Short & Simple 3 – Safeguarding Monetary Institutions and Banking

It was seen in parts 1 and 2 that government, as our collective agent, is able to use its currency to attract some workers and resources to the public sector. This enables it to carry out important functions. One of these functions is to shape and regulate the monetary and banking system.

Having established the currency, the government is responsible for ensuring that funds denominated in its unit of account are sufficiently accessible. Otherwise, there will be disruptions to the economy, as people struggle to meet everyday needs.

Many modern governments have chosen to delegate certain monetary functions to the private sector. This is especially true when it comes to issuing the funds needed in the economy.

Although some funds enter the economy as currency when the government spends, most of the funds we use are issued by commercial banks and are in the form of commercial bank deposits.

We will look at how banks create these funds a little later in the series. For now, it is enough to know that they do this through lending. If we apply for a bank loan, and our application is successful, we will be provided with a new deposit, which we can spend.

It is worth reflecting on:

(1) the relationship between government and the commercial banks; and
(2) the promise banks make when they create a deposit.

(1) The government and banks are in a public-private partnership. The government is the guarantor of the monetary system. When difficulties arise, the government can always step in, because it is the currency issuer.

Most currency is issued by the central bank, which acts both as the government’s banker and the bank for all other banks. The capacity of the central bank to provide currency to the banks is unlimited.

This clearly has the potential to create undesirable incentives in the banking system.

A private bank – like any private business – seeks profit. Its own private interests will not always align with society’s collective interest.

If some banks believe, for instance, that the central bank will always bail them out, no matter how foolish their lending behavior happens to be, the results can be destructive.

Government, being responsible for the integrity and smooth functioning of the financial system, needs to oversee and regulate banks and other financial institutions to ensure that their activities are serving public purpose.

(2) As we will see in a future installment of the series, banks lend by simultaneously creating a deposit. The borrower gets a new deposit in a bank account, but will need to repay the loan later.

A commercial bank deposit is not currency. It is a bank’s promise to supply the government’s currency to the deposit holder. Since the government is the sole issuer of currency, banks ultimately depend on government to obtain it.

Even so, banks do not need to have the currency at the time they make the promise. They just need to know that, as necessary, they will be able to get it.

The bank promises to provide the currency at par, meaning that each dollar of deposit is completely convertible into a dollar of currency.

With a current account or checking account, the bank is obliged to supply currency on the spot, whenever the deposit holder requests it. With a term deposit, the bank promises to supply currency at a future date.

To guarantee that deposit holders can always convert deposits into currency (up to some limit set by government), the central bank acts as lender of last resort.

This means that if a bank is short of currency and cannot obtain it from another bank, it can borrow from the central bank.

This makes deposits “as good as currency” for most purposes, up to the limit at which deposits are guaranteed by government.

For banks, however, there are terms attached when they borrow currency from the central bank, including an interest charge.

Banks that get into financial difficulties may also be subjected to greater regulatory oversight, or even dissolved.

To the extent the government guarantees deposits, it is to protect deposit holders, not reckless banks.

Of course, in reality, power and politics come into play, and irresponsible banks, especially if large, do not always pay the appropriate price for bad behavior. Possible policy responses include tighter regulation or public banking.

Ultimately, these choices are political and are meant to be determined in a democratic manner by society as a whole.

9 thoughts on “Short & Simple 3 – Safeguarding Monetary Institutions and Banking

  1. “In effect, private banks can print the country’s currency.”

    Yes and Sita can empty the nation’s bins. That is a clear subsidy of to the private bin collectors that other industries do not enjoy.

    Or as everybody else calls it – ‘public sector outsourcing’.

    It’s hardly a shock that government employs private contractors to undertake its tasks. There is a debate whether outsourcing is worth the candle, but the banks are nothing special. They are just outsourced agents of the sovereign state.

  2. “The government and banks are in a public-private partnership.”

    I’ve never cared for that framing. Get real, for-profit banks are not managed for the public good. Yes, they have to comply with some government regulations, and they enjoy some government benefits, but so do all businesses, and so do all individuals. In order to drive a car, I have to be licensed by government, and I have to follow government regulations while I drive on public roads, but no one accuses me of being a “public-private partnership.”

    Let’s consider the alternative view — that private banks are managed for selfish interests. That would mean that most of “our” fiat currency is created and controlled by private banks for selfish purposes. The government still has the power to create and destroy money through fiscal policy, but chooses to make limited use of that power, leaving the economy largely in the hands of selfish private banks. That is the real world as I see it, and as Steve Keen sees it.

    “In reality, power and politics come into play … Ultimately, these choices are political and are meant to be determined in a democratic manner by society as a whole.”

    That assumes we live in an informed democracy. But if voters are “informed” by the media, and if the media is controlled by oligarchs, does that still count as an “informed democracy?” If voting districts are gerrymandered to favor a particular outcome, is that a democracy? If leaders are selected by an antiquated electoral system rather than popular vote, is that a democracy?

    MMT assumes that government serves the “public purpose.” But a fiat money system could exist in a totalitarian state or in a corrupt state that did not serve the public purpose (whatever that is). There are many unstated POLITICAL assumptions in MMT ideology. I think that is a weakness.

