Money derivative creation in the modern economy

It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.

In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).

Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.

In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.

But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.

This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.

Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.

But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.

Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.

But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.

Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.

(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?


Speech to the Brazilian Chamber of Commerce in London

Last week I spoke to a small group in London about the current monetary situation and the outlook for gold. The speech lasts about 20 minutes and the video can be found here:



Mark Carney’s grand experiment began today

I was grateful to the BBC World at One programme for giving me the opportunity today to comment on Mark Carney’s first Inflation Report. You can listen to what I said here.

The essence of what the Bank has announced is well known: they have begun using forward guidance to anchor both inflation and interest rate expectations as a cover for more active monetary policy.

This will usher in a new age of monetary Kremlinology.

The policy is all about the Committee’s intentions and judgments. It’s hedged about with provisos and escape routes. Journalists were quick to ask who thought what on the Committee, spotting that which thresholds are used and which judgments are made is dependent on the opinions of a few wise men.

If you read Mark Carney’s speech to the U.S. Monetary Policy Forum in New York last year, it is clear what he intends. Mark Carney apparently understands the critique of the Austrian School, but he believes it is “a counsel of despair for current problems” so he proposes to prevent the disruption easy money creates using “broader macroprudential management”.

Today’s announcement includes,

The  guidance will remain in place only if, in the MPC’s view, CPI inflation 18 to 24 months  ahead is more likely than not to be below 2.5%, medium-term inflation expectations remain  sufficiently well anchored, and the FPC has not judged that the stance of monetary policy poses a significant threat to financial stability that cannot otherwise be contained through the  considerable supervisory and regulatory policy tools of the various authorities.

In so far as we did not already, we now live in a world of extensive explicit discretionary power over both money and the financial system which ought to allocate real capital to the most productive uses. To believe this will end well is hubris.

Manipulating the expectations of millions of individuals, households, businesses and financial market participants will create herding on a mass scale. Like a loose load in a ship, that will result in severe instability.

Employment created through an “exceptionally stimulative monetary stance” will come to an end when that stimulation is withdrawn. In chasing its employment threshold, the Bank will paint the economy and society into a corner.

Inflation will take the Bank by surprise. The “slack in the economy”, on which the Bank is relying to avoid price inflation, will turn out to be wasted capital, not idle capital waiting to come back into use. Prices will rise.

I’m reminded of something I heard economist Steve Horwitz say, and I feel sure he will forgive and correct me if my notes are not faithful,

Central banks cannot solve the problems they created any more than an arsonist makes a good firefighter.

Unfortunately, Mark Carney is nevertheless about to conduct a grand experiment which will prove that this is so.


Gordon Kerr critiques the Greek bailout on Bloomberg

I was glad to see Cobden Partners’ Gordon Kerr on Bloomberg yesterday, explaining why the Greek bailout will fail:

As I wrote elsewhere, the western world may be in a second crisis of state socialism, a crisis of the welfare state. It appears that politicians’ excess spending pledges over what they could raise in taxation have been covered indirectly by chronic credit expansion since the end of Bretton Woods. As Hayek, Mises, Huerta de Soto and others have explained, that was bound to lead to a banking crisis.

If this thesis is essentially correct, it may be that Greece is simply in the vanguard of a pattern which we should expect elsewhere. That implies a need for everyone who cares about peace and prosperity to think fundamentally and without fear or favour about our plight. That’s why I am proud to be associated with both the Cobden Centre and Cobden Partners.


Beyond the Mondragon experiment

When Labour peer Maurice Glasman recently went on BBC Radio 4 with TCC’s Detlev Schlichter I was disappointed and a little taken aback to learn of his Lordship’s ignorance when it came to the Austrian School of Economics. While towards the end of the interview he accepted the need for honest – backed – money, he went on to demonstrate his ignorance when he implied that free marketeers have a prescriptive attitude to ownership philosophies and organisational models. I was really saddened by this not least because like so many other Austro-libertarians I have spent years pointing out that genuine markets would encourage more open and diverse forms of ownership including mutuals.

When I was fifteen I avidly watched this excellent BBC documentary on the Mondragon Experiment which sparked a life long interest in mutuals, friendly societies and co-operatives. Later, as a university student I went on to study a wide range of radical dissenters including a wide range of anti-statists. Indeed, it is with this history in mind that I find it ironic that away from the naïveté of Lord Glasman, it is Conservative Prime Minister David Cameron who is planning to introduce a Parliamentary bill promoting co-operative forms of ownership and doing so in key areas such as education and healthcare.

Thirty-two years on from the BBC’s film on the Mondragon Experiment, maybe opinion formers are finally rediscovering the libertarian tradition of collective forms of organisation and self-help without the state. As much a part of a market as any other form of non-coerced organisation or ownership philosophy, I do hope Lord Glasman and his Purple Book friends take note.


Are you ready for EuroCrash the musical?

I am not joking. It has finally happened. And I want to see it. As reported by Bloomberg, ‘Euro Crash! The Musical’ is coming to town. According to this report this spectacular and timely production “transposes the single-currency story to a deep dark forest. Mark and Gilda can’t find their way out. They are lured into the gingerbread Euroland house, where Papa Kohl and Madame Mitterrand run a school of fiscal discipline attended by some wayward pupils – personified nation states like Callum of Ireland and Stavros of Greece”. The show’s numbers include “a chorus praising the virtues of the Bundesbank and former U.K. Chancellor of the Exchequer Norman Lamont singing “Our currency’s gone down the plughole” in the shower”.

“EuroCrash!” is showing in at the Cockpit Theatre in London from 8 to 11 February 2012 and I am definitely going to see it. For more information and to book your ticket(s) just click here.


Strippers and bankers’ just rewards

There are many times when working alongside the TCC team I have to smile.

Having read a City AM article by our own Dr. Jamie Whyte earlier the morning I hope this makes you smile too.



TCC doubles its media coverage since September

Earlier this morning I updated The Cobden Centre’s media page. Since September we have not only again doubled the volume of our coverage but its quality continues firmly on an upwards trajectory. Slowly but surely, bold Cobdenite messages are becoming part of legitimate discourse. While we still have a long way to go, the following link highlights welcome progress. Enjoy!


TCC’s Detlev Schlichter delivers important victory on BBC Radio 4

I am delighted that yesterday morning TCC Senior Fellow Detlev Schlichter did our ideas proud on BBC Radio 4’s show Start the Week. On with Angela Knight (British Bankers Association), Maurice Glasman (Labour Peer) and Philip Coggan (The Economist), Detlev made a significant impact on the programme’s intellectual agenda. By the end, he led the consensus.

I am now in no doubt that along with Steve Baker MP and Dr. Jamie Whyte who already regularly appear on BBC Radio, another star has been born.

The programme can be heard here.


Via Bloomberg: Kerr says euro woes may prompt return of gold standard

Following his recent paper The law of opposites: Illusory profits in the financial sector, TCC Advisory Board member and founder of Cobden Partners Gordon Kerr appeared on Bloomberg. The video is here.

Click for video

Gordon dealt with the flaws in IFRS, the reasons for the debt crisis, the case for hardening money, the need for international money in support of trade and more.

Later in the day, I said in the Commons that the Government’s response to the ICB report seemed to take accounting for granted, asking the Chancellor to consider the issue seriously in the forthcoming white paper.