, if their reserves ever prove to be inadequate to meet a demand from their depositors.

    You may be thinking, by now, that I’m arguing that the banks do create money! But not so. What they are creating are asset/liability pairs just like anyone else can when they write out an IOU. If I was only worth £1000 I too could write out IOUs for much more -theoretically. The difficulty of course would be that my IOUs would be much less credible than a banks IOUs and they would be less acceptable. Unlike you or I, all commercial banks have an account at the reserve bank, and a system in place to use their assets (their loans) to acquire loans themselves as needed which are invariably created by keystroke by the reserve bank.

    That’s what gives a bank its credibility, but that’s not the same thing as an ability to create money. Not even the Scottish banks can do that. Their £10 notes don’t have quite the same status as Bank of England issued £10 notes.

    It is the government owned reserve bank which does have the ability to create money out of thin air – not the commercial bank. We’ve seen that hoo- haa in the discussion of QE. In principle they aren’t doing anything that you or I couldn’t if we did somehow manage to build a certain level of financial credibility.

    Did you read the link I previously provided from New Economics Perspectives?

    I suggest you read at least the first paragraph

    “….while there is truth in this metaphorical claim, the metaphor can also be seriously misleading, and leads some to attribute powers to commercial banks that are actually retained by the government alone under our system.”

    the paragraph starting:

    No, banks are not self-funding, either individually or in the aggregate. The “out of thin air” language, while containing elements of truth, can be extremely misleading, and people using this language sometimes woefully under-represent the significance of central bank liabilities…………….

    and the last two paragraphs.

    “What is true in the “from thin air” metaphor is that commercial banks are able to initiate the process of expanding deposit balances via lending without first obtaining any additional assets that might be needed to handle the added payment obligations…………..”

    “But it is crucial to recognize that banks do not and cannot simply manufacture their own assets – whether from thin air or otherwise. What they manufacture are liabilities; that is, debts……..”

    • Dear Mr. Martin,

      Unlike you or I, all commercial banks have an account at the reserve bank, and a system in place to use their assets (their loans) to acquire loans themselves as needed which are invariably created by keystroke by the reserve bank.

      That’s what gives a bank its credibility, but that’s not the same thing as an ability to create money.

    • Dear Mr. Martin,

      I think you highlighted an important point about the nature of banks when you made the following comment.

      “Unlike you or I, all commercial banks have an account at the reserve bank, and a system in place to use their assets (their loans) to acquire loans themselves as needed which are invariably created by keystroke by the reserve bank.
      That’s what gives a bank its credibility, but that’s not the same thing as an ability to create money.” – petermartin2001

      Government effectively guarantees the convertability of Bank Credit into Government Money.
      For these reasons Bank Credit functions almost indistinguishably from Government Money (notable execeptions being taxes, clearing, etc) & is why Bank Credit is a component of the Money Supply while mine & yours is not.

      Vilhelmo.

      • Government’s guarantees to banks are arbitrary and range from nothing in some countries to billions of dollars in others. Bank credit is part of the M3 definition but not M2 for example.

        What money is is really dependent on how we define the word. Everything becomes much clearer if we think in terms of IOUs and who’s written them. IMO.

        If they are written by Government they tend to be termed government money when they are cash. But gilts or bonds if they are interest bearing.

        If they are written by banks that’s bank money, in common parlance. If interest bearing they can be bonds too, Because banks are very reliable it’s not normally necessary to make any distinction between their IOUs and government IOUs.

        If the IOUs are written by a Casino then we call them chips, rather than money, but the chips function as money within the casino! You can spend them at the bar, for example, in some casinos.

  10. “The money you think is created in the lending process has ultimately to be borrowed from somewhere, and usually that somewhere is the government owned reserve bank”

    That doesn’t sound right to me Peter, but I’m happy to be corrected.

    My (current) understanding is that commercial banks only borrow from the central bank (and each other) to meet shortfalls in their reserves. They do not borrow to lend, and reserves are never loaned. That’s one of the common misunderstandings with QE.

    I think I’d also question your assertion that to lend banks have to first borrow from either the reserve bank or their depositors. The belief that banks make their money on the spread between the deposit rate and the lending rate just doesn’t add up. I think that’s a myth promoted by the banking system to divert attention from what’s really happening, that is, the leveraging of bank capital. Banks are not intermediaries.

    That then raises the question, why do banks seek our deposits ?

    I can’t think of any one source where I’ve seen this question answered satisfactorily but my guess is that they need deposits to meet reserve requirements, to fund their trading activities, and might I cynically suggest, to mop up savings and stop them leaking into the corporate bond market. They certainly don’t need them to lend.