    Alternatively, MMT could do like Ellen Brown and insist on public banking to better serve the “public purpose.” Or, MMT could insist on a command economy to better serve the public purpose. After all, government spending and taxation are “commands” by any other name. Of course conservatives would object to those things, and that gets to the heart of why conservatives have never been comfortable with fiat money.

    Good essay, Peter, I only wanted to put a little more emphasis on MMT’s implicit political assumptions.

  3. Neil above tries to claim the outsourcing of money printing to private banks is no different to other jobs that government outsource. Well the first difference is that given that governments and their central banks ALREADY issue a fair amount of money (most spectacularly and on an astronomic scale in the case of QE) why bother to outsource? That’s like local government emptying 20% of the bins in a city (to continue with Neil’s bin emptying example) and outsourcing the remaining 80% to a contractor.

    Second, it costs literally nothing for the state to print money and spend it on whatever: when Alistair Darling and Mervy King wanted £60bn to rescue two banks at the height of the crisis, all they had to do was press a button on a computer mouse!

    Third I have no objections to private money lenders (aka banks) as long as they obtain their money in the same way as other businesses, namely to earn it or borrow it at the prevailing rate of interest. But private banks have the money printing option as well. Nice if you can help you business along with a spot of money printing isn’t it? Why can’t I do that?

    As Messers Huber and Robertson put it in their work “Creating New Money”…

    “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves.
    So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit. This additional special profit is hidden from bank customers and the public, partly because most people do not know how the system works, and partly because bank balance sheets do not show that some of their loan funding comes from money the banks have created for the purpose and some from already existing money which they have had to borrow at interest.”

  4. Actually, banks do not create money out of thin air, consumers and business people do. The banks are just a conduit for money creation.

    When I walk into a bank and get a loan, I have created a promissory note and the bank holds it for safekeeping. It is my asset because the bank instantly gives me a claim on that promissory note in the form of a matching deposit. The bank has nothing to do with it.

    When I buy something of value and pay with a cheque, the bank transfers ownership of that promissory note to the vendor. My deposit account falls, the vendor’s deposit account rises.

    As for the bank, they get paid for the work involved in intermediation and credit risk assessment, i.e., assessing whether I can make good on the stream of payments implied in my promissory note.

    There is no free lunch here for the banks.

  5. Ahmed,

    Re your claim that private banks do not create money, several Nobel laureate economists (including Milton Friedman) are or were in their lifetimes under the impression that they do, and advocate/d a system under which only the state creates money.

    However, I agree there is SOMETHING in your claim that it’s bank customers who create money: that is, a bank is nothing without its customers. So in that sense, money creation is a joint enterprise involving a bank and its customers.

    Put another way, as the old saying goes “loans create deposits”, thus if there is no one to lend to, banks clearly cannot create deposits (aka money).

    Next, I am puzzled by these two sentences of yours: “It is my asset because the bank instantly gives me a claim on that promissory note in the form of a matching deposit. The bank has nothing to do with it.”

    The first sentence says that banks very definitely do something: in particular create a deposits (i.e. create money). The second sentence then says “The bank has nothing to do withit”. Bit of a self contradiction that, isn’t it?

    Re your point about “credit risk assessment” etc, yes, banks perform various useful tasks which they are fully entitled to be paid for. Indeed several of those tasks would be exactly the same under a full reserve (i.e. government money only) system. To that extent, as you say, “there is no free lunch here for banks”.

    However, the indisputable fact is that the supply of endogenous money (commercial bank created money) rises every year. Money supply figures published by central banks confirm that. If a bank (or indeed any other corporation) can in effect just print bits of paper with “£10” stamped on them, and hire them out, that’s clearly more profitable than lending out money which banks have had to earn or borrow, as my above quote from Messers Huber and Robertson makes clear. To that extent there is a free lunch for private banks.

  6. Ralph,

    It’s like arguing whether water comes out of a tap or a river. The following quotes are from an article by Dan Kervick (a link to the full article is provided at the end):

    [Quote on consumers creating IOUs, an asset, out of thin air ]
    “Among the most common ways of paying one’s own debts or paying for goods and services is to pay with the debt of a third party. For example, suppose I give a signed note to Pat Brown that says, “I agree to pay Pat Brown, or the bearer of this note, $100 on demand.” And suppose Pat has a $100 debt to the corner grocer. Pat might attempt to pay the grocery tab with that IOU. If the grocer accepts the note, then Pat has paid a debt with a debt.

    Once I have issued and signed the note, and Pat has accepted it, I have a liability. And if that liability is of a kind that Pat is legally permitted to sign over or otherwise transfer to a third party, it is said to be “negotiable”. If Pat does whatever is legally required to convey the IOU to the grocer to pay the grocery tab, the grocer becomes a “holder in due course” of the negotiable liability. At that point, Pat no longer has a debt to the grocer. But I still have a debt. I previously had a debt to Pat; but now I have a debt to the grocer. That’s what it means for a debt liability to be negotiable: the creditor who holds that debt as an asset can transfer it to a third party, so that the debtor ends up owing the same debt to a new creditor.

