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Restrictions on the creation of money by the private sector

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TheMotorcycleBoy
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Restrictions on the creation of money by the private sector

#434120

Postby TheMotorcycleBoy » August 11th, 2021, 4:51 pm

Hi folks

As I divulged over here Pay rises in the Gold Standard Era, I'm currently reading Mervyn King's "The end of alchemy". This book also discusses in depth the creation of money in economies like ours.

If I recall correctly, someone from TLF (it might have been Go Seigen, apologies if I've misremembered) who informed me ages ago that its commercial banking that is actually behind most of the "creation of new money" these days. Not the central bank. However the above book also communicates this:

What is striking about these figures is that the production of money has become an enterprise of the private sector. The amount of money in the economy is determined less by the need to buy stuff and more by the supply of created by private sector banks responding to the demand from borrowers. In normal times, changes in the supply of credit will be driven by changes in the demand from borrowers to which banks react, and in turn those developments will reflect the influence of the of the interest rate set by the central bank.

However, what I wondering was doesn't the BoE have any other way, i.e. other than increasing the interest rate to curtail the potential for excess lending by private sector banks. For instance don't all commercial banks ultimately have to bank with, and hence clear transactions with, the central bank, so in that case, I assume that this means, if a particular banks lends out too much money to its customers, doesn't that hit a kind of logical overdraft limit for that bank with the BoE?

thanks Matt

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Re: Restrictions on the creation of money by the private sector

#434149

Postby SalvorHardin » August 11th, 2021, 6:20 pm

Yes. The commercial banks create the majority of new money in the economy on a day to day basis through making new loans.

The central banks can create truly spectacular amounts of money, mostly by buying government debt (gilts for the UK) as seen with quantitative easing, but in normal times it's the quoted banks who generate the most new money.

The Bank of England can impose all sorts of restrictions to prevent the banks from increasing the money supply, if it feels that it needs to. Such as increasing the banks' minimum deposit requirements with it

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Re: Restrictions on the creation of money by the private sector

#434160

Postby bungeejumper » August 11th, 2021, 7:01 pm

TheMotorcycleBoy wrote:However, what I wondering was doesn't the BoE have any other way, i.e. other than increasing the interest rate to curtail the potential for excess lending by private sector banks. For instance don't all commercial banks ultimately have to bank with, and hence clear transactions with, the central bank, so in that case, I assume that this means, if a particular banks lends out too much money to its customers, doesn't that hit a kind of logical overdraft limit for that bank with the BoE?

One way of reining in bank lending is to increase the banks' capital ratios, of course. At present, under Basel III, they are generally required to maintain an 8% ratio overall. But that's a blunt instrument compared with adjusting the discount rate. And anyway, it isn't wholly within the supervisory orbit of the BoE. Ho hum, back to the drawing board. :|

BJ

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Re: Restrictions on the creation of money by the private sector

#434176

Postby TheMotorcycleBoy » August 11th, 2021, 8:10 pm

SalvorHardin wrote:The Bank of England can impose all sorts of restrictions to prevent the banks from increasing the money supply, if it feels that it needs to. Such as increasing the banks' minimum deposit requirements with it

Thanks. I think I get it. It does sound similar to the concept of an OD, but instead of placing a maximum value on the indebtness of the bank, rather the BoE is stipulating a minimum credit level for the bank, before it can go on a lending spree.

I'm wondering if that means that the BoE is attempting to link the liabilities that the commercial bank has with its customers, with the liabilities that the BoE could be faced with for this particular private sector bank. Since the BoE will have to eventually clear the cheques that the commercial bank's customers will write to pay for their expenditures. I think!

bungeejumper wrote:One way of reining in bank lending is to increase the banks' capital ratios, of course. At present, under Basel III, they are generally required to maintain an 8% ratio overall.

I see. Effectively the debt/equity ratio for banks.

But that's a blunt instrument compared with adjusting the discount rate.

