how central bankers and textbooks distort the nature of banking and central banking
Norbert Häring1 [Handelsblatt, Germany]
1
The author is economics correspondent of Handelsblatt, the German business
daily. He is co-director of the World Economics Association and co-editor of
the World Economic Review. The author has no material conflicts of
interest with regard to any of the subjects discussed in this paper.
Copyright: Norbert Häring, 2013
You may post comments on this paper at
“The study of money, above all over fields in economics, is one in which
complexity is used to disguise truth or to evade truth, not to reveal it.” John K. Galbraith
Introduction
This paper will argue that we are being intentionally and systematically
mislead about the nature of money and about the role of central banks and
commercial banks in the monetary system. We are led to believe by central
bankers and by textbooks, like the ones of Krugman and Wells (2009) and Mankiw
and Taylor (2011), that central banks have always been government institutions
acting in the public interest. In reality, central banks’ historical origin and
role had more to do with the desire of private bankers to control and
coordinate the process of private sector money creation. That most money is
created in the private sector is something that central bankers like to gloss
over and textbooks “explain” in a distorted and unnecessarily convoluted
way.
While governments have increased their influence over central banks over
time, these still fulfill functions which are mostly in the interest of the
banking industry. They coordinate private sector money creation and act as
lenders of last resort for commercial banks. It is far from clear, whether
central banks will side with commercial banks or with the public at large, if
their roles as protector and coordinator of the former and their role of
promoting the interest of the latter are in conflict. The desire of central
bankers to hide the lucrative role of commercial banks in the process of money
creation and their distorted account of central bank history give reason to be
suspicious in this regard.
This is particularly relevant today, as during the financial crisis
central banks have emerged as the most powerful agents in economic policy. An
examination of the disclosed calendar of US Treasury Secretary Tim Geithner by
the research institute Bruegel revealed that the President of the European
Central Bank was the person Geithner called most often in Europe,
with a big margin to the runners up. Between January 2010 and June 2012, 58 out
of 168 calls of Geithner to European officials went to the president of the ECB
(Pisany-Ferry 2012 )2.
In Europe, the ECB is involved as a member of the so called “Troika”
(with the EU-Commission and International Monetary Fund) in drawing up and
enforcing reform and austerity programs for crisis countries like Greece, Portugal
and Ireland.
These Memoranda of Understanding go into almost all areas of economic, labor
market and social policy and are
very detailed. The ECB is taking their decisions in complete
independence from governments and parliaments. Other major central banks are
also independent from government, even though not in such an extreme way. If
there is an important element of central banks serving the interests of the
financial industry, this unchecked power should be regarded as highly
problematic.
I will examine the rhetoric of two central bankers, Jens Weidman and
Otmar Issing, regarding the process of money creation, inflation and the role
of central banks. Weidmann is Präsident of Deutsche Bundesbank and member of
the Governing Council of the European Central Bank (ECB). Otmar Issing was a former board member (Until
2006) of the European Central Bank in charge of economics. I use the rhetoric
of these two German central bankers, because, due to the tradition of the
Bundesbank to give prominence to monetary aggregates, German central bankers
are more inclined to explicitly talk about money than the average European
central banker.
I will also examine how two widely used economics textbooks by Krugman
and Wells and by Mankiw and Taylor treat the subject. Drawing on Häring and
Douglas (2012) I will juxtapose this rhetoric of central bankers and textbooks
with the historical and current evidence. I will argue that this rhetoric
frames the minds of central bankers, other policy makers, academics and -
through economic journalists educated with the same textbooks - the general
public, in a very unfortunate way. This prevents them from understanding the
current financial crisis and from drawing the right policy conclusions from
it.
The narrative of Jens Weidmann and Otmar Issing
According to the central bankers’ narrative, governments created central
banks to use and abuse fiat money creation for the financing of government
expenditure, crating runaway inflation in the process. In a widely reported
speech in Frankfurt in September 2012 entitled Money Creation and Responsibility,3 Bundesbank-President Jens Weidmann (2012a)
made references to Goethe’s drama Faust II to take a swipe at government
controlled fiat money.
In Faust II, Mephisto (the devil) talks the Emperor, who is in dire
straits financially, into signing an IOU, which Mephisto copies many times to
issue it as paper money for the benefit of the Emperor. Soon, however, money
issuance gets out of hand. It ends with runaway inflation.
Weidmann interprets Goethe’s scene as an impressive rendering of the
dangers of creating fiat money for financing government expenditure. He argues
that the government’s power to create money from nothing brings with it the
temptation to create too much money to get extra financial leeway, and he
asserts that governments have historically more often than not given in to this
temptation. “If we look back in history, we see that government-owned central
banks were often created with the purpose of giving those governing the country
free access to seemingly unlimited financial means.” He proceeds to say that
governments control over the central bank in combination with governments need
for money often resulted in too much money and runaway inflation.
The goal is clear and explicit. Weidmann wants to drive home the lesson
that you cannot entrust government with managing the monetary system and that
you therefore have to guard the central banks’ independence from
government.
In another speech, given a few days later (available here4 in German), Weidmann gives the example of the first
known paper money system of the Chinese-Mongolian Emperor Kublai Khan and his
successors. “Off course, the Chinese Emperors recognized the importance of the
invention and made much use of it. They produced more and more money bills –
unfortunately without taking the old ones out of circulation. The result is
hardly surprising. There was inflation. At the end of the 13th Century, one
bill was worth 1000 copper coins, almost 150 years later it was worth less than
one.”
6 This section draws on Chapter 2 of Haering and Douglas (2012)
In his speeches on money and inflation, Jens Weidmann
does not utter a single word about money creation by commercial banks; he does
not even mention commercial banks. Even though he is not explicitly saying so,
all his remarks give the impression that only the Government via a government
owned and controlled central bank issues money, and only for the benefit of the
government.