    As to the question, “can commercial banks create money out of thin air” I’d say, when it comes to lending, the answer is yes, and I don’t think that article by Dan Kervick disagrees:

    “What is true in the “from thin air” metaphor is that commercial banks are able to initiate the process of expanding deposit balances via lending without first obtaining any additional assets that might be needed to handle the added payment obligations and withdrawal claims that the additional deposit liabilities might impose on the bank.”

    • Yes. Point taken. I should have phrased that sentence better than I did. What I meant was that they can do that if needed and the support of the central or reserve bank underpins the lending practices of the commercial banks. If they didn’t have that support they would have to maintain much higher levels of reserves to guard against a run on their deposits.

      Yes, banks do borrow to maintain their reserves. If their lendings increase they will need to increase those reserves, so in that sense, they are borrowing to fund loans. The loans come first, of course, and the banks look at ways to finance those loans later.

      I am in basically in agreement with Dan Kervick. But there are many who don’t see it the way he does and take the ‘thin air’ argument much too far

  11. The loans come first, of course, and the banks look at ways to finance those loans later.

    I could still be barking up the wrong tree here Peter, but I would’ve said “and the banks look at ways to cover their reserve requirements” and avoid any suggestion that banks have to cover their loans with borrowed money.

    If banks were simply intermediaries making say 2% on the spread how could they record profits of between 15 and 20 percent on capital without creating money ex nihilo, as has been the case with Ozzie banks in recent times.

    Given typical Basel Accord risk weighted leveraging that would only be possible if banks didn’t have any costs of operation (let alone obscene executive remuneration!)

    The subject deserves a better analysis than my “back of bus ticket” musings and I wouldn’t be distressed if some banking expert shot me down in flames.

    On another tack, you wrote “The conventional wisdom is that money can be created by the Reserve bank, in printed form or by keystroke, and lent out via the commercial banks, as they need, to regulate the level of activity in an economy.”

    You didn’t go on to say that this “conventional wisdom” is also wrong. That would imply that the central bank controls the money supply, which, after the Volker experiment, we know it doesn’t. As Bill Mitchell has often explained, the commercial banks create loans to meet the borrowing desires of the private sector and the central bank provides the necessary reserves. The reality is, the tail wags the dog.

    • John, you’ve nailed it!
      I urge all readers of this blog to visit the Positive Money UK website at http://www.positivemoney.org and find the summary of the book published earlier this year, Modernising Money. It explains in great detail exactly how our loony financial and banking system works, why it crashed so badly in 2008, why quantitative easing as practised by the central bank of the US (the mis-named, privately owned Federal Reserve) and the government-owned central bank of the UK (the Bank of England) is so ineffective, and puts forward a plan for a saner, viable monetary and banking system in which the central bank, which must be government-owned, creates not only the physical coins and banknotes (which make up only 2 or 3% of the money in circulation), but also 100% of the nation’s digital currency (the stuff that’s in our bank accounts). In this system, digital currency would be permanently circulating and would not disappear when a loan is repaid (as happens now).
      The power of private banks to create money ex nihilo and lord it over the people would be no more, and banks would have to become mere financial intermediaries living off their margins, which is what they have always held themselves out to be. Incidentally, just as no licence is required to manufacture widgets, no licence would be required to become a financial intermediary!
      One consequence of having the government-owned central bank creating our digital currency free of debt and free of interest, at a rate to just match economic growth so as to ensure zero inflation, and gifting it to central government to spend into circulation according to its democratic mandate, would be that taxation could be reduced by more or less the same amount as the new money so created. People’s incomes would go up, making it possible for more of us to become savers and investors, and at last we could have people’s capitalism instead of crony capitalism. What a pity that neither Karl Marx nor John Maynard Keynes thought of such a system!
      All of the wonderful technology that has enriched our lives was created by scientists and engineers, not by bankers, accountants and lawyers, none of whom should be remunerated at anywhere near what a good scientist or engineer should be!

    • John, Yes I’d agree with this. At a time when the private sector are net saving then there will always be an excess of reserves so financing loans isn’t a problem for banks. In more normal times the excess reserves will be converted to Treasury bonds.
      When the private sector are net spending there could be a shortage of reserves, and that would be when borrowing from the central bank would occur which would tend to put the public sector into surplus.

  12. PJM,

    I’m just wondering about a few things I’ve seen on your webpage:

    “If there’s £100 in your bank account, someone else must be £100 in debt.”
    Yes that £100 is part of the so-called National debt. [29.11 I now don’t think that’s right. Its the account holders asset and the banks debt. The bank’s reserves at the central bank are part of the ND though. PM]

    If we want more money in the economy, we have to go further into debt to the banks

    The problem at the moment is caused by people not spending enough. They are saving their money in the bank.

    The government can spend money into the economy using deficit spending. That’s why the deficit is quite high at the moment. In accounting everything adds up to zero so if the government sector is in deficit the non-governmental sector must be in surplus and vice versa.