Sure, since the banks could choose to ignore base rate tweaks.

thanks Matt

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Re: Restrictions on the creation of money by the private sector

#434480

Postby GoSeigen » August 13th, 2021, 8:12 am

TheMotorcycleBoy wrote:However, what I wondering was doesn't the BoE have any other way, i.e. other than increasing the interest rate to curtail the potential for excess lending by private sector banks. For instance don't all commercial banks ultimately have to bank with, and hence clear transactions with, the central bank, so in that case, I assume that this means, if a particular banks lends out too much money to its customers, doesn't that hit a kind of logical overdraft limit for that bank with the BoE?

thanks Matt


This appears to be a misapprehension of the nature of money. A commercial bank does not need an overdraft with anyone in order to "lend money" [nonsense term when referring to monetary policy -- money issuance is more like it]. Money by definition is certain types of liability of banks which are repayable on demand at face value. Banks do not need to have an overdraft to create this liability. All they need to do is enter into a contract with a counterparty. The liability created thereby is money by definition. Just as the corresponding loan typically granted to the contractual counterparty is borrowing by definition.

[Individuals can do similar transactions with each other -- but the liability is not called money and is not counted as such because it is not a liability of a bank and does not have the backing of the banking system and law. An example is where I grant one of my employees a credit note repayable on demand because they don't want all of their wages in cash. I have purchased their labour and funded that with the credit note I issue them. The employer's asset in this case is the balance owed them by me; their interest is either a rate agreed when I issue the note or the implied safety of my holding their savings and taking on the risks of it being lost/stolen etc. I have effectively created "money", and this is pretty much what a bank is doing. But it's different because my credit note is not usable in any other businesses or banks for that matter, the note must be presented to me personally for repayment, and no statistics will be gathered on my credit note and it will not be counted in the national money supply.]

So if banks don't have an overdraft, how does the BoE control the amount of money being issued? Well, in the decades up to 2008 broad money supply was not directly controlled: it was believed that "inflation is everywhere and always a monetary phenomenon" and therefore that if inflation were targeted and controlled then money supply would naturally follow. This worked wonderfully until 2008, with central banks raising interest rates when inflation was too high and lowering them when inflation was low enough and the money issuance by commercial banks seemingly was under control because inflation obediently fell and fell and fell.

2008 exposed (as predicted repeatedly by Krugman and his like) a critical flaw in Friedmanite monetarism, namely that it assumed velocity of money was more-or-less fixed by the plumbing of the financial system. In fact, when interest rates approached the zero lower bound velocity collapsed as predicted by Krugman and no amount of Central Bank money printing since has managed to reverse it. https://fred.stlouisfed.org/series/M2V

This all calls into question the controlling-inflation approach to monetary policy because clearly the concept has broken down near the zero interest rate level. So coming back to MCB's question, we have seen new tools adopted by central banks to try to influence money supply. QE is the obvious one. Increasing capital requirements is another, producing the opposite effect of course (CB's have still been in their inflation-fighting mode after all, old habits die hard, and besides, there was need for higher capital ratios to restore confidence in the stability of commercial banks).

If and when inflation returns, perhaps central banks will resort to other tools than inflation targeting, whose reputation seemingly is in tatters. Perhaps something akin to a gold standard? I've no idea on the timing of this though. Everyone is very relaxed about inflation at the moment and for fairly sound reasons historically speaking.

GS

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Re: Restrictions on the creation of money by the private sector

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Postby TheMotorcycleBoy » August 14th, 2021, 9:34 am

Hi GS,

Thanks for your reply, it's helped advance a few of my thoughts.

GoSeigen wrote:This appears to be a misapprehension of the nature of money. A commercial bank does not need an overdraft with anyone in order to "lend money" [nonsense term when referring to monetary policy -- money issuance is more like it].

Ok fair enough. However don't private banks still need an account with the BoE? I'd assumed this was a legal requirement in order that they can clear funds when their account holders credit customer accounts at different banks. However, despite whether or not this is the case, I presume they must have an implied overdraft limit, as suggested by the capital ratios mentioned in bungeejumpers earlier post.

Money by definition is certain types of liability of banks which are repayable on demand at face value. Banks do not need to have an overdraft to create this liability. All they need to do is enter into a contract with a counterparty. The liability created thereby is money by definition. Just as the corresponding loan typically granted to the contractual counterparty is borrowing by definition.

Ok.

[Individuals can do similar transactions with each other -- but the liability is not called money and is not counted as such because it is not a liability of a bank and does not have the backing of the banking system and law. An example is where I grant one of my employees a credit note repayable on demand because they don't want all of their wages in cash. I have purchased their labour and funded that with the credit note I issue them. The employer's asset in this case is the balance owed them by me; their interest is either a rate agreed when I issue the note or the implied safety of my holding their savings and taking on the risks of it being lost/stolen etc. I have effectively created "money", and this is pretty much what a bank is doing.