Otmar Issing, who talked at the same event in Frankfurt, made it even more obvious that money creation
by commercial banks is a taboo subject in public. The former Chief Economist of
the Bundesbank and later of the ECB talked about paper money, government
finances and inflation. A focus of his talk was the free-banking alternative
favored by Friedrich August von Hayek, which involves no central bank but has
commercial banks issue their own banknotes in competition with each other. Even
while discussing this proposal, Issing manages to entirely avoid the words bank
and banknote, rather making it seem as
if he was talking about different (national) “currencies”, rather than about
domestic money issued by commercial banks.
While this speech is not publically available, Issing
gave a very similar speech in 2003 upon receiving the Hayek-Prize, which is
available in German5 on the ECB’s website. The word bank does
not appear, other than as “central bank”.
Weidman and Issing are the rule rather than the exception. Western
central bankers rarely, if ever, make it explicit that commercial banks create
money.
Historical evidence and current practice6
Before we look at the treatment of the subjects:
central banks, banks and money creation by leading textbooks, we will first
take a look at the history of important central banks, to see if Weidmann’s
narrative is correct. We will see that it is not. Neither did or do governments
have a monopoly on money creation, nor did they routinely abuse any power they
had in this regard. The insinuation of Weidmann and Issing that it is only
central banks who create money will turn out as just as wrong.
Paper money in early China
It is no coincidence that Weidman goes back to 13th Century
China
to give us an historical example of government-controlled money creation that
went wrong. He has to do so because, contrary to his claim, the important
central banks in the west historically were created by private bankers for
private gain. It is true that bankers created them in cooperation with the
government as a new scheme to give credit to the government. This usually
involved privileges conferred on these commercial banks, notably the privilege
that their notes would be accepted for payment of taxes and duties. But still,
central banks were not government controlled entities, issuing money on behalf
of the government. The bulk of the seignorage, i.e. the direct monetary gain
from printing money, usually went to private bankers. There was a lot of
political controversy, historically, about whether commercial banks or the
government should issue money, and for a long time, the commercial banks
prevailed in this fight even as far as banknotes are concerned. As far as
deposit money is concerned, the largest part of the money supply, banks have
prevailed until today. So Weidmann is clearly giving a badly distorted
account.
Not even the Chinese example that Weidmann chooses is
a good one to make his point. Contemporary reports about the economy of Kublai
Khan’s empire and of his successors stress how wealthy and well organized it
was. China was far ahead of Europe at that time. The system of paper money might or
might not have been instrumental, but it is far from straightforward to argue
that this monetary system was a failure. The devaluation of this paper money
over 150 years, that Weidmann alludes to, amounts to a hardly spectacular five
or six percent inflation annually. According to Werner (2007), this paper money
system worked well for decades, if not centuries, as all available research
reports the Chinese economy as flourishing during that time.
The Bank of England
The Bank of England was founded in 1694 as a private
enterprise. A consortium led by the Scottish businessman William Paterson had
suggested the scheme. It would afford King William and Queen Mary a large loan.
The consortium was granted the right to found the privately owned Bank of
England and to create money by issuing banknotes. They lent those “Notes of the
Bank of England” and some gold to the crown against interest of 8%. (Rothbard,
2008). The Bank of England was awarded the monopoly of issuing banknotes in London by the Bank
Charter Act of 1844. Only in the 20th century did the
Bank of England move away from commercial endeavors. It was nationalized in
1946. Until then it was a private institution working mostly for the financial
benefit of its private shareholders.
No evidence here for the theory of central banks as
creatures of governments over issuing money for the benefit of the
government.
The US
Federal Reserve and its predecessors
The merchant banker Alexander Hamilton, the first
United States Secretary of the Treasury, successfully promoted the chartering
by Congress of the privately owned First Bank of the United States in 1791, a bank with special
money creation privileges. He staunchly opposed the idea that the government
itself should issue the money needed to fund manufacturing and the settling of
the west. He wanted commercial banks to do it, but they should have the strong
backing of the government. This backing consisted, among other privileges, in
accepting the notes of the First Bank in duties and taxes (Nettels, 1962).
The bank faced stiff political opposition. The fight
was not about fears of over-issuance, though. It was about the
constitutionality of outsourcing the regulation of money to a private company
and about the privileges conferred to private bankers at the expense of farmers
and other producers and the public at large.
Private bankers’ highly privileged role remained a
source of political controversy for more than a century. After its 20 year
charter ran out in 1811, a
bill to recharter the First Bank of America failed. Five years later,
the banker Alexander Dallas, in his other capacity as Secretary of the Treasury,
initiated the chartering of the Second Bank of the United States. He endowed the –
again – predominantly privately owned bank with the same privileges as the
First Bank had had (Rothbard 2008).
President Andrew Jackson eventually was successful in
his campaign to take away the privileges of the Second Bank in 1836. Jackson insisted that it
was improper for Congress to pass the important task of creating money and
regulating its value to a private corporation.
Thus, the predecessors of the Federal Reserve offer
nothing in evidence for the theory of central banks as creatures of
governments, over-issuing of money for the benefit of the government.
For eight decades the US would not have a central bank. Banknotes
were still printed and circulated in the economy, though. They were printed by
a multitude of competing commercial banks. As Issing pointed out in this
speech, such a system has the potential advantage that competition of banks
might prevent over-issuance in such a system and the palpable disadvantage that
transaction costs are very high, if notes of more than a thousand banks with
different discounts from their nominal value are circulating.
In 1862, Salmon Chase, who had been installed as
Treasury Secretary by banker and financier Jay Cooke and his newspaper owning
brother, pushed through Congress a national banking law that alleviated the
competitive limit to money creation that banks had faced in the absence of
coordinating central bank (Rothbard 2008).
The new layered system had New York City based national banks at the
top, designated as central reserve city banks. They could give loans and thus
create deposit money as a multiple of the amount of Treasury bonds, gold and
silver they held. Other nationally chartered banks in big cities, the reserve
city banks, could hold their reserves in the form of deposits at central
reserve city banks or in Treasury bonds. They could create a multiple of these
reserves as checking accounts. National banks in smaller places called country
banks, could hold more modest reserves also at reserve city banks to back up
the loans they gave (Champ 2007; Rothbard 2008).