    I’m just wondering if you are aware of , and/or agree with the concept of sectoral balances?
    See for example:

  13. Here’s a review of the book, “Modernising Money”, and I feel compelled to say that I couldn’t have written it better myself. As copied and pasted – albeit with my correcting a few typo graphical errors – direct from the Positive Money UK website http://www.positivemoney.org:

    “The solution that we are all looking for, 3 Mar 2013 – by Simon Thorpe.
    How many times do you hear that the government is massively in debt, and that there are only two options – either (a) increase taxes, or (b) cut government spending? This story, which is repeated endlessly by politicians, economists and journalists is a fiction. And Andrew Jackson and Ben Dyson’s excellent book explains why. The real problem is that governments have handed the power to create the nation’s money supply to the commercial banking system. And those banks are responsible for creating 97% of the money in the UK system. They create that money “out of thin air” when they make loans. And then they charge everyone – individuals, businesses and governments – interest on those loans.My own calculations back up the claims made both in Modernising Money, and in the Positive Money groups’s previous book “Where does money come from?” (also highly recommended).

    Since 1995, the UK government has paid over £495 billion in interest charges on government debt. That’s a substantial proportion of the £1.1 trillion in public sector debt. And these payments have been going on for decades. Indeed for most of the 1960s and 1970s, the government was paying around 3.5% of GDP to the banks in the form of interest charges, reaching a peak of over 4.5% in 1981-2.What Jackson and Dyson demonstrate is that those payments were totally unnecessary, because there is absolutely no reason why the nation’s money supply needs to be created as interest bearing debt by commercial banks. The Bank of England could, and should, be creating the money supply. And it should be providing that money supply to power the economy free of interest charges.The usual argument trotted out by the defenders of the Banks right to create the money supply is that if governments were to be given control of the money supply, they would be tempted to increase the money supply too fast, and the result would be hyperinflation – we would end up in Zimbabwe, or the Weimar Republic.But Jackson and Dyson calmly demolish these arguments. In an appendix, they demonstrate that the Zimbabwe/Weimar Republic arguments are phoney. They also demonstrate that, left to the commercial banks, money creation is done in a way that follows only one objective – maximising bank profits. And that is why a vast amount of the newly created money has gone to fuel house price inflation – with the result that working families are now priced out of the housing market.But the real killer is that they don’t propose to hand over the keys of the money creation mechanism to the government. No, they propose that money creation for the economy should be the responsibility of an independent, yet publicly accountable “Money Creation Committee” whose job would be to regulate the supply of money in the economy. I find this argument absolutely convincing, and it completely avoids all the usual counterarguments to monetary reform.Putting the money creation process in the hands of people who have nothing to gain from excessive money creation would end the boom and bust cycles that have plagued economies since the dawn of banking. It’s a point that was also demonstrated in a recent publication by two IMF economists who used state of the art economic modelling to show that taking the money creation power away from commercial banks and using what is known as Full-Reserve Banking would be extremely beneficial (“The Chicago Plan Revisited”).To make one last point, consider the following. Since 1983, the UK banking system has been increasing the total money supply (measured by M4) by an average of 10% every year. Even if you take into account inflation, you still get a net increase of 7% per year. But since the financial crisis in 2008-2009, the banks have effectively been removing around 7-8% of the money in the economy every year. That’s because everyone has been desperately trying to pay back their debts. And when they pay back the money they owe to banks, that money actually disappears. That is why the economy is in crisis.The commercial banks not only have the power to create money out of thin air when they create loans, they have the power to destroy in when those loans are paid off. Indeed, if we all tightened out belts, eliminated all our debts, and the government slashed all public spending to pay back all the “money” that it has borrowed from the banking system, there would be no “money” left.That is why the system needs to be fixed. The money supply should be in the hands of a publicly accountable central authority, and it should be injected into the economy debt-free. That is what Jackson and Dyson are proposing. And they are absolutely right.
    Everyone, but everyone, should read this book. If you hear a politician, economist or journalist saying that tax rises and cuts in public spending are the only options, you can tell them that they are completely wrong.

  14. PJM,

    Look, I don’t mind you spruiking your book, providing you are prepared to discuss its contents.

    I’m a bit concerned about this for instance

    When you pay down your debts, the money that leaves your bank account doesn’t go to anyone else – it just disappears. This is because loan repayments are just the opposite process to money creation: banks create money when they make new loans, and effectively ‘destroy’ money when they repay loans.

    They would only tear up their own IOU just like you or I would if they got one back. Is that what you are saying?
    But they wouldn’t tear up a government IOU, ie a £10 note, any more than you or I would. They tend to get quite upset when bank robbers remove large quantities of them from their vaults!

