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Steve Keen: Banks central function as creators & destroyers of money.

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"The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money.

A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries."

 

 

The IMF gets radical?

--,

Published 5 Nov 2012

 


An IMF working paper has received a lot ofattention recently – and not for the usual reasons. Whereas the IMF is usually criticised for being dogmatic about free market economics and effectively beholden to the banks, this paper is being both praised and criticised for wanting to radically reform them.

This clearly isn’t official IMF policy, but the fact that it has been released by the IMF is noteworthy, and the paper deserves careful attention. It is an enormous paper, not just in length (56 pages of text) but also in the range of topics covered, and it will take at least three posts to do it justice. In this one, I’ll focus on its analysis of today’s monetary system.

I had better declare an interest at the outset. I have met chief author of the paper, Michael Kumhof, at several conferences now – twice at the American Monetary Institute, once at INETin Berlin, and once at Ireland's Institute for International Affairs – and I consider him a friend. What I especially like about Michael is his intellectual openness. Though he works strictly in the neoclassical paradigm, unlike the vast majorityof neoclassical economists, Michael is open to other approaches. Most importantly, Kumhof takes money, debt and banks seriously, whereas most neclassical economistsdelude themselves about banks with the naive “loanable funds” model.

This realistic perspective on banking is the hallmark of the first, very literary, section of the paper, which discusses both the actual mechanisms of money creation now and the historical debate about the nature of money and the proper role of banks. I do urge everyone to read this section, since it is so rare to have the actual practices of banking realistically discussed in a formal academic paper, let alone one issued by the IMF.

The contrast between Kumhof and Jaromir Benes (the paper's co-author) and run-of-the-mill neoclassicals like Paul Krugman on the role of banks is quite stark. Krugman stated the essence of the Loanable Funds model in his openingsalvo on my primer on Minsky earlier this year:

“If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand.”

Benes and Kumhof describe this perception of banks as mere intermediaries between savers and borrowers as the hallmark of someone who doesn’t understand banking:

"The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries."

Table one shows a very parsimonious vision of the “resulting book entries” for both models – abstracting from all intermediate steps.

Table 1: Parsimonious comparison of Loanable Funds and Bank Lending

Banking sector
Assets
Liabilities
Balance
Models of Lending
Loans
Reserves
Patient
Impatient
Krugman
DR $X
CR $X
0
Kumhof
CR $X
CR $X
0

In Krugman’s “loanable funds” model, all the action is on the liabilities side of the banking system’s ledger: money is taken out of 'Patient’s' deposit account (a debit, shown as DR in the table) and transferred to 'Impatient’s' (a credit, shown as CR). Patient’s deposit account falls and patient has less spending power; Ipatient’s account has risen and he/she has more spending power, and in the aggregate, the two cancel each other out. Neither new money nor additional spending power has been created (except at the margin, if Impatient is a spendthrift and Patient is a miser).

In Kumhof’s model, there’s action on both sides of the ledger: the banking sector’s level of loans rises by $X, and the deposit account of the “Impatient agent” (to use Krugman’s terminology for borrowers) is credited with $X. Money and additional spending power has been created pari passu with additional bank debt. Impatient’s spending power has risen, without any offsetting fall in patient’s spending power. Bank reserves also play no role in the process (they have a transitory role in a slightly more complicated example here, but the end result is the same).

Kumhof’s model accords with the “endogenous money” approach that I take, and as he notes emphatically in the paper, this is the actual process of lending that some central banks have been trying to get academic economists to understand for decades – and so far to no avail. He cites two central bank papers that add to my arsenal of similar statements. Here’s the one from the New York Fed:

"Suppose that bank A gives a new loan of $20 to Firm X, which continues to hold a deposit account with bank A. Bank A does this by crediting Firm X’s account by $20. The bank now has a new asset (the loan to Firm X) and an offsetting liability (the increase in Firm X’s deposit at the bank). Importantly, bank A still has $90 of reserves in its account. In other words, the loan to Firm X does not decrease bank A’s reserve holdings at all."

One wonders how much longer neoclassical economists like Krugman will continue to dismiss such views as the province of “Banking Mystics”. To Kumhof’s great credit (pardon the pun), his is the first theoretical neoclassical paper to acknowledge the actual nature of banking, and to try to take this into account in a mathematical model.

I’ll cover the model in a future post, but there’s also much more to the literary section of the paper that is worth reading – in particular, his treatment of the history of money, banks, debt, and Debt Jubilees. I’ll cover those issues next week.


 



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1 Comment


Paul Hanly wrote:

Europe has proven that government austerity and private austerity at the same time causes recession (unless changes in the net external sector can offset it.)

Many now accept that this problem is accentuated where a country is not the sovereign issuer of it's own currency, but merely the user of some other body's currency as are the countries of the EMZ. (The IMF gets radical? November 5)

Richard Koo has shown us that Japan has proven that GDP and employment can be maintained by increasing government debt and spending whenever the private sector deleverages, but most people have concerns about how Japanese government debt unwinds in the face of aging population likely causing total savings to reduce.

Steve Keen has done much to make us and financial journalists realise that contrary to mainstream economics debt growth/contraction rates have huge impact on the economy.

Now it remains for financial journalists and commentators to understand Modern Monetary Theory/Realism and the comparative advantages of fiat currencies and to know about the periods surrounding the fall of the gold standard and the period surrounding the breakdown of the Bretton-Woods fixed exchange rate regime. These understandings are slowly building.

This IMF paper will assist but we need a simple summary based on Australia and its institutions to assist in this process.

5 Nov 2012 12:25 PM

 

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Comments

  • doyla66
    doyla66 Monday, 05 November 2012

    .....the big secret unanswered question...... do Australian Banks create money out of thin air too???....and then loan it to you.....even the Reserve Bank dodged that answer, when I phoned and asked......

  • doyla66
    doyla66 Monday, 05 November 2012

    Oxford Online Quote of the week:"Banking establishments are more dangerous than standing armies” Thomas Jefferson (1743-1826) American statesman

  • doyla66
    doyla66 Monday, 05 November 2012

    “Banks lend by creating credit. They create the means of payment out of nothing”, former [US]Secretary to the Treasury, Ralph M Hawtry.

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