One can see that money creation in the national
banking system was driven mostly by the interests of the banking community in
the early United States.
While it is true that the idea behind the national banking laws was, besides
creating a national currency, to help the government finance the civil war. However,
the money that the government created was only a fraction of the money that
commercial banks were allowed to create on top of the government bonds that
they were forced to hold. The result of the new system from which initiator
Cooke benefitted very handsomely, was a great expansion of the number of banks
and of deposits and also a series of severe financial crises in fairly short
order. There were panics and bank runs in 1873, 1884, 1893 and 1907, because
banks, notably those in New York
at the top of the money issuing pyramid, repeatedly had difficulty to meet
demand for redemption of their deposits (Champt 2007; Rothbard 2008).
As a reaction to these crises, the Federal Reserve
System was created in 1913, again upon private bankers’ initiative. At a secret
meeting at Jekyll Island, Georgia in December 1910, they
hammered out the essential features of the new Federal Reserve System. Bankers
representing the interests of Rockefeller, JP Morgan and Kuhn, Loeb &
company, the most powerful institutions of the time, dominated the meeting. The
continental European, notably the German system served as a model for the basic
structure. The idea was to make the process of money creation more disciplined
and orderly and to have a deep pocketed institution to bail out the banks if
the public lost confidence in the notes they had issued. The bankers wanted the
government only as paymaster, though. Otherwise, it was supposed to have as
little influence over the process as possible (Rothbard 2008).
To this day, the twelve regional Federal Reserve
Banks, which are in charge of regulating banks, are owned and governed by their
member banks. Before the subprime crisis, this fact was never advertised and
often concealed by the pretense that the Federal Reserve System was a public
institution.
The Federal Reserve Bank of New York is the one in charge of regulating,
overseeing and bailing out Wall Street banks with public money. Wall Street
banks chose the President of the New York Fed and charged him with regulating
and controlling them. A board chosen and dominated by bankers makes sure he
does it right. Only during the subprime crisis did the Federal Reserve give up
the pretence of being a public institution. The New York Fed, managing US$1.7
trillion of emergency lending programs for banks and brokerages, was called
upon to inform the public of the whereabouts of the public funds going to Wall
Street. At this point, the Federal Reserve of New York insisted – ultimately in
vain – that as a private institution it is not bound by the Freedom of
Information Act.
Central banking in Germany
In Prussia, the political powerhouse of mid-19th Century
pre-unification Germany, a central bank called Preussische Bank was created in
1846 as a hybrid institution, which was run by government representatives but
with a capital base which was mostly provided by wealthy businessman and
private bankers, who would have a right to a dividend as long as the bank was
profitable (Lichter 1999).
The reason for founding the central bank was a dearth
of money in circulation in a period of beginning industrialization. There were
coins circulating and small denomination treasury obligations, but not enough. In
stark contrast to Weidman’s account, the Prussian bureaucracy under-issued the
debt certificates that served as small denomination paper money rather than
over-issuing them and the Royal Bank was stingier with credit than the business
community in the commercial centers wanted them to be.
The Prussian bureaucrats were loath to give commercial
banks the freedom to emit currency, because they feared that too much money
would be issued. Their mistrust was fuelled by the fact that none of the
bankers’ proposals for the licensing of private note-issuing central banks had
a provision of unlimited liability of the banks’ owners as prevailed in the
Scottish free banking system. The contemporary US-system with private note
issuing banks and correspondingly many different notes trading at varying
discounts was regarded as a bad example to be avoided (Lichter 1999).
The fight in Prussia over the right to issue
notes had an important political dimension. The fact that private shareholders
were invited to provide the capital for the Preussische Bank was a compromise
between the preference of Prussian bureaucrats like Minister Christian von
Rother, who wanted to keep note emission in public hands and mistrusted profit
oriented private bankers in this respect, and the King’s perceived need in
pre-revolutionary times to appease a dissatisfied moneyed citizenry, which was
pressing for the right to issue banknotes (Lichter 1999, p. 89f).
From 1871 to 1876 the Prussian Bank would serve as the
central bank of the newly unified German Reich and eventually would become the
Reichsbank, which was also run by the government and owned by private
shareholders.
The German model of giving a (near-)monopoly of note
issuance to a government run central bank was considered highly successful and
would later, together with the Bank of England, become the blueprint for the
Federal Reserve System.
Money creation by commercial banks today
We have seen that for much of history, government was
only indirectly involved in issuing banknotes, and had nothing like a monopoly
on it. Over time, most governments took over the responsibility for central
banks and the issuance of banknotes, which functioned as means of payment. (Some
of that control they have relinquished again recently by deciding to let
independent technocrats, often with commercial banking backgrounds make the
relevant decisions.) However, even where the government had or has this
monopoly to issue notes, this is far from being a monopoly to issue money.
Today, only a fraction of the money which circulates in the economy consists in
cash issued by the central banks. M3, the preferred definition of money of the
European Central bank is 11 times larger than the sum of currency in
circulation and reserves of commercial banks at the central bank, i.e. base
money. We make by far the largest part of our payments without using any
government issued banknotes. We pay by transferring deposits at commercial
banks to someone else and we receive our paychecks in the form of deposits in
the bank, i.e. in electronic money, created by commercial banks.
This money is created any time a commercial bank gives
credit to a non-bank or buys an asset from a non-bank. If I take a mortgage
loan from a bank of €100,000, the bank will credit my account with a deposit of
€100,000 in exchange for my obligation to pay back, say €150,000 over time. €100,000
in new deposits has been created by a few keystrokes and signatures. It might
soon leave my bank account, as I pay my house with it, but it will remain in
the banking system, as I will transfer the money to somebody else’s account at
another bank. (The money market, on which commercial banks exchange liquidity,
will in normal times make sure that my bank will be able to obtain the central
bank deposit needed to make the transfer.)