    “Where did the IOU come from? Was it created from thin air? More or less. Yes, a certain amount of paper and ink and work might have been involved in producing it, so its production didn’t come with zero cost. But typically the cost of making the promise will be so low in proportion to the amount promised, that we don’t go far wrong in thinking of the promise as having been produced from thin air, created ex nihilo as it were.”

    [Quotes about how banks do not have that ability]
    “No, banks are not self-funding, either individually or in the aggregate. The “out of thin air” language, while containing elements of truth, can be extremely misleading, and people using this language sometimes woefully under-represent the significance of central bank liabilities and the government in the US financial system. Banks can indeed create deposit account liabilities from thin air, just as you and I can create liabilities from thin air when we issue IOU’s and someone accepts them. But those deposit liabilities are debts of the bank, just as the IOUs that you and I issue are our debts. And these bank debts are not just so-called debts or pro forma debts. They are real debts which banks must and do routinely pay off in the course of doing everyday business; and the assets a bank uses to pay these debts come from sources external to the bank. A bank cannot simply manufacture its own payment assets from thin air.”

    “People who are fond of saying the banks create money “from thin air” often seem to suggest that banks are no different than the government in that regard, and can thus obtain valuable monetary assets simply by manufacturing them ex nihilo, in effect profiting from pure seigniorage in the way a currency-issuing government can. But this picture is wildly inadequate. If banks could simply summon their assets into existence out of the aether, then every bank in the country could be as rich as an Arabian Gulf emir, manufacturing money at will to purchase solid gold chandeliers, 100-story luxury high rises, Olympic swimming pools, indoor ski slopes, and a personal entourage of world-renowned chefs, attendants and masseuses. The sky would be the limit. But clearly this is clearly not the case. There is a lot to complain about with regard to banking; lots of people in the banking system are making completely unwarranted profits from a massively bloated and exploitative financial system. But the wrongness here comes from the banking system’s ability to suck, squeeze and swindle assets from others; not from its simply conjuring these assets out of nothing.”

    A link to the full article by Dan Kervick is below:

    http://neweconomicperspectives.org/2013/06/do-banks-create-money-from-thin-air.html

  7. Ahmed,

    Thanks for you detailed response. Dan Kervick’s article gets to the nub of he problem and I’ll go thru it line by line and do a write up on my blog. But it’s a long article, so that wont be for a week or two.

    There is nothing in your first four paragraphs I disagree with. But I have a problem with the fifth and sixth.

    You claim there that the liabilities which private banks issue are debts of those banks. Agreed. You also say “They are real debts which banks must and do routinely pay off in the course of doing everyday business..”.
    That is certainly true at what might be called to microeconomic level: i.e. where bank X creates and lends $Y to Joe Bloggs, and Bloggs spends the money, which in turn is deposited at bank Z, then bank X has to pay $Y to bank X in “real money” (i.e. central bank issued money) to settle up.
    However, in the aggregate, those inter bank debts pretty much cancel out. The net effect is that the commercial bank industry as a whole can over the period of a year issue home made money which depositors simply accept and store in their bank accounts. To that extent, the commercial bank industry never repays those debts. Indeed that is the process via which the endogenous money supply expands almost every year. Moreover, to the extent that depositors keep that money in current accounts (“checking accounts” in US parlance), banks won’t even need to pay any significant interest on those so called “debts”. (I get zero interest on my high street bank current account).

    Re your last main paragraph and seigniorage, I agree that the way which a state or government profits from seigniorage is not the same as the way private banks profit (assuming they do profit). A state is much the same as a backstreet counterfieter in that in both cases its essentially a case of printing bits of paper and swapping those for real goods and services. Now for private banks.

    Assume the private sector thinks it is short of checking account money. One option is for the state to print money and spend it into the economy. That way the state (i.e. all of us) share the seignorage profit.

    Alternatively, private banks can supply the needed money, or most of it. And they do that by creating it from thin air and lending it out. They have to marginally cut interest rates. But that’s not a problem for them since the extra money they lend comes from thin air. Banks and those they lend to obtain real goods (quite likely property) in exchange for bits of paper, i.e. they make seigniorage profits.

  8. Dan Lynch: MMT assumes that government serves the “public purpose.” But a fiat money system could exist in a totalitarian state or in a corrupt state that did not serve the public purpose (whatever that is). There are many unstated POLITICAL assumptions in MMT ideology. I think that is a weakness.

    This “assumption” is not best understood as an ideology, but as a tautology. Whatever the government spends on is spending on “the public purpose” by definition. Economics, as worldly philosophy, is not interested in what might be, but what is.

    This sort of point was once well understood. Abba Lerner emphasized that his thinking applied to the “socialist” economies of his day, basically any monetary economy. People thinking about the capitalist and socialist economies up to the 60s & 70s did absorb this lesson in comparative economics, but like so much else, they were overwhelmed when the Neoclassical Empire struck back.

    BTW: Lerner & his not-quite-student Minsky first met when Lerner had just returned from an unsuccessful attempt to enlighten Trotsky on the virtues of Functional Finance.

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