    • Peter Martin, I just took a New Zealand twenty dollar note out of my pocket to see if it is a government IOU. It doesn’t appear to be, as it has on it the words “THIS NOTE IS LEGAL TENDER FOR TWENTY DOLLARS”.
      it is an example of fiat currency and as such it’s not backed by anything and is not a promise to pay — it is merely legal tender for twenty New Zealand dollars, and is not redeemable for anything at all.
      Please justify your claim that banknotes are government IOUs.

    • So you’re saying that $20 is worth $20 because the NZ government says it is? And if I said my business card was worth $20? You wouldn’t believe me.

      The truth is slightly different.

      The NZ government imposes taxes and so has the power to put you in jail if you don’t pay them. If I had the power to put you in jail I could give you a tax demand which had to be paid in PM business cards. I could then make you wash my car or dig my garden to get the business card to pay the tax demand. Neat trick eh?

      Randall Wray explains it all very well:

      • Peter Martin, all that you just wrote may well be true, but so what — it’s irrelevant! Fiat currencies are not meant to be redeemable. They have value because you can pay your taxes with them. By that same definition, bank deposits created ex nihilo are also, in effect, both money and legal tender, because you can pay your taxes with them. Probably, if you were silly enough to take a wheelbarrow full of currency notes to the tax office and said you wanted to pay your income tax, you’d most likely be suspected of not declaring all your income!

    • IOUs do have the peculiarity that it makes sense for the issuer to destroy them, when they receive them back, but it doesn’t make sense for anyone else to destroy them.

      So the NZ government are not being wasteful if they burn a bagful of used $20 notes. They can just write out some more.

      You, too, can write out a $20 iou. It makes sense for you to rip that up when you get it back.

      If you have a NZ bank account , say with the ANZ, then the currency shown in your statement are the IOUs of the ANZ. They aren’t quite the same thing as NZ government issued dollars. But, of course, if you make a withdrawal in cash you will be issued with nice shiny new NZ government issued dollar notes. The ANZ are honouring their IOU to you.

      However, it is not beyond the realms of possibility that one day they may be unable to do that and you may lose some or all of your deposit.

      If that were to happen, you might then think that the question of who has written the IOU is not quite so irrelevant, after all!

      The confusion between a commercial bank’s IOUs with the real thing is, IMO, at the heart of the “out of thin air” misunderstanding regarding the creation of money. You can’t in a free society prevent anyone writing out a IOU.

  15. Peter Martin wrote: “If that were to happen, you might then think that the question of who has written the IOU is not quite so irrelevant, after all!”
    That’s precisely one of several good reasons why government should issue ALL of a nation’s currency, including all the digital money! How come, Peter, that Mervyn King, the former governor of the Bank of England, and Adair Turner, the recently retired head of the UK’s Financial Services Authority, to mention only two prominent economists who headed major government authorities, get it and you don’t? Perhaps, if you took the trouble to read “Modernising Money” and the more recent Positive Money publication “Sovereign Money”, you would get it. Your understanding, or more correctly the lack of it, puts you firmly in the camp of neoclassical economists. Australia’s own Prof. Steve Keen’s book “Debunking Economics” is another resource that you could well consult.

    • OK What about Dan Kervick’s article? Do you disagree with him too?

      I think DK and I are saying the same thing , in effect. You’re accusing the banks of creating money but we’ve both established they can’t do that.

      The banks can create their own IOUs though and that’s really what you’re objecting to! Your book should perhaps be retitled Modernising Commercial Bank IOUs and you could register http://www.positivebankious.org !

      Your proposal wouldn’t work unless all the banks were nationalised and 100% reserve banking were the norm. Personally, I wouldn’t have a problem with the former but I doubt either would find majority acceptance.

  16. Peter martin wrote:
    “I think DK and I are saying the same thing , in effect. You’re accusing the banks of creating money but we’ve both established they can’t do that.”
    No, you have not established that “they can’t do that”!
    Perhaps you just have a problem with semantics.
    My definition of money (and as far as I’m aware it’s universally accepted) is “If central government and local government accept it in payment of taxes and rates respectively, then it’s money.” Try paying your taxes or your rates with your own IOU and see where that gets you!

    • PJM,

      Yes OK. That’s where the bank’s fractional reserves come in which are held in an account at the central bank. They are definitely real money because they are held in the government’s central or reserve bank. Banks can pay either the government, other banks or customers in ‘real money’ when required. But they can only do that if all their customers don’t demand the same thing at once. That would be a run on the bank.
      Banks can run on much smaller reserves than they used to, or to be more correct a smaller capital base, because they have the support of the central bank at their disposal when required.
      The difference between their reserves/capital base and the sum total in all accounts can be considered to be the bank’s own IOUs.
      And, furthermore, anyone can pay their taxes with a their own IOU. That’s what a personal cheque is. The payment would need to be cleared in exactly the same way as a direct transfer from a personal bank account would have to be cleared. The first would be much more likely to bounce than the second but, in principle, both could bounce.

