There is a lively debate in the comment section of this blog on QE, credit creation, the difference between credit and cash, and so forth. Thank you to all those commenting. Understanding how money is created is fundamental to an understanding of this financial crisis.
As a response to one of the commenters I inserted a few paragraphs from my book…But thought it might be more appropriate to insert it here. So herewith – on one condition: that you all buy ‘The Coming First World Debt Crisis’ Palgrave, 2006.
From Chapter Two of ‘The Coming First World Debt Crisis’…
Bank money does not exist as a result of economic activity. Instead, bank money creates economic activity.
As long as fifty years ago, the economist Joseph Schumpeter noted that
” it proved extraordinarily difficult for economists to recognise that bank loans and bank investments do create deposits…And even in 1930, when the large majority had been converted and accepted the doctrine as a matter of course, Keynes rightly felt it necessary to re-expound and to defend the doctrine at some length…and some of the most important aspects cannot be said to be fully understood even now.”
Schumpeter, History of Economic Analysis. Allen and Unwin. 1954
……..many of us still assume that bank loans represent a gift from someone who, unlike ourselves, has taken the trouble to deny themselves a portion of their income and to deposit this in a piggy-bank or savings account. Most mainstream economists still believe that banks have “savings” – either theirs, or those of others – and extend these savings to others as credit – charging interest. This is not the case. The money for a bank loan does not exist until we, the customers, apply for credit.
In other words, far from the bank starting with a deposit, and then lending out money, the bank starts with our application for a loan, the asset against which we guarantee repayment, such as our house, and the promise we make to repay with interest. A clerk then enters the number into a ledger.
Having agreed the loan, the commercial bank then applies to the central bank which provides – on demand – the necessary cash element of the loan.
This cash element (notes and coins) is the small proportion of the loan that will be tangible to the borrower. The rest is bank money, which is intangible. Once the commercial bank has obtained the cash from the central bank we the borrowers, then obligingly re-deposit both the bank money (the undrawn part of the loan) and the cash, which together make up the sum of the loan, in either our own, or in other banks – creating deposits. Even if we spend the cash, the recipient of our cash will deposit it.
The Central Bank in issuing the cash, charges a rate of interest to the commercial bank. The commercial bank pays this in due course, adds its own interest, and passes both charges on to the borrower.
Cash on demand
While an increasing amount of transactions can be carried out without cash, there are many that still depend on cash, like coins for parking meters, so we, bank customers, want to hold a portion, albeit (in the UK) only a small proportion, of our money as cash .
A bank is therefore obliged to offer cash to its customers according to demand, depending on their credit standing or overdraft limit. As a consequence banks have to hold a ratio of deposits in the bank, as cash. This is known as the cash ratio or ‘reserve requirement’. This tends to be a small fraction of total deposits. In any case, as noted above, any cash issued and spent (mostly in retail transactions) very quickly returns to the banking system as deposits.
This being the case, a popular illusion nevertheless persists: that banks can only lend on the basis of reserve requirements. In other words, to lend £1000, banks need a reserve requirement of £100 in their vaults. The reality is exactly the opposite. Reserves are created to support lending. The Bank of England (for example) provides cash to British commercial banks, based on public demand for that cash. Cash is created by the central bank only once borrowers apply for loans from the banks and central banks place no limit on the cash made available to banks. Because the central bank provides cash on demand, there is therefore no limit to the cash, bank money or credit that can be created by commercial banks.
However, there is a cost to commercial banks in applying for cash (as we explain below); they pay interest to the central bank for this cash (and promptly pass on the cost to the customer). There is however, no cost in the creation of bank money, or free money – the proportion of the loan that is intangible, that is not cash.
The decline of cash and the rise of credit
In the UK in 1982 the ratio of coins and notes to bank deposits was 1:14. At the end of 2005 the ratio had more than doubled, to 1:34. Put differently: in 1982 there was about £10.5 billion in circulation as notes and coins. Retail and wholesale deposits amounted to almost 14 times as much: £144 billion. By 2005 there was only £38 billion circulating in notes and coins, and almost 34 times as much – £1,289 billion – held in banks as retail and wholesale deposits (Office for National Statistics, May 2006). So for every £1 circulating in cash in 2005, £34 took the intangible form of bank deposits.
These historic numbers demonstrate that the ratio of cash to bank money is not a constant: cash declines over time as confidence in bank money grows, and we make ever-greater use of e.g. credit cards, bank transfers and internet banking.