This deposit money created by commercial banks is
equivalent to legal tender for all practical purposes. The government accepts a
transfer of this deposit money as taxes and everybody is obliged to accept it
for payment in normal business. That these deposits created by commercial banks
are “money” is also recognized by the fact that all major central banks, like
the Federal Reserve, the European Central Bank and the Bank of England count
them as money in the monetary statistics they compile.
Even when commercial banks were refused the privilege
to issue banknotes in 19th Century Prussia, they were able to create
money by issuing fungible deposit slips on current account balances of their
customers. Whoever presented these deposit slips had the right to have the
balance paid out in cash. This enabled commercial banks to lend out much more
money than they had in deposits, since most customers would leave the deposits
in the bank and transfer the deposit slips to pay their bills (Lichter 1999).
The Reserve Position Doctrine (RPD), also called
Monetarism, which was first propagated by the Federal Reserve (Bindseil 2004)
and later also by the Deutsche Bundesbank and, for a few years, by the ECB,
rests on the assumption that central banks control the process of money
creation. They issue so-called base money in the form of currency and bank
deposits at the central bank, i.e. reserves. Banks use this base money to give
credit and thus create a more or less fixed multiple of the monetary base in
deposits, according to the money multiplier (see next section).
In reality even central banks ostensibly adhering to
the Reserve Position Doctrin, have not been steering the monetary base, but
have been occupied with setting an interest rate on the money market, with
which they try to influence and smooth short-term interest rates in the economy
in general. Goodhart (2001) claims that the Fed continued to use interest rates
as its fundamental modus operandi, even if it pretended to pursue monetary base
control. He talks of play-acting and even deception in this regard.
Ulrich Binseil (2004) who used to be head of liquidity
operations of the ECB and currently is Deputy Director General of financial
market operations, makes it clear that interest rate targeting, which has long
been the norm for all major central banks, and control over base money are
incompatible: “Today, there is little debate, at least among central bankers,
about what a central bank decision on monetary policy means: it means to set
the level of short term money market interest rate that the central bank aims
at in its day-to-day operations.” And he quotes Goodhart (1989, p. 293) a
renowned academic economist with central banking experience, saying “Central
bank practitioners, almost always, view themselves as unable to deny setting
the level of interest rates, at which such reserve requirements are met, with
the quantity of money then simultaneously determined by the portfolio
preferences of private sector banks and non-banks.” In other words: the central
bank will normally feel obliged to provide whatever demand for monetary base is
created by the interaction of private borrowers and banks, because otherwise,
short term interest rates would gyrate wildly.
Thus, according to this view prevailing among central
banking practitioners, central banks fulfill the task of supporting money
creation by commercial banks by providing reserves as needed and disciplining
the process in such a way that runaway inflation does not erode the public’s
trust in the money thus created.
Even if one should be of the opinion that the central
bank is able in our current monetary system, to control the amount of money
that commercial banks create, it is certainly not justified to give the
impression, as Mr Weidmann and Mr Issing do, that only (government owned)
central banks create money and that all money creation is for the benefit of
the government. Even if the central bank were to control commercial banks’
money creation, it would still be done by commercial banks for the benefit of
commercial banks (and at the risk of taxpayers who have to bail them out, if it
goes wrong). Central bankers never, ever talk about the hugely profitable
privilege that the ability to create legal tender means for commercial
banks.
The textbooks’ narrative
“The essence of the contemporary money system is
creation of money, out of nothing, by banks often foolish lending.” Martin
Wolf, Financial Times, November 9, 2010
“It proved extraordinarily difficult for economists to
recognize that bank loans and bank investments do create deposits.” Joseph
Schumpeter (1954, p.1114)
There is very little on the history of central banks
in the textbooks of Krugman and Wells and of Mankiw and Taylor, and what there
is, is distorted. Thus, students who happen to find out about private ownership
and control of central banks must regard it as an oddity, given that they have
been led to believe that it is part of the nature of a central bank to be a
public institution serving only the interest of the general public.
Mankiw and Taylor report that the Bank of England was
created in 1694, but without giving any background. Then they proceed to
claiming that “(a)rguably the most significant event in the Bank of England’s
300-year history was when the UK government granted it independence in the
setting of interest rates in 1997”
(p.625-6). This wrongly implies that until then the Bank was taking its orders
from government and could not set interest rates independently. However, this
was only the situation for a few decades in this 300-year history. It is
noticeable that for Mankiw and Taylor the granting of the monopoly to issue
banknotes for Greater London in 1844 or the nationalization in 1846 are less
important than the decision to partially reverse the nationalization by granting
the Bank partial independence from the government.
Of the Federal Reserve, Mankiw and Taylor note the
year of creation and that the president appoints the seven governors. They
mention that the decision making body Federal Open Market Committee includes
the Presidents of the regional Feds, but fail to mention that these are private
institutions owned and controlled by the banks in the respective region.
Krugman and Wells are silent about the Bank of
England, but are a little more explicit on the Fed. They let us know (p. 812)
that “… the legal status of the Fed is unusual: It is not exactly part of the U.S.
government, but it is not really a private institution either.” What do they
mean by “not exactly” part of the government, and “not really” a private
institution, a description taken from the websites of the Federal Reserve
System? Students are left in the dark. They mention that the Board of Governors
is appointed by the President and approved by the Senate, but remain silent on
who appoints the Presidents and boards of the twelve regional Federal Reserve
banks. While earlier versions of the textbook only stated that the regional
Federal Reserves have a board of directors, the 2009 version is at least
hinting at the truth by adding that the board of directors is “chosen from
the local banking and business community” (my italics). This is somewhat
misleading. Two thirds are chosen by the local banking community, one
third by the Board of Governors in Washington.