  17. Peter Martin wrote in response to my definition of money (and as far as I’m aware it’s universally accepted) is “If central government and local government accept it in payment of taxes and rates respectively, then it’s money.” :”Yes OK. That’s where the bank’s fractional reserves come in which are held in an account at the central bank. They are definitely real money because they are held in the government’s central or reserve bank.”
    Problem is, neither you nor I can use central bank reserves to pay our taxes and rates, and therefore, by the definition with which you have just agreed by writing “Yes. OK”, central bank reserves are not ‘money’ by the definition given above — they’re merely accounting sleight of hand to befuddle the public into believing that the banking and monetary system is kosher — which it plainly is not, otherwise we wouldn’t have had the crash of 1929 or all the other asset bubble bursts that have occurred since, culminating in the crash of 2007-2008!
    Peter, methinks it’s time you conceded that you can never win this debate, because there is no logical reason why we the people should remain so collectively stupid as to allow private banks to have such control over us. The truth will set us free!

    • PJM,

      “Problem is, neither you nor I can use central bank reserves to pay our taxes and rates”

      Yes we do. When our tax payment is cleared, the same amount, penny for penny, is deducted from our bank’s reserves.

      Or, if we pay in cash, that is real money too and is deducted from our bank’s reserves when we make a withdrawal at an ATM. In fact the cash itself can be considered to be part of the bank’s reserves.

      But, on the other hand if we ask our bank for a bank cheque, that would be an IOU of the bank and the same amount wouldn’t be deducted from the bank’s reserves. That may, or may not, happen later depending on where the cheque was processed. If it was presented to the same bank (say it was for rates and our council used the same bank) then it wouldn’t be.

      Have you got it yet?.

      PS Yes anything held at the central bank, and I would include government bonds, can be counted as real money. In other words they are IOUs of the government/central bank rather than IOUs of a commercial bank.

    • ” ….monetary system is kosher — which it plainly is not, otherwise we wouldn’t have had the crash of 1929 or all the other asset bubble bursts that have occurred since, culminating in the crash of 2007-2008!”

      The retail side of banking normally works very well. Not perfectly I know – I get annoyed by some of the charges like anyone else but they didn’t cause the recent crash. So its important to know which are the good parts and the irresponsible parts of the banking system and not throw out the baby with the bathwater.

      • Thanks, Peter Martin, for all your ‘explanations’, flying as they do against the weight of the evidence.
        It’s just as well that engineers don’t have the same mind-set as you. If they did, our cars would all still have carburettors, for they worked very well! Let’s all give a special thought of thanks to the engineers who, despite knowing that carburettors worked very well, went ahead and developed electronic fuel injection, which works much better. The wind-up HMV grammophone I used as a child worked very well, too — and there are countless other examples.
        Perhaps if you made the effort to read “Modernising Money” (even a summary) and/or “Sovereign Money: Paving the Way for a Sustainable Recovery”, you’d begin to understand that sovereign money would do for our monetary system what electronic fuel injection has done for automobile fuel economy and performance — and more!
        Having led the horse to the water, I’m unwilling right now to spend any more time on trying to get him to drink!

  18. Peter Martin wrote: “And, furthermore, anyone can pay their taxes with a their own IOU. That’s what a personal cheque is.”
    Words, words, words….here we go again! A personal cheque is not a personal IOU. Rather, it is merely your personal instruction to your bank to take the specified quantity of bank deposit money out of your account and credit it to the bearer’s account. When a taxpayer pays tax with a personal cheque, government does not extinguish the tax due until after the cheque has cleared.

  19. PJM,

    It’s a pity we disagree. I’d say your motivations are similar to ours but MMTs understanding of the problem, and of the nature of money itself, is different from yours.

    Before you go I’d just ask you about your claim that “To reduce the burden of personal, household, and government debt, new money will be created free of any corresponding debt ……..”

    How can you have money which is debt free? That’s not how we understand money. We, or rather Eric Tymoigne and L. Randall Wray say:

    “Monetary instruments are never commodities, rather they are always debts, IOUs, denominated in the socially recognized unit of account. Some of these monetary instruments circulate as “money things” among third parties, but even “money things” are always debts — whether they happen to take a physical form such as a gold coin or green paper note”

    The problem for us is that the word debt has negative connotations. If somehow the national debt were ever repaid then no-one would have any money at all! So in reality its quite a good thing in this context!

