This is an article about where money comes from, why its important and once you understand this, I hope that you will start seeing money creation as a golden opportunity to solve many of our societies ills.
Before we start on the subject of money creation, we need to clarify what is money.
So what is money?
When I ask this question to friends, they automatically reach into their pockets or purses and pull out a coin or a note. And those that do not know me protectively cover their pockets or bags with their hands. Physical money. The stuff you can touch. Then they will talk about the money they have in the bank. Not physical money. So according to my friends money consists of a mixture of cash and numbers in a bank statement.
Highlighting the difficulty of defining what money is, the US Federal Reserve says
“there is still no definitive answer in terms of all its final uses to the question: What is money?”US Federal Reserve
That is the US Fed saying their is no definitive definition of what money is.
“Although there is widespread agreement among economists that money is important, they have never agreed on how to define and how to measure it”
Miller and VanHoose Essentials of Money, Banking and Financial Markets
Economists talk about things like M0 M1 M2 or M3. These are all different measurements of money supply, depending on its definition. So the apparently simple question of what is money comes up against a surprisingly defuse answer.
So lets ignore that we cannot define exactly what money is, and move on to looking where it comes from.
Do you know where money comes from?
In a survey to over 1000 people, the question where does money come from was asked with 5 posible responses:
- central government
- central bank
- capital and money markets
- global financial infrustructures
What do you think is the correct answer?
84% responded either central government or central banks.
Instinctively we feel that money creation is a function of government or a government body. This intuitively makes sense and feels right.
It is wrong!
According to the same economists that struggle to define what money is, there is consensus that physical coins and notes make up only 3% of the broadest money supply definition.
So who creates 97% of money?
Banks do. What a revelation. Money creation is not a function of the state. Money creation is a function of private banks.
How does a bank create money supply?
Banks simply loan out money they do not have, thus creating new money. So, you get a loan to buy a car, sign the contracts ect, and the bank simply adds the agreed amount into your account. This is not transferred from another account that had surplus numbers in it. It is an act of creation, new money is made and recorded in your account through a mechanism of credit creation. Banks create money by credit creation.
BANG! New money has been added to the total money supply.
Ok so thats all very interesting, and maybe I did not know that, but so what.
We kind of know what money is, and who creates it. Yet economists ignore who creates money in their economic models.
“Incorporating money in models of [economic] growth would only obscure the analysis”
David Romer (2006), Advanced Macroeconomics
It is disconcerting to see that economists have the common decency to at least agree that money is important, but not include money creation in their economic models.
Why should I care that banks create 97% of money supply?
It is this lack of economic models that leaves regulators regulating the wrong things.
I believe regulating the wrong things enables global economic crisis. Global economic crisis effects us all, and in todays modern fractured political landscape, economic crisis brings political crisis. I believe future economic crisis will generate greater social unrest. Does anything have a greater negative impact on our communities then this?
Hold on a moment, that was a jump, from money creation to regulation of banks. How did that happen.
Ok, well, we all accept money creation is a core fundamental of our lives, and once we discover that 97% of money created is created by private banks, thats when how banks are regulate comes into focus.
So lets have a look at modern banking regulation. I bet you did not wake up this morning and think, “humm today I really want to read about bank regulation!”
Banking is regulated through a series of global agreements called the Basel accords. These are produced by the Basel Committee on Banking Supervision. This committee is made up of central bankers and representatives of countries banking regulatory bodies. Fundamentally the Basel accords aim to ensure that the more significant the risk a bank is exposed to, the greater the amount of capital the bank needs to hold to safeguard its solvency.
The first came into effect in 1988.
1988 Basel I
Focuses on credit risk, and the classification risk weighting of bank assets. Your mortgage has a classification weighting.
2004 Basel II
Developed a 3 pilar approach to bank regulation:
- minimum capital requirements
- supervisory review generating something that sounds very complex called the Internal Capital Adequacy Assessment Process (ICAAP).
- market discipline which aims for greater transparency, by developing a set of disclosure requirements which enables third parties to measure the captial adequacy of a bank themselves, and not depend solely on that banks own statement.
2010 Basel III
Basel III was a response to the financial crisis of 2007 – 2008. Basically increasing the current 3 pilar system but forcing greater minimum captial requirements, greater supervisory review, and greater transpacency.
The good news is that you now understand the core concepts of modern global bank regulation. Congratulations! If your still reading, I salute you.
