Ask most people how banks work and they’ll tell you that they take in deposits from customers and lend them out to other customers. They’ll tell you that banks make their money by charging more interest to borrowers than they pay to their depositors, or lenders. It is a nice idea that the Positive Money group would thoroughly approve of, but unfortunately it does not work like that. The positive money group (see http://www.positivemoney.org) is quite right to tell us all that is just not the case at all.
If we look into our bank accounts we see what we usually assume to be £ or $ of exactly the same form as we see in our purses and wallets. There is a key difference though. The banknotes in our wallets are, nearly always but with a few exceptions, the IOUs of central banks. In the USA this is the Federal Reserve. The Bank of England, in the UK and the Reserve Bank of Australia (RBA) in Australia. If we take a pile of banknotes into our bank to deposit into our account the bank will, in turn, put those notes into its own account at the reserve or central bank. Then it will just credit our account with the same amount. So they replace central bank IOUs for their own IOUs whenever someone deposits banknotes. The same process would apply to a government cheque to pay a soldier’s salary for example. If someone deposits a bank cheque from the same bank then the process is much simpler. The bank cheque is used as an authorisation to credit our account by a set amount. If from another bank, the process is handled through ‘clearing’ which is simply the process of cancelling each others bank IOUs by contra, with any remaining imbalance being settled from the banks’ reserve accounts at the central bank.
Banks also create their own IOUs when they lend. If we borrow money from a bank they simply create their own IOUs at the touch of a keystroke. Effectively they have created new money “out of thin air”. This causes the PM group to become very alarmed!
They blame the commercial banks for pretty much the whole of the difficulties the western economies have had recently. Is this really justified? Well, partly. The banks’ stop-start approach to lending causes all sorts of problems. However governments do have the ultimate power to regulate their economies using a variety of fiscal and monetary methods. If bank lending is causing problems, it is down to governments to act to nullify them . Nationalising banks or forcing them to adopt 100% reserve accounting, or whatever other remedies PM may advocate, could possibly have worked 30 ir 40 years ago, but in the age of the internet when banks can be located anywhere in the world that kind of ‘solution’ is no longer an option.
The crunch issue for all banks, wherever they are, is that they do have, from time to time, to back up the money they have created supposedly “out of thin air” with real government money. The mistake which I think many are making is to assume that bank created money, created when loans are issued, stays in the economy until that loan is repaid. It doesn’t.
Suppose I borrow £1000 from my bank. The bank edits my account upwards to show that extra money. So its just been created. “Out of thin air”! Fair enough. I then write out a cheque for £1000 to the taxman. The taxman puts the cheque through the clearing system but he doesn’t want bank money, bank IOUs, he wants real government money. The bank supplies this from its reserves. At the same time it edits my bank account downward so eliminating the newly created “money”. I still owe the bank £1000.
This would be relatively unusual but possible. A more usual scenario would be that a bank would lend money to a business, say a builder, who would hire bricklayers, joiners, buy raw materials etc for his building project. Every transaction would attract the usual government taxes. Income tax. VAT, NI contributions, Corporation tax etc. As the newly created money is spent and respent it rapidly dwindles until there is nothing left. It has nearly all gone to the government’s taxman who doesn’t want the money as it was originally created. He insists that banks convert their IOUs to government IOUs. Of course if they can’t do this they are in default just like you and I would be in default if we wrote out a cheque with insufficient money in our accounts to back it up.
When banks are lending money freely governments tend to have high tax returns too. So much so they’ll often boast how competent they are in their fiscal policies which may well have even produced a budget surplus. Unless governments are in charge of economies which are net exporters, like Germany, it is a mistake for that to happen. It is a sign that they have allowed private lending to get out of control and that a recession will be about to follow.
Although some would claim that banks have a licence to print money, it isn’t quite like the PM group lead people to believe on their website. If this were really the case then banks could never go broke of course.
A couple of mistakes in the above article.
First re the idea that government gradually withdraws newly created commercial bank money, government does not accept that sort of money in payment of taxes: it only accepts central bank or base money.
Second, even if government did accept commercial bank money, governments only collect money in order to spend it (assuming government is not deliberately running a surplus or deficit) so there’s no net withdrawal.
Hi Ralph, Thanks for dropping by.
I don’t think we are in disagreement on the point you raise. I agree that government does want its own money back for tax payments. Governments won’t accept bank created money , or bank IOUs. That doesn’t mean that we ourselves can’t use bank created money to pay those taxes though. It doesn’t mean that when we buy a item with bank created money we are excused government taxes.
Most people would just write a cheque for their tax or make a transfer without giving it a second thought. They just expect it will happen.
The banks have to be able to convert their issued their IOUs to government IOUs as the requirement arises and they have to make withdrawals from their reserves to do that. So effectively , by swapping one kind of IOU for another the government does take back that newly created money. So maybe there is a slight disagreement after all?
2 certainties in life, Death and Taxes. “Colma is a small incorporated town in San Mateo County, California, near the northern end of the San Francisco Peninsula in the San Francisco Bay Area. The population was 1,792 at the 2010 census. Yet over 1 million people are buried there.
Who would have thought that the dead raise more new monies than the living, with people even selling on their relatives burial grounds/plots, the deathly real estate drivers.
Of course the banks and governments will be collecting through these initiatives, the banks will print and borrow and the government will take it’s taxes.If there is a source or need people will pay for then printing new money and taken tax is a definite!
At the same time it edits my bank account downward so eliminating the newly created “money”. I still owe the bank £1000.
The bank still has the asset (your loan) and you still have the liability (on your loan a/c) so I wouldn’t say the newly created money had been eliminated.