  20. Joining this discussion again, there is some disagreement between Peter M and PJM about money. Some economists regard all money as a debt, because the government can tax it out of existence. I tend to regard physical cash as money and not a debt, and electronic money loaned into existence starts life as “credit”, but then becomes money because it can be converted into physical cash from a current or deposit account (unless it is in a long term bond), and can be used to pay taxes, so in that sense is real money. Deposit accounts are also underwritten by the tax payer up to £85,000.
    The accounting of assets and liabilities is a red herring, in the sense that both greatly expanded during the boom years and the money supply increased because of extra commercial bank lending. The central bank has recently provided some cheap money borrowed by the commercial banks through it’s funding for lending scheme, but this is a small proportion of the overall money supply. It is notable that the money supply has grown very much more slowly over the last 6 years, as people and government try to pay down debts, and has only been maintained because of the quantative easing since 2007.

    • ” I tend to regard physical cash as money and not a debt” A Bank of England banknote would be government money. It’s an IOU of the government, or the Bank of England, if you think there is a difference.

      The Bank of England can write as many as they like and burn as many as they like – just like anyone can do with their IOUs.

      The only money which wouldn’t be a debt would be commodity money like gold bullion.

  21. Peter Martin said – “The problem at the moment is caused by people not spending enough. They are saving their money in the bank.”

    I don’t agree with this Peter, there is a money shortage because of the huge debt build up in the boom years, people and government are trying to pay down debt, especially when interest rates are so low. In fact private sector and public debt are still increasing. In other words, there is too much debt and not enough money.

  22. Simon,

    I probably should have said ‘people and companies’ were not spending enough. There’s no real desire to spend or borrow at present as the private sector generally try to recover after the 2008 crash.

    The comment is a general one, relating to the total aggregate demand in the economy. This is low because those who have money are, generally, not spending, and those who don’t have any can’t spend either.

    The overall picture can only be understood by looking at the balances of the public, private and overseas sector.
    See for example:

    If you would like to click on the 3 spoken link on my blogroll you’ll see a comprehensive set of graphs for the UK which look very similar.

    Notice that the private sector is in surplus is almost a mirror image of public sector debt. Its just not possible for both to be in deficit simultaneously unless the trade deficit was huge.

    These graphs are very good indicators of the state of the economy and good predictors of future problems. See my latest post.

    I posted a cartoon youtube link previously which gives a good explanation of the concept.

  23. In fact private sector and public debt are still increasing. In other words, there is too much debt and not enough money.”

    Private sector debt is certainly one problem. Households are battening down the hatches out of fear of unemployment whilst business in this climate is understandably reluctant to invest.

    But a shortage of money is not the problem. Commercial banks can create almost infinite quantities of money but they’re cautious about who they lend to, and those who might best qualify for loans don’t want to borrow. So the private sector grinds to a halt.

    But public debt is only a problem to the extent that it’s not big enough. This is perhaps the most important insight one gets from an understanding of MMT and the sectoral balance.

    When both the private and external sectors are a drain on spending, then there’s only the public sector left to do the heavy lifting. And that means deficit spending.

    But with a new bout of deficit hysteria drowning out rational discussion of a way out of the mess don’t expect things to turn around any time soon.

  24. “But a shortage of money is not the problem. Commercial banks can create almost infinite quantities of money but they’re cautious about who they lend to, and those who might best qualify for loans don’t want to borrow…”

    But it is a problem, because there is always more debt plus interest than money, and if all the debt was paid off, there would be no money. The only way to get money into the system now is to create more credit / debt, so it a self defeating system, requiring government and people to be in perpetual debt servitude. Better to introduce debt free money, which can be used to pay down existing loans over time.

  25. To answer Peter Martin’s request for information, expressed in his comment “Before you go I’d just ask you about your claim that “To reduce the burden of personal, household, and government debt, new money will be created free of any corresponding debt ……..”
    How can you have money which is debt free? That’s not how we understand money.” the following has been copied and pasted from the Positive Money UK website:

    {Editors Note: Comment has been edited to remove wholesale copying and pasting. Comments should be original and to the point. Short quotations are OK but beyond that please provide a link as below. }

    https://www.positivemoney.org/2013/11/sovereign-money-creation-vs-modernising-money/

  26. @PJM @ Simon,
    Can you provide any examples of debt free money?

  27. “@PJM @ Simon,
    Can you provide any examples of debt free money?”
    To Peter Martin:
    Yeah, I just did, but you, in your ‘wisdom’, deleted it.
    As I said before — one can lead a horse to water, but one cannot make it drink!
    How about you make an exception and reinstate my post?
    For those of you who are interested in finding out the truth, just go to the website http://www.positivemoney.org
    As Mark Twain said, “It’s not what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so!”
    The truth is that every time a bank makes a loan, it creates the principal ex nihilo, but does not create the interest. The interest has to be borrowed by some other participant in the banking system in which we the common people are mere debt slaves! This truth, once understood, can set us free!