Most members indeed come from the local financial community, but they
don’t have to. The point is: banks control the regional Federal Reserve Banks
that are supposed to control them. You would not know from reading Krugman and
Wells?
Without explaining the “unusual legal status”, Krugman
and Wells (p. 813) arrive at the surprising conclusion that “the effect of this
complex structure is to create an institution that is ultimately accountable to
the voting public, because the Board of Governors is chosen by the president
and confirmed by the Senate.” Had they given the complete picture they would
risk being laughed at for this apologetic conclusion.
The equally apologetic treatment of commercial banks’
money creation by the textbooks is also highly misleading. Mankiw and Taylor
only start talking about where money comes from after page 600 under the
unlikely headline “Money and Prices in the Long Run”. That is: explaining our
monetary system is relegated to near the end of the book and reduced to its
impact on prices in the long run.
Krugman and Wells introduce the “hypothetical market
for loanable funds” on page 678 to explain how savings are used to finance
investment. Banks as intermediaries channel money from savers to investors. The
interest rate is the price that equates saving and investment, just like it
does in the market for potatoes. No money creation by banks at this point,
actually no money at all. It might as well be a generic good like grain that is
being saved and passed on to investors who need grain to pay workers until they
can sell their product. Money in the modern sense appears only on page 804
under the equally unlikely header “Stabilization Policy”. Again, money is
relegated to the near-end of the book and does not deserve its own
chapter.
In wording, Krugman and Wells continue to follow the
loanable funds doctrine in the section on money. They pretend that banks are
mere financial intermediaries, collecting deposits, from a multitude of savers
and passing them on as loans to companies, households and government. This is
very odd in a chapter in which they explain how banks create deposits. It
is a clear contradiction. A banking system that creates deposits in the process
of lending does not have to wait for deposits to come in, in order to
intermediate them.
In order to hide the contradiction, both textbooks
stubbornly insist that the process of money creation starts with cash being
deposited in a bank. Deposits are created in the textbook examples, but they
remain in the background. The textbooks rather focus on cash that is deposited
in the bank and then is being lent out again as cash (with a small fraction
retained in reserve), redeposited and lent out again. Thus, the rhetoric of
loanable funds can in a superficial way still be used. Rather than individual
banks creating money they only intermediate the cash that has been deposited. It
just so happens that the banking system overall intermediates the same cash
many times.
But why should banks limit themselves to creating
money in this roundabout way? In reality, the process typically will start with
a bank giving credit to someone and in the process crediting this person’s bank
account with the respective sum of deposit money, thus creating
deposits, not intermediating them. If someone deposits €1000 in the
bank, as in Krugman/Wells example, the bank can just deposit the whole €1000 at
the central bank as reserves and – given a reserve requirement of 10% as in the
US, or 1% in the euro area – be entitled to lend out €10,000 or €100,000
respectively, without having to wait for any further deposits. They will
routinely do just this, rather than lending out €90 or €99 (depending on the
reserve requirement) and then wait for new deposits to come in before lending
more.
Mankiw and Taylor (p. 629) explicitly tackle the
possible amazement of students that might arise from the fact that banks can
create money out of nothing: “At first, this creation of money by
fractional-reserve banking may seem too good to be true, because it appears
that the bank has created money out of thin air”, they concede. Then they try
to appease their readers’ minds by alerting them to the fact that no wealth is
created by this creation of deposits, because “… as the bank creates the asset
money, it also creates a corresponding liability for its borrowers.”
Here the explanation ends, even though here it would
only start to get interesting. The bank creates “the asset money” for itself in
the sense that the bank can demand interest on it. This is real wealth that the
banks derive from their money creation. In the process they create a debt for
someone else. For society, no wealth is created, that is true. But for
themselves, their shareholders and managers, banks have created wealth and the
rest of society has the debt.
In the pre-crisis version of their textbook, Krugman
and Wells (2005, p. 969) had a box, in which they explicitly defended banks
against the possible charge of being dishonest, because they promise to pay
back deposits in full upon demand, while they know they will not have the
liquid funds to do so, if many customers require it at the same time. Krugman/Well’s
(2005) answer was negative, and they offered a bizarrely out of place
comparison to justify this. They equated the expectation of the bank’s
customers being able to take out their money in the bank at any time they want
to the expectation of (potential) customers of car rentals to be able to rent a
car any time they want. If too many (potential) customers want to do this at
the same time, not enough cars will be available, they remind us. Everybody
accepts that, and equally, everybody should accept the risk of losing their
money in a bank run, is their conclusion. The fact that banks have entered into
a contractual obligation with somebody who entrusted their money to them, while
car rentals have not taken any money from potential customers and have not
legally promised anybody to give them a car at any time, plays no role in their
comparison.
The extensive space that most major textbooks afford
to the money multiplier is a relic of the monetaristic Reserve Position
Doctrine, which claims that central banks control base money and, through the
money multiplier, overall money. ECB policy maker Ulrich Bindseil (2004) is
puzzled by the stubbornness with which influential textbook authors teach an
outdated doctrine. He blames it on the interest of central bankers to avoid
responsibility about unemployment:
Overall, the 20th century thus seemed to have
witnessed in the domain of monetary policy implementation a strange symbiosis
between academic economists stuck in reality-detached concepts, and central
bankers who were open to such concepts, partially since they allowed them to
avoid explicit responsibility. Masking responsibility seemed to be of
particular interest whenever the central bank’s policies were strongly
dis-inflationary and thus causing recession and unemployment.
This kind of deception is not the topic of this paper.
Bindseil is quoted here to show that even seasoned policy makers, intimately
involved in the interaction of the central bank with commercial banks,
considers the money multiplier fetish of economic textbooks an aberration.
Capture by financial interests
The interest of central banks in making their
influence on the economy less clear cut might go some way in explaining this
aberration. However, there is also the interest of commercial banks in having
something hidden. And this interest could be even more influential. There is a
complete absence in all major textbooks of any mention of the pecuniary
benefit, which banks derive from their role in “the money multiplier”. This
points to a taboo imposed by the interest of a very powerful group. If you
present the money multiplier in the distorted way textbooks do, with banks
appearing to be mere intermediaries, it is very hard to see this profitable
privilege. Money gets somehow multiplied, but you do not see anybody directly
claiming the value of this newly created money.