It has simply been credited to the recipient’s bank’s reserve account via the payer’s bank’s reserve account at the central bank. It’s a feature of our monetary system that broad money and base money circulate as equivalents (except for payments of taxes of course).
Banks can only become illiquid (unable to cash cheques) if the inward flow of deposits dries up or the central bank refuses to supply reserves.
For better or worse I think those days are gone.
I think the point I’m trying to make is that bank money (bank IOUs) is eliminated when it is used to pay taxes (or other government fees) or to buy bonds. The govt won’t accept bank IOUs.
On the other hand, if I’d used that £1000 to buy a car it probably wouldn’t have been eliminated. The seller would have happily accepted bank IOUs. In both cases (tax and car), the bank has its asset and I have the liability in both cases (tax and car) too, So that doesn’t prove the continued existence of the bank IOUs.
Look at this this way. The government won’t take bank IOUs. I certainly have not got them after I’ve paid my tax. And bank IOUs don’t mean anything when they are in the bank’s own possession.
I think you’ve overlooked the fact that governments don’t just sit on the money that they collect via taxes. They spend it. So following this to the logical conclusion:
“The banks have to be able to convert their issued their IOUs to government IOUs as the requirement arises and they have to make withdrawals from their reserves to do that. So effectively , by swapping one kind of IOU for another the government does take back that newly created money. ”
So when transfers are made by banks to the government, it can destroy bank-deposit money. But these bank deposits are re-created as soon as the government makes a transfer back to banks (i.e. when it spends). These two will cancel each other out, meaning that this effect of ‘taking back newly created money’ is insignificant.
Thanks for the mention! Looking forward to part 2…
“I think you’ve overlooked the fact that governments don’t just sit on the money that they collect via taxes. They spend it.”
I think you’ve overlooked those countries where the government runs a surplus – and frankly those where it runs a deficit.
Which shows you in no uncertain terms that government spending and government taxation are *not* operationally connected in any way.
Big mistake in thinking there.
Neil – that’s doesn’t affect the point I made:
1. If they run a surplus, then they will buy back government bonds from the market (i.e. pay down the national debt). In which case, taxation will destroy deposits, and buying back the debt will re-create deposits.
2. If they run a deficit, then when pension funds etc buy bonds, deposits will disappear. They will be re-created when government spends back into the economy.
Point being, whatever government does that remove deposits from the system, it will shortly after do something re-creates them. Peter’s point therefore doesn’t have any significant implications.
Yes I agree with Neil. Government spending and taxation can’t be considered as the former following on from the latter.
I’m planning to develop this concept in Part2 (when I get time. I still have my main job to do!), but just to give you a preview, I did start to think about how credit bubbles affect sectoral balances when I first came across the idea, less than a year ago. Its just assumed that credit bubbles are bad things in themselves but just why is less well known. The reason is that they force government deficits to be less than they should be, and can even force them into surplus, and so impoverish the private sector. Because Positive Money believes in the concept of debt-free money, when issued by govt, it does mean that PM doesn’t allow for the concept in sectoral balances. That’s another big deficiency in PM BTW.
If you look at this graph:
You can see the sectoral balances for the USA over the last half century or so . Neil has done a very good job compiling sectoral balances for the UK if you are interested in those. See his website:
The normal state of affairs is that the US Government is in deficit. That’s fine, except the neo-liberals in their wisdom have decided that government deficits are a bad thing. The one time things weren’t normal was just before the turn of the century when the Clinton Administration managed to turn deficit into surplus. That surplus was the start of the GFC.
So how come Clinton managed to show a surplus when he didn’t raise taxes or cut spending that much? The answer is he allowed and encouraged the private banks to run a credit bubble based on the share market. As credit was issued taxes flowed into the government’s coffers in the way I’ve described in the post. So everyone was happy – but only for a time. The crunch came when the stock market bubble burst and the banks stopped lending. By this time President Bush was in office and his solution was simple enough. Start another bubble in the housing market.
Three sector balance analysis is a very powerful tool. It’s high time that the PM group took it on.
I’d just add that I think those who do support the PM idea have their hearts in the right place. But the campaign for 100% reserve banking is a distraction from the real issue which is neo-liberal, or austerity, economics.
PS “Buying back the debt”, or governments reducing their debt, doesn’t recreate deposits. It removes them. When governments increase their debt they increase the financial assets of the non-government sector. You’ve got it the wrong way around. That’s very easily seen once you’ve decided to accept the idea of sectoral balances.
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“Buying back the debt, or governments reducing their debt, doesn’t recreate deposits. It removes them. When governments increase their debt they increase the financial assets of the non-government sector.”
How does debt reduction by governments/buying back debt not recreate deposits? With what do governments reduce their debt?
“Buying back the debt” was Ben Dyson’s phrase. If we consider that both cash and bonds are IOUs of government then buying back the debt is just a swap of one type of IOU for another and so doesn’t mean much. The problem is that some types of debt aren’t actually counted as debt (which can be confusing) but all liabilities of govt including cash should be included.
In the USA they don’t count coins as debt. But they should. At present the USA can theoretically eliminate its entire National Debt by striking 18 x trillion dollar coins. (You might want to Google that!)
Government’s reduce their debt when they run a surplus. ie They receive more in taxes than they spend. The tendency is to think of a surplus as a sort of profit. But whereas company profits can be spent by investing in new plant and machinery etc surpluses can’t be spent. If they were they wouldn’t be surpluses any longer.
So Governments can only reduce their debt by destroying money. Govt debt is everyone else’s asset. No debts = No assets.