    • PJM, You are welcome to have another try at the posting. The rules I’m enforcing would typically be what is expected in an academic environment. Short quotes and references are fine, if they are accompanied by your own reasoning. Block copying of whole pages and arguments along the lines of “read this book, website, or whatever, then you’ll realise you’ve got it all wrong” aren’t OK.

      • By the way, Peter Martin, you seem to have a reading problem. My initials are PJM, not PLM. As you had previously said that you wouldn’t bother to look at the contents of the Positive Money UK website, I felt that maybe, just maybe, if i copied and pasted a tiny proportion of its content, you might just deign to read it. I shouldn’t have wasted my time. may you find peace in your own ignorance — there you join the masses!

      • PJM,

        Apologies for getting your initials wrong. I’ve now fixed up the mistake in all previous comments.

        I think you must be confusing me with someone else. I haven’t said that I wouldn’t look at your website. In fact I have looked at it.

        John Armour has looked at it too and makes some good points. If you’re cranky with me maybe you could still answer him! It has to be in your own words though 🙂 Or maybe we could discuss them on the positive money website itself?

  28. But it is a problem, because there is always more debt plus interest than money, and if all the debt was paid off, there would be no money

    I think your fears are unfounded Simon because you don’t discriminate between money created by the commercial banking system (which nets to zero) and money spent into the economy by government in a fiat system.

    Although the issuance of bonds to “finance” deficits makes it look like debt, it’s not.

    • I do have sympathy for the last sentence. I’ve thought about different words to express ‘debt’. National Liability maybe for National debt? However, the purchase of bonds does get included in what is known as the National Debt.

      So I think we do have to tackle it head on. Yes it is called a debt. BUT, its not like a debt for a purchase of a house or a car. It is only a debt or liability in an accounting sense and it never will be paid off. Neither the borrowers nor the lenders would ever want that.

      Its not a concept which would be easy for a politician to explain to a voter though. That is a big problem.

  29. PJM, I read the section on national debt in your positivemoney link. It’s a “curate’s egg”: bits of it are excellent.

    But the following assertions are ridiculed in the MMT literature, and rightly so:

    “Government bonds compete with private sector investments for funds, so government borrowing diverts money away from private sector investments and increases the rate of interest the private sector pays to attract investment.”

    This is the so-called “crowding out” hypothesis which has no empirical basis.

    “Individuals may start saving more (and so spending less) in expectation of an increase in future taxes (to pay off the debt). (This is known as Ricardian Equivalence).

    Same thing for “Ricardian Equivalence”, no evidence. Neo-liberal nonsense.

    “Because of the potential for adverse effects to long term interest rates and the exchange rate.”

    See UK, Japan, and the USA and observe the opposite effect.

    Mercifully, no mention of Reinhart and Rogoff.

    A lot of other misleading/mistaken stuff too. I think MMT is a much more reliable source of information on money.

  30. Its not a concept which would be easy for a politician to explain to a voter though. That is a big problem.”

    Most economists don’t even get it.

    “Science advances one funeral at a time” (Max Planck).

  31. It’s absurdity is that, if you asked 100 different economists how money is created, you’d get 100 different answers. There should be more clarity on the process. It’s almost as if the powers that be are purposely obfuscating the issue. Surely not?

  32. It’s absurd that, if you asked 100 different economists how money is created, you’d get 100 different answers. There should be more clarity on the process. It’s almost as if the powers that be are purposely obfuscating the issue. Surely not?

  33. Peter J. Morgan

    For me, this article by Professor Joseph Huber has clarified why some MMT explanations didn’t make any sense. I urge all posters, including Peter Martin, to read it:
    http://www.sovereignmoney.eu/modern-money-and-sovereign-currency/

    Also, since Peter Martin began this thread, there has been a Bank of England paper published in its Quarterly Bulletin for Q1 2014, called “Money creation in the modern economy.” It spells it out in no uncertain manner that banks do indeed create money out of thin air, each and every time they make a loan. The URL is http://www.bankofengland.co.uk/publications/documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

    • PeterJM,

      There is also this article from the same BoE source which needs to be read in conjunction with your BoE reference:

      http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneyintro.pdf

      A key point of the article is that “Money today is a type of IOU”. An IOU is a liability to the issuer and an asset to the holder. You, and the banks, can write as many IOUs as you like to yourself and not be a penny better off. The banks are indeed creating money when they do this but they still aren’t any wealthier either. That’s because they are creating a debt, or a liability, to exactly counterbalance the asset they’ve also created.

      You’d be happy to hold a commercial bank’s IOU. You’ll trust that. The person who you’d like to buy a cup of coffee from, or some fish and chips or whatever, will trust it too. So the bank’s IOU can be used as money. He probably wouldn’t trust my IOU, so mine can’t be used as money. That’s the only difference.