That seems debatable. One interpretation would be that you have merely acted as a extension of the your bank. Since it is your bank which actually creates the sovereign currency. But arguably that would depend on the precise definition of money. Actually you did elude to this (the bit of yours put in bold above!).

(Also when you wrote the employer's asset, didn't you mean the employee's asset? Surely it's their asset, but your liability?)

So if banks don't have an overdraft, how does the BoE control the amount of money being issued? Well, in the decades up to 2008 broad money supply was not directly controlled: it was believed that "inflation is everywhere and always a monetary phenomenon" and therefore that if inflation were targeted and controlled then money supply would naturally follow. This worked wonderfully until 2008, with central banks raising interest rates when inflation was too high and lowering them when inflation was low enough and the money issuance by commercial banks seemingly was under control because inflation obediently fell and fell and fell.

Ah. In other words, when inflation rises, BoE and hence banks raise rates, suppressing demand, and hence money creation, and taxation continues to reduce the supply.

2008 exposed (as predicted repeatedly by Krugman and his like) a critical flaw in Friedmanite monetarism, namely that it assumed velocity of money was more-or-less fixed by the plumbing of the financial system.

Are you referring to the QTM? i.e. https://www.investopedia.com/insights/w ... -of-money/

In fact, when interest rates approached the zero lower bound velocity collapsed as predicted by Krugman and no amount of Central Bank money printing since has managed to reverse it. https://fred.stlouisfed.org/series/M2V

It's very surprising that the above linked chart would suggest that V(of M2) is less in Q2/2021 than Q3/2020. Especially given the recently observed CPI rises. Perhaps the empirical datas lag each other somewhat?

If and when inflation returns, perhaps central banks will resort to other tools than inflation targeting, whose reputation seemingly is in tatters.

I'm not sure what event leads to the inflation targeting reputation being in tatters statement, except possibly the GFC, of 2007-2009. Actually Mervyn King's book adds an interesting viewpoint which suggests (to me) that those events were out of the CBs hands. He observes that after the fall of communism and the Chinese embrace of capitalisim, the resulting massive over supply of cheap goods, combined with the West's desire to overspend, and the Chinese tendency to oversave, that our money markets became flooded with dollars, pounds and euros lent very cheaply by the Chinese. A global economic imbalance.

Everyone is very relaxed about inflation at the moment and for fairly sound reasons historically speaking.

Hopefully the Fed and the BoE have it all under of control!

thanks again,
Matt

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Re: Restrictions on the creation of money by the private sector

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Postby GoSeigen » August 14th, 2021, 1:50 pm

TheMotorcycleBoy wrote:
[Individuals can do similar transactions with each other -- but the liability is not called money and is not counted as such because it is not a liability of a bank and does not have the backing of the banking system and law. An example is where I grant one of my employees a credit note repayable on demand because they don't want all of their wages in cash. I have purchased their labour and funded that with the credit note I issue them. The employer's asset in this case is the balance owed them by me; their interest is either a rate agreed when I issue the note or the implied safety of my holding their savings and taking on the risks of it being lost/stolen etc. I have effectively created "money", and this is pretty much what a bank is doing.

That seems debatable. One interpretation would be that you have merely acted as a extension of the your bank. Since it is your bank which actually creates the sovereign currency. But arguably that would depend on the precise definition of money. Actually you did elude to this (the bit of yours put in bold above!).

(Also when you wrote the employer's asset, didn't you mean the employee's asset? Surely it's their asset, but your liability?)

Sorry about the typo, employee is correct.
No, I've created something like money because the note the employee holds is my liability over and above all issued currency. I didn't hand over a banknote -- which would have been the sovereign currency. It's only an analogy though so am not going to defend it to the death. [EDIT: the intention being to illustrate that money creation is not necessarily constrained by an overdraft, more by the commercial realities, which the central bank seeks to influence in its monetary interventions.]
So if banks don't have an overdraft, how does the BoE control the amount of money being issued? Well, in the decades up to 2008 broad money supply was not directly controlled: it was believed that "inflation is everywhere and always a monetary phenomenon" and therefore that if inflation were targeted and controlled then money supply would naturally follow. This worked wonderfully until 2008, with central banks raising interest rates when inflation was too high and lowering them when inflation was low enough and the money issuance by commercial banks seemingly was under control because inflation obediently fell and fell and fell.

