Can commercial banks create money out of thin air? (2)

Since my first posting on this topic it has occurred to me that each bank behaves exactly like a government with a fixed rate currency to support. That was the situation with most countries up until the 1970’s when national currencies were fixed against the US$. In the UK I remember the rates were around  $2.40 to £1.00 in the final days of a fixed exchange rate.

The UK government could print, or create, as many £ as it liked but it had to have a sufficiently good financial base to support that rate. If the reserves dropped too low then the currency speculators would take positions against the pound bringing it under downward pressure.

How does that work with a bank? Well for a start we know that the neo-classical multiplier  doesn’t fit the observable facts so we can forget all reference to that theory. There are those who claim that banks can create their own money without limit. That seems to be going much too far in the opposite direction. If they could really do that they could grow without limit, and never ever fail or fall into bankruptcy.

What could be a better theory? If I look in my bank account I can see, say $2000. but are they really dinky-di Australian dollars?  Sure I can put my card into the ATM and out do pop the genuine article. But what about the rest? I would argue these Commonwealth Bank IOUs  are actually Commonwealth Bank Australian dollars – which can be considered a sub-currency. The Commonwealth Bank can create, in theory, as many of these as they like, by keystoke. However they can’t overdo it. They can’t create CBA_A$ without limit. They do have to maintain the confidence of the market that they are have enough reserves to maintain their peg to the Australian dollar. So, the more they lend, the more reserves (or capital base) they need to do this.

Of course it’s the same story with all the other Australian banks. There are ANZ_A$ , Westpac_A$ etc. Providing all these banks are in good financial shape,  there is no effective difference between their IOUs or sub-currencies and and the Reserve Bank of Australia issued currency. But if any of these banks ever fell into difficulty that link could be broken and some deposit holders could find they lose part of their savings.

This theory is consistent with the observation that QE doesn’t work in the way intended. Once the bank has decided what reserves it needs it doesn’t make any difference whether they are in bonds or cash. It won’t change the bank’s lending practice.

I haven’t seen anyone else make this observation so it is possible there is a flaw in the theory. Any comments either for or against are welcome.

********************

The previous posting on this subject generated quite a bit of heat. The line I’m advocating didn’t go down well with those who were of the opinion that commercial bank lending goes much further.   That is a pity because I would say they, like the proponents of MMT, are motivated to have a better functioning economy, and do advocate full reserve banking as a key policy towards this end.

I’m not sure that FRB is necessary but, if it is, then it should only be done with a a full understanding of the issues involved. Goodwill isn’t enough.  Changing things and hoping for the best isn’t ever going to work. The basic theory needs to be right.
I’d make the same argument to people like Russell Brandt who argue for revolutionary change. OK, so we have a revolution, and then what?

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One response to “Can commercial banks create money out of thin air? (2)

  1. The limitation banks face in practice are risk capital regulations. They need to hold equity against loans, so they have an upper limit to lending (they need profits or to raise equity). In Canada, bank reserves were abolished in the 1990s, with very little visible effect.

    In the US in the 1800s, the banks did effectively act like they had their own currencies. Cheques from weaker banks would clear at other banks at below par. One of the things that creating the Fed caused was the creation of the clearing system so that all cheques would clear at par. I am not sure about the details, but I think Randall Wray covered this in his book “Understanding Modern Money”.

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