      But Joseph Huber doesn’t agree with the BoE. To him, money is not a debt or an IOU. As he points out, debt and money are different words!

  34. Peter J. Morgan

    No, Prof Huber well knows that at present, 98% or so of what we use as money is an IOU.
    Prof. Huber says, rightly, that Sovereign Money is not debt. It is my understanding that he also agrees that bank money is debt. In a total Sovereign Money banking and monetary system there would be no bank money (i.e. no debt money) and all money would be simply sovereign money — coins and notes and electronic tokens issued debt-free and interest-free by an independent (free from political — as well as capitalist — control) agency of the state, gifted to the government and spent into existence by the government according to its democratic mandate, with a corresponding reduction in taxation.
    With an economic growth rate of, say, a tiny amount over 3% p.a., there would be on average a mandated monthly increase of 0.0025% in the money supply.
    There would be only one kind of money and no need for separate reserve bank money – i.e. reserves – and banks would have to earn their profits by competing on a level playing field with all other finance organisations that were so inclined to act as financial intermediaries, to attract term deposits from savers, aggregate them and on-lend to borrowers, making a living from the margin between the interest rates that they paid savers and the interest rates that they charged borrowers. No bank would be too big to fail and those that did would have their depositors listed among their creditors. There would be no such thing as a risk-free ‘investment’ and no need for government intervention other than the usual regulation of the activities of companies.

    • I’d put it that Professor Huber says, wrongly , that Sovereign money is not debt.

      The BoE says it is debt or a liability. It says, for example:

      “Currency is made up mostly of banknotes……most of which are an
      IOU from the Bank of England to the rest of the economy”.

      It says that money generally is an IOU. Money is an IOU of the issuer. So if money is issued by Barclay’s bank it is an IOU of Barclay’s Bank. If money is issued by the UK’s central bank, the Bank of England, it is an IOU of the BoE. If we regard the BoE as a part of government then it follows that money (££) is an IOU of government too.

      What’s the big problem? Its all logically very consistent. You’ve just got to think in terms of liabilities which serve the function of money and stored financial assets. So, they don’t need to be repaid. All countries need their National debts as a store of those assets. We can’t do without them.

  35. Peter J. Morgan

    To me, Peter Martin, the fact that if you take a pound note to the Bank of England and ask for the debt that it represents to be paid to you, they’ll simply give you another pound note in exchange for the old one. Therefore, it’s not a debt at all!
    The same thing happens in New Zealand. Please tell me, what happens in Australia?

    • I think we’ve had this conversation previously. The BoE consider their issued banknotes are indeed IOUs. As you were keen to present their opinion as evidence in your original posting on this thread, you might like to consider why they think that.

      • Peter J. Morgan

        I have, Peter, and I believe that the evidence shows that whoever in the Bank of England wrote that statement is wrong, for the reasons stated above. I have no idea why they would make such an incorrect statement, however.
        Please tell me: What would the B of E give you in exchange for a ten pound note?

      • If they didn’t tell you to b****r off they’d give you two fives! Or a pocketful of change.
        At one time they’d have given you a small amount of gold. So, then it was easy to see that a paper note was an IOU for that gold. But, as time went by, one by one, the world’s currencies were de-linked to gold. Did that therefore mean the paper currencies were no longer IOUs?
        The US$ was the last to come off the gold standard in the early 70s and when it did, nothing much changed. Or at least it wasn’t much noticed. So what makes the US$ worth anything at all? What does the US government owe anyone who owns dollars?
        The answer is that the US government imposes taxes on its citizens. It say they owe the government. But, as the holders of dollars are also owed by the government they can use those dollars to pay their taxes. So the IOU of the US$ cancels out the you-owe-me of the tax demand.
        That’s the theory. That’s not just what MMTers say. Its what the economists at the BoE say too. If you don’t like their opinion you shouldn’t bring them into the argument.

  36. I don’t have time to read all of these posts!

    The point is simple, banks do create money out of thin air! When a bank makes a loan, it creates a deposit to it’s customer. The depositor can then write a check for what he wants to buy, or convert his deposit into cash and proceed with his purchase. Either way, purchasing power, aka money is created by the bank. The money supply is inflated. This is a very simple process.

    Don’t let semantics confuse you!

    • Yes of course. The banks can create ££ and you or I can go out and buy something with it which will stimulate the economy.
      The Govt can do the same thing when they give you a tax cut. We get the £££ and then go out to buy something to stimulate the economy.

      So are the two equivalent? In the short term yes. But, unlike the tax cut, in the longer term the loan has to be repaid which means that we’d have less spending money in the future than we would have if we hadn’t taken out the loan. This has a depressing effect on the economy.

      This is the basis of Fisher’s debt deflation theory.

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