Ah. In other words, when inflation rises, BoE and hence banks raise rates, suppressing demand, and hence money creation, and taxation continues to reduce the supply.

Not taxation. The money supply falls whenever banks cancel the money issued, i.e. essentially when repayments of already issued loans exceed new borrowing -- which would be expected to happen if saving rates and borrowing rates are higher.
2008 exposed (as predicted repeatedly by Krugman and his like) a critical flaw in Friedmanite monetarism, namely that it assumed velocity of money was more-or-less fixed by the plumbing of the financial system.

Are you referring to the QTM? i.e. https://www.investopedia.com/insights/w ... -of-money/

In fact, when interest rates approached the zero lower bound velocity collapsed as predicted by Krugman and no amount of Central Bank money printing since has managed to reverse it. https://fred.stlouisfed.org/series/M2V

It's very surprising that the above linked chart would suggest that V(of M2) is less in Q2/2021 than Q3/2020. Especially given the recently observed CPI rises. Perhaps the empirical datas lag each other somewhat?

Inflation is not directly proportional to velocity alone, there are four variables involved: the price level, velocity of money, money supply and aggregate production, so personally I wouldn't speculate on quarterly movements; of those four, velocity was assumed by Friedman to be constant.
https://www.stlouisfed.org/on-the-economy/2014/september/what-does-money-velocity-tell-us-about-low-inflation-in-the-us

If and when inflation returns, perhaps central banks will resort to other tools than inflation targeting, whose reputation seemingly is in tatters.

I'm not sure what event leads to the inflation targeting reputation being in tatters statement, except possibly the GFC, of 2007-2009. Actually Mervyn King's book adds an interesting viewpoint which suggests (to me) that those events were out of the CBs hands.

Which I agree with: Krugman and others referred to it a "pushing on a string" and advised that fiscal measures were needed, a remedy which was anathema to monetarists.
He observes that after the fall of communism and the Chinese embrace of capitalisim, the resulting massive over supply of cheap goods, combined with the West's desire to overspend, and the Chinese tendency to oversave, that our money markets became flooded with dollars, pounds and euros lent very cheaply by the Chinese. A global economic imbalance.

Yes that was my view too (though I'd expand the discussion to talk about globalisation and trade liberalisation rather than just China).

Everyone is very relaxed about inflation at the moment and for fairly sound reasons historically speaking.

Hopefully the Fed and the BoE have it all under of control!

thanks again,
Matt


Well they don't really. Fiscal expansion is already off the scale compared to previous levels. UK borrowing is 100% of GDP vs <34% before the GFC. And inflation is either still on the floor or dangerously above Central Bank targets, depending on who you talk to!

GS

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Re: Restrictions on the creation of money by the private sector

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Postby scrumpyjack » August 14th, 2021, 1:56 pm

I think the term 'aggregate production' is rather out of date now as so much of the digital economy, which forms an increasing proportion of the total economy, does not involve the production of physical goods.

There isn't a factory of Netflix subscriptions and no more productive resources are consumed in selling one copy of software as opposed to millions of copies, or a song on Itunes.

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Re: Restrictions on the creation of money by the private sector

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Postby TheMotorcycleBoy » August 14th, 2021, 7:20 pm

GoSeigen wrote:Not taxation. The money supply falls whenever banks cancel the money issued, i.e. essentially when repayments of already issued loans exceed new borrowing -- which would be expected to happen if saving rates and borrowing rates are higher.

Of course. If someone borrows £100 one year, and then repays it the next, then that previously created £100 is subsequently destroyed.

However, it's not really that simple, is it? Banks lend on interest, so actually if the rate for the above loan is 5%, then actually £105 is returned back to the bank. So presumably £2 is absorbed in costs, £2 is passed to the bank's owner, £1 is passed to any of the banks savers.

Perhaps some of that £5 = £2 + £2 + £1 has an inflationary effect, in the intervening time, since the borrower must settle their interest charges each month. Due to the inflationary effect I've just surmised, subsequent borrowing is for £105 not £100; therefore even if the face value of the originally created money loaned is destroyed on maturity, it seems likely to me the creation of deposits, results in the net increase of the money supply.

There could be some truth to your earlier "inflation is everywhere and always a monetary phenomenon" quote.

Matt


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