Ad Hoc Commentary – the Bank of England explains away two misconceptions about money creation

If you were taught that:
1. Commercial banks lend out the deposits that savers placed with them, and
2. The central bank control the quantity of broad money via the money multiplier

Then you should read the Bank of England’s latest Quarterly Bulletin at:
http://www.bankofengland.co.uk/publications/Pages/quarterlybulletin/2014/qb14q1.aspx
In particular you would want to read the articles entitled ‘Money in the modern economy’ and ‘Money creation in the modern economy’.

Yours truly will just summarize it here for those who have no time.

Summary of ‘Money in the modern economy’:
1. Money in the modern economy is an IOU that everyone trusts.
2. Base money is IOU from the central bank.
2a. Central bank IOU to banks = reserves.
2b. Central bank IOU to consumers = currency.
3. Broad money is IOU to consumers.
3a. Central bank IOU to consumers = currency.
3b. Commercial banks IOU to consumers = deposits.

In short, money today is a financial asset that everyone trusts. The operative word is trust. This trust emanates from the central government. People trust base money (reserves and currency) because it is an IOU from the central bank. People trust broad money (currency and deposits) because deposits are IOU from the commercial banks that are in turn guaranteed by government’s deposit insurance.

The astute reader will note that BoE’s document features only the central bank, commercial banks and consumers (households and companies). What about government? Didn’t Figure 2.1 of the latest IMF Fiscal Monitor at http://www.imf.org/external/pubs/ft/fm/2014/01/fmindex.htm put general government expenditure at over 40% of GDP in selected advanced economies? We know government issues IOU to spend. We know that government IOUs are trusted by most – the interest rate speaks for itself. However, curiously, government IOU is not considered money. Instead it is relegated to non-money just like IOUs from consumers, i.e. mortgages and corporate bonds.

Summary of ‘Money creation in the modern economy’:
1. 97% of broad money consists of bank deposits.
2. The main source of deposits is from bank lending. In other words, banks ‘print’ money when they approve loans.
3. The main destruction of deposits is from deleveraging. In other words, consumers ‘tear up’ money when they repay loans.

The article went on to say that the main constraint on money creation is monetary policy through the interest rate lever. That is Keynesian economics. The Monetarist will have their rebuttals and we will not venture into a Keynes vs. Friedman debate.

If banks indeed ‘print’ money when the consumers (households and companies) borrow, then why do we pretend that money is not printed when governments borrow? Since government debt bears an interest rate burden, isn’t it a misconception that it is more inflationary to print currency than to borrow. Borrowing is just printing with an interest rate burden. Governments should just run the printing presses for deficit spending instead of borrowing.

Even Martin Wolf from the Financial Times agrees with the BoE that bank lending is fountain pen money, created at the stroke of bankers’ pens when they approve loans:
“…In the UK, 97 per cent of broad money consists of bank deposits mostly created by such bank lending. Banks really do “print” money….”
http://www.ft.com/intl/cms/s/0/46a1ce84-bf2a-11e3-a4af-00144feabdc0.html

Good luck in the markets.