If you were to describe the process in the less
convoluted, direct way, as it really happens, it would be obvious who gets to
claim the value of the new money. The borrower who takes a loan of €1000 from
the bank gets credited 1000
in deposit money in exchange for the promise to pay back
€1000 plus interest. The bank gets interest on deposit money, which it can
create out of nothing and which will disappear again from the banking system as
the loan is paid back. All it costs the bank is the (usually lower) interest
rate it has to pay on the small fraction of reserves required (or necessary) to
give a loan of €1000.
The authors of the most influential textbooks are
highly recognized economists with very close ties to central banks and to the
financial elite. There is no dearth of opportunity in which members of these
groups could tell them about perceived anti-finance biases or mistaken
thinking, if they had passages in their textbooks, which could be construed as
anti-finance or having some perceived bias.
Recently an intense discussion has started about the
close ties of economists with the financial industry and about undisclosed
conflicts of interest of this sort – a discussion that was almost completely
absent until the latest financial crisis. Only in 2012 did the American
Economic Association approved a code of conduct for its members. Economist
Devesh Kapur (2009) was still a rarity when he spelled out these conflicts of
interest in the Financial Times in June 2009. He noted that “there would
be little chances of being invited to a lucrative talk at Citigroup if one were
in favor of sovereign debt-forgiveness in the 1980s, against capital account
liberalization in the 1990s or against stock options in the 2000s.”
What is still lacking is a serious discussion of the
even closer ties of many central bankers with the financial elite and about the
undisclosed and unfettered conflicts of interest that arise from them. It is
standard for influential central bankers to obtain highly paid jobs in the
financial industry after they leave their public office. ECB-board member and chief economist Otmar
Issing caused a bit of an uproar, because he did not even obey the informal
cool-off period of one year ususally observed by top-ranking ECB officials
before taking a job with Goldman Sachs as an advisor after leaving office in
2006.
It would go beyond the scope of this paper to delve
much further into this, but a look at a microcosm called Group of Thirty (G30)
can serve to illustrate the overly cozy relationship of high finance, central
banking and eminent economists.
According to its own websiteLong Term Finance and Economic
Growth”.7, the G30 is a private, nonprofit,
international body composed of very senior representatives of the private and
public sectors and academia, whose work impacts the current and future
structure of the global financial system by delivering actionable
recommendations directly to the private and public policymaking communities. One
such set of recommendations was delivered in February 2013 in the form of a
report called: “8 The report reads like a wish-list of the leading
internationally active banks. Recommendations include more public-private
partnerships, more capital market based (rather than pay-as-you-go) private
pension saving, reviving loan-securitization, promoting international capital
movements, toning down bank regulation, government guarantees to take away the
risk of certain investments.
If you look at the membership of this lobby-group it turns out that it
is packed with current and former central bankers with strong ties to the
financial industry. Textbook-author Paul Krugman is also among the members, as
is Mario Draghi (President of the ECB, formerly Golman Sachs), Mark Carney
(President of the Bank of Canada – from July 2013 of the Bank of England –
formerly Goldman Sachs), William Dudley (President of the New York Fed,
formerly Goldman Sachs), Gerald Carrigan (Goldman Sachs, formerly President of
the New York Fed), Axel Weber (UBS, formerly President of Deutsche Bundesbank),
Jacob Frenkel (JP Morgan Chase, formerly Governor of the Bank of Israel), Paul
Volcker (former Fed-Chairman), Jean Claude Trichet (former President of the
ECB), Leszek Balcerowicz (former Governor of the National Bank of Poland),
Jaime Caruana (General Manager of the Bank for International Settlements and
former Governor of the Bank of Spain), Guillermo de la Dehesa Romero
(Santander, formerly Deputy Director of the Bank of Spain), Roger Ferguson
(TIAA-CREF, formerly Swiss Re and formerly Vice-Chairman of the Fed), Stanley
Fisher (Governor of the Bank of Israel, formerly IMF and formerly Citigroup),
Arminio Fraga Neto (Gavea Investimentos, formerly Governor of the Central Bank
of Brazil), Philipp Hildebrand (Blackrock, formerly Chairman of the Swiss
National Bank), Mervyn King (Governor of the Bank of England until June 2013),
Guillermo Ortiz (Grupo Financiero Banorte; formerly Governor of the Bank of
Mexico), Masaaki Shirakawa (Governor of the Bank of Japan), Yutaka Yamaguchi
(former Deputy Governor of Bank of Japan) and Zhou Xiaochuan Governor of the
People's Bank of China).
This makes twenty current or former top-level central bankers of the
most important central banks of the world, the majority of which are now
holding or have held very senior positions in commercial financial
institutions. While this might look like a convenient venue for central bankers
to exchange views, it is important to note that active central bankers meet
regularly at the Bank of International Settlements in Basel for gatherings which are behind closed
doors but nonetheless official. The unofficial Group of Thirty is better
characterized as a private sector pressure group dominated by those central
bankers who are particularly inclined to straddle the narrow divide between
public service and private gain in commercial financial endeavors.
The conflicts of interest arising for this are very relevant for the
subject of this paper and might well explain, why leading central bankers and
central banks seem to have tabooed talk and research about money creation by
commercial banks. As a (rare) economic journalist writing about the workings of
the monetary system occasionally, I have routinely been confronted with two
reactions in the general public: outrage or disbelief. Since the privilege of
having your debt declared legal tender is extremely unusual, this sector has a
very big interest in avoiding the first of these two reactions by the public. Pretending
that central banks are the only ones “printing” money is a probate strategy to
achieve that. Central bankers seem to play along, for reasons that are not too
hard to fathom, if you consider the history of important central banks and the
typical career path of influential central bankers as evidenced by the
membership of the Group of Thirty.
