“Positive Money” : A Fallacy Built on a Little Known Truth. (Part 1)

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.