I am guessing that you now grasp that this is important, but prehaps the why is this is important is somewhat unfocused.
On the one hand we have economists that ignore money creation in their models of growth, and on the other politicians ignore that they are not the creators of money when regulating economic activity. That does not sound too promising.
Basel II did not work. We all suffered the 2007/08 financial crisis. The reaction of the regulators was to increase the Basel II requirements and call it Basel III.
Basel failed and sadly I predict it will fail again, and the response will be Basel IV with more increases in the 3 pilars. Which I predict will also fail leading to Basel V …..
Lets take a quick look at the history of modern banking panics and systemic banking crisis. This I have taken directly from wikipedia and it is not complete, but is very illustrative:
- 4 crisis.
- 12 crisis
- 17 crisis
- 13 en menos de 20 años.
What I find truly shocking is how after centuries of accumulated experience in bank regulation regulators have failed to stop banking crisis. Worse, the number and impact is growing fast.
The fundamental error of the Basel regulatory framework is that it does not look at money creation. By focusing on banking asset captilization ratios regulators will ALWAYS be running behind incorrectly valued risk. This risk becomes apparent to regulators during a crisis and not before. The bubble bursts before the risk is regulated.
So we think we know what money is, that it comes from banks, and we have all seen how bank regulation is inherently flawed.
Ok, this all sounds a bit scary, why are you telling me this?
This is the worlds largest economic lever. Banks decide who gets all new money created, and therefore effectively decide what it is used for. Interest rates and the other tools used by regulators are secondary to this single factor.
This means that effective economic policy is in the hands of private banks. Banks who are under unceasing and ever increasing pressure to increase short term share value, and not long term economic value.
Is this a doomsday or the sky is falling on our heads article … err no. A simple effective solution which is technically very easy to implement is sitting right there staring us in the face.
Regulators simply have to look at the purposes for which money is being created, for what activities, rather then running behind innovations in financial tools, trying to update risk classification and capital ratios. Something that by its very nature will never be correctly updated before a crisis, rather after one.
Let me explain…
The effect of new money creation can be good or bad, depending on its consecuences.
Productive credit creation is GOOD because it invests in:
new technologies, products, services and is added value based.
Outcome: growth without inflation
Consumption credit creation is bad because it invests in:
consumption, but not more goods and services.
Outcome: inflation without growth
Asset credit creation is BAD because it invests in:
credits to purchase existing assets, so more money goes into an existing asset market.
Outcome: asset inflation, boom bust cycles, crisis.
Both consumption credit and asset credit creation are unsustainable activities. Yet asset credits, consumption credits and financial transaction credits makes up the vast majority of new money creation.
Why does this happen?
Ideally new money creation should flow towards productive credit creation. That is to build new factories, inventions, anything productive with a GDP measured added value. Odd that economists would all agree on this point.
The problem is it is expensive for banks to provide productive credits to the majority of the productive economy. Because the majority of all developed economies productive economy are small and medium sized companies.
For a bank it is more cost effective to provide new credits to multinationals. So one single billion euro credit to a multinational is much cheaper to do than 1,000 new credits of 1 million to a thousand small companies. This is so obvious that banks concentrate there productive credit creation in large sized loans to large multinational companies.
This leaves small and medium sized companies (remember the largest part of an economy) starved of credit.
The majority of the new money created via credit is used in the speculative economy, rather than the productive economy.
That is the problem. Ignored by regulators, poorly understood by economists, money creation is used for speculating, generating economic crisis for the majority of us.
Bankers find themselves trapped in an impossible game of musical chairs. New money creation is the economic leaver that generates banking crisis and could be the source of sustainable non inflationary economic growth. However the pressure on short term bank share prices makes it impossible for them to react alone. This is where regulators must step in. As a crisis occurs and the music ends, less chairs are left and fewer banks survive each crisis.
This concentration of the banking sector is recognized by all as something called systemic risk. And something to be avoided. This is the idea that a bank becomes too big to fail, because its failure would drag the rest of the economy down with it. Our regulatory system generates this systemic risk, one that regulators are tasked with avoiding.
I believe understanding banks true role in our economy and regulating what banks really do is a necessary precondition for solving many of the world’s problems, such as:
- banking crises,
- business cycles
- depletion of finite resources
- welfare state
This is why I wrote this post.
Now I have only one more question..
Are bank regulators in denial, or are they scoundrels?
I will leave this question unanswered.