A consequence of the taboo: policy failure
Given the long-standing taboo to talk about money
creation/credit creation by commercial banks in a reasonable way even in
textbooks, it is no wonder that central bankers and other policy makers did not
have the frame of mind to understand what was going on in the credit booms in
the run ups to the Asian crisis and the dotcom bubble and the subprime crisis. In
the run-up to the most recent financial crisis, banks were pumping massive
amounts of credit into the real estate market in the US
and in parts of Europe. In the Euro area as an
aggregate, this led to many years of double digit growth in credit volumes and
in monetary aggregates, including M3, to which the ECB long pretended to pay
special attention. Real estate credit increased with excessive rates of up to
30% for years in several countries like Ireland,
Greece and Spain. There
was a similarity strong lending boom in the US which also was ignored.
The money flowing into real estate created a
self-reinforcing bubble of rising prices, a booming economy and even more
credit, until the bubble finally burst. According to a large empirical study of
Schularick and Taylor (2012) on many historical financial crises, this episode
was typical. They characterize most financial crises of the last five decades
as “credit booms gone bust”.
Even after this failure to understand the role of
finance in producing boom and bust cycles was exposed, the intellectual
situation has not improved much, if any.
US Secretary of the Treasury Tim Geithner, who had
been President of the New York Fed in the run-up to the crisis, said in written
testimony to the Financial Services Committee of Congress on September 23, 2009
(quoted from Petifor 2013): “The purpose of the financial system is to let
those who want to save, save. It is to let those who want to borrow, borrow. And
it is to use our banks and other financial institutions to bring savers’ funds
and borrowers’ needs together and carefully manage the risks involved in
transfers between them.” No wonder the Fed could not see the credit bubble
building that the banks were blowing up, if the President of the most influential
Federal Reserve Bank can see banks exclusively as intermediator of pre-existing
funds.
Vitor Gaspar, in his capacity as Portuguese Minister
of Finance, came to Frankfurt in January 2013
to praise his country’s adjustment program. He diagnosed the excessive build-up
of debt by households, government and companies as the underlying cause of the
Portuguese crisis. This built-up of debt had happened partly while he had been
working in Frankfurt for the ECB as head of
Economic Research. Commercial banks had provided that excessive credit
refinancing with funds from the ECB. It had showed up in double digit growth of
the money aggregate M3, which the ECB ignored. However, debt buildup or debt in
general was not part of the research program of the ECB. Asked if he would draw
any lessons from the diagnostic failure of the ECB and its failure to do
anything about this debt buildup, he said: “I am embarrassed, because this is
an important question and I have to admit that I have not thought about it. I
cannot answer out of hand”, (Haering 2013).
The situation in the ECB’s economic research
department did not improve post Gaspar. A paper in which one could have
expected some lengthy and explicit analysis of money and credit creation by
commercial banks is the ECB’s October 2012 “Report on the first two years of
the macro-prudential research network” (European Central Bank 2012 ).9 It aims
to answer questions like: “How does widespread financial instability affect the
real economy? How can the leverage cycle be described theoretically and
empirically? How can these models help understand the causes and features of
the recent financial crisis.
You would not easily infer from reading this 80 page review of the state
of knowledge by the ECB that this is about a crisis produced by a credit boom. The
tabooed expressions credit creation or money creation do not appear. The
expression “credit boom” is used twice in a rather cursory way, barely enough
to include the paper by Schularick and Taylor (2012) in the reference list. The
work of Minsky on financial instability, which focuses on cycles in credit
creation is mentioned once, but not at all discussed. Neither is the work of
scholars, who do not obey the loanable funds doctrine but rather have included
credit creation in their models and were able to predict the latest crisis on
that basis, like Robert Shiller, Nouriel Roubini, Steve Keen, Michael Hudson,
Dean Baker and Wynne Godley. The list is from Bezemer (2009). None of these are
included in the references.
In the rhetoric of this ECB report, banks do not create and destroy
credit and money. All they do is increase or decrease their leverage, which is
defined in the report as the ratio of debt to equity.
In its Monthly Report of October 2012 (European Central Bank 2012,
p.56), the ECB’s economics department makes the fallacious thinking behind this
explicit: “The concept of monetary liquidity attempts to capture the ability of
economic agents to settle their transactions using money, an asset the agents
cannot create themselves.” As Knibbe, Mahé and Schrijvers (2013) point out,
this refusal of the ECB economics department to accept the fact that private
agents can create money is in direct contradiction to the very monetary
statistics that the ECB assembles and presents. These are based squarely upon
the idea that banks can create money and even legal tender.
Conclusion
This paper aimed to give substance to the claim that
central bankers and prominent textbook authors share a desire to let us think
that the creation of the vast majority of our means of payment by commercial
banks for their own benefit is normal, harmless, without alternative and under
the control of the central banks. Central bankers do so by avoiding any mention
of private money creation or credit creation, and by pretending instead that
central banks have a monopoly to create money. Textbook authors do so by
distorting the process of money creation, using the rhetoric of the inappropriate
loanable funds model. Their account of the role and legal status of central
banks is highly selective and biased. Alternative monetary systems are hardly
ever seriously discussed.
The result is that even five years into the financial
crisis brought about by a long and pronounced credit boom, economists working
for central banks and most prominent economist outside central banks still seem
to lack a frame of mind that would allow them to understand credit cycles.
The look into the history of central banks and the
mechanisms by which commercial banks create money has revealed that there is
indeed an important element in the nature of central banks of serving the
interests of the banking community. We have seen that leading textbook authors
and central bankers are actively trying to disguise this. This should be kept
in mind then assessing the appropriateness of letting independent central
banks, which do not have to answer to the electorate or their representatives,
wield wide ranging powers in economic policy and banking supervision.
A suggestion for further research is to examine, how
the major scholarly journals, notably finance journals, deal with these issues.
Cursory observation suggests that credit creation or money creation are taboo
words in the leading journals. The strong role of economists very closely
related to the Federal Reserve System in the leading finance journals might go
pretty far in explaining any such finding.
References
Bezemer, Dirk, 2009, “No One Saw This Coming: Understanding Financial
Crisis Through Accounting Models”, MPRA Paper No. 15892, 16. June 2009.
Available: http://mpra.ub.uni-muenchen.de/15892/
Bindseil, Ulrich, 2004, “The Operational Target of Central Bank Policy
and the Rise and Fall of the Reserve Position Doctrine”, ECB Occasional Studies
Series, No. 372. Available:
Champ, Bruce, 2007, “The National Banking System: A Brief History”,
Working Paper 07-23 of the Federal Reserve Bank of Cleveland. Available:
European Central Bank, 2012, “Report on the First Two Years of the
Macro-prudential Research Network”, October, Frankfurt.
Available:
Goodhart, Charles E (1989), The Conduct of Monetary Policy, Economic
Journal, 99, 193-346.
Goodhart,
Charles.E, 2004, “The Bank of England,
1970-2000”,
in: R. Michie and P. Williamson (eds.) “The British Government and the
City of London in the Twentieth Century”, Cambridge University
Press.
Group of Thirty, 2013, “Long Term Finance and Economic Growth”, Special
report of the working group on long term finance, Available: http://www.group30.org/rpt_65.shtml
Haering, Norbert and Niall Douglas, 2012, “Economists and the Powerful:
Convenient Theories, Distorted Facts, Ample Rewards”, Anthem (The Other Canon
Series).
Häring, Norbert, 2013, „Stimmt es, dass in Portugal der Bock gärtnert?“ Handelsblatt,
January 31, 2013, p.11.
Issing, Otmar, 2009, "Der Zettel hier ist tausend Kronen wert"
– Wie lässt sich die Inflationsgefahr bändigen?, Speach at the 18. Kolloquium
des Instituts für bankhistorische Forschung (IBF): Papiergeld –
Staatsfinanzierung – Inflation. Traf Goethe ein Kernproblem der Geldpolitik?,
18. September, 2012, Frankfurt.
Issing, Otmar, 2003: Rede aus Anlass der Verleihung des internationalen
Preises der Friedrich-August-von-Hayek-Stiftung,
Friedrich-August-von-Hayek-Stiftung, 12. Oktober 2003 Berlin. Avialable:
Kapur, Devesh, 2009, “Academics Have More to Declare Than Their Genius”,
Financial Times, June 24. Available: http://www.ft.com/cms/s/0/6584fd56-6027-11de-a09b-00144feabdc0.html#axzz2KoQxYPZz
Knibbe, Merijn, Erwan Mahé and Remco Schrijvers, 2013, “Monies, Debt and
Policy. The Concept of Endogenous Money as a Basis for Houesehold and
Non-financial Companies instead of Bank Centered Monetary Statistics”, Paper
presented at the World Economics Association Conference on “The Political
Economy of Economic Metrics”, Jan-Feb.
Krugman, Paul and Robin Wells, 2005, Volkswirtschaftslehre ,
Schaeffer-Poeschel, = German Edition of “Economics”, W.H.Freeman & Co.,
2005.
Krugman, Paul and Robin Wells, 2009, Economics, 2nd Revised Edition. W.H.Freeman
& Co.
Lichter, Joerg, 1999, Preußische Notenbankpolitik in der Formationsphase
des Zentralbanksystems 1844 bis 1857, Duncker und Humblot.
Mankiw, N. Gregory and Mark P. Taylor, 2011, Economics, 2nd Revised
Edition, Cenpage Learning.
Nettels, Curtis P., 1962, The Emergence of a National Economy 115-1815, M.E. Sharpe.
Petifor, Ann, 2013, The Power to Create Money out of Thin Air, Post on
Prime Economics, January 2, 2013, available at: http://www.primeeconomics.org/?p=1443
Pisani-Ferry, 2012, Tim Geithner and Europe’s
phone number, 4th November, Bruegel,
http://www.bruegel.org/nc/blog/detail/article/934-tim-geithner-and-europes-phone-number/
accessed 24th November 2012.
Rothbard, Murray N., 2008, The Mystery of Banking, 2nd. Edition,
Ludwig von Mises Instiute, online avialable at http://mises.org/Books/mysteryofbanking.pdf
Schularik, M. and A. Taylor, 2012, “Credit Booms Gone Bust: Monetary
Policy, Leverage Cycles and Financial Crises, 1870-2008", American
Economic Review, American Economic Association, vol. 102(2), pages 1029-61,
April.
Schumpeter, Joseph, 1954, “History of Economic Analysis”, Allen and
Urwin.
Weidmann, Jens, 2012a, “Money creation and responsibility”, Speach at
18. Kolloquium des Instituts für bankhistorische Forschung (IBF): Papiergeld –
Staatsfinanzierung – Inflation. Traf Goethe ein Kernproblem der Geldpolitik?,
18. September, 2012, Frankfurt. Available:
Weidmann, Jens, 2012b: „Vertrauen - Voraussetzung und Erfolg einer
stabilen Währung“, Speach at Jahrestagung des Markenverbandes, 27. Spetember
2012. Available:
Werner, Richard, 2007, Neue Wirtschaftspolitik: Was Europa aus Japans
Fehlern lernen kann, Verlag Vahlen.
________________________________
SUGGESTED CITATION:
Norbert Häring, “The
veil of deception over money: how central bankers and textbooks distort the
nature of banking and central banking”, real-world economics review,
issue no. 62, 25 March 2013, pp. 2-18, http://www.paecon.net/PAEReview/issue63/Haring63.pdf
Δεν υπάρχουν σχόλια:
Δημοσίευση σχολίου
Σημείωση: Μόνο ένα μέλος αυτού του ιστολογίου μπορεί να αναρτήσει σχόλιο.