If anyone thought that banks lend depositors’ funds instead of creating new money when lending, which then become deposits, they should read The Bank of England’s latest working paper No. 529, which explains how the creation of new money becomes a deposit.
Issued on 29th of May 2015, the paper clearly states what Modern Monetary Theorists have been saying for over two decades. It also restates its own quarterly bulletin 2014 Q1, Money Creation in the Modern Economy.
In a way, it is a somewhat surprising move that blows the whistle on the popularly held view that banks are essentially intermediaries between depositors and borrowers. Importantly, it states quite emphatically that the current text book approach, and what most people believe, is erroneous.
The paper says, “The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist.”
What this means is that current economics courses that teach how banks operate in the real world, are pie in the sky. The paper states that banking does not operate the way current standard, student textbooks outline, which effectively renders the mainstream economists approach to debt and deficits and macroeconomic policy in general, as wrong.
In short, banks are not constrained by reserve holdings anymore than Central Banks are constrained by tax receipts.
The paper also buries the money multiplier, or fractional reserve lending theory when it goes on to say, “in the real world, there is no deposit multiplier mechanism that imposes quantitative constraints on banks’ ability to create money in this fashion. The main constraint is banks’ expectations concerning their profitability and solvency.”
It says, “in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor.”
It states, “The bank therefore creates its own funding, deposits, in the act of lending. And because both entries are in the name of customer X, there is no intermediation whatsoever at the moment when a new loan is made. No real resources need to be diverted from other uses, by other agents, in order to be able to lend to customer X.”
This paper is a vindication of Modern Monetary Theory taught by a small number of economists including Bill Mitchell, Warren Mosler, Randall Wray, Steven Hail, Stephanie Kelton and others. The Bank of England, however, is not the first to do so.
The U.S. Federal Reserve, back in September 2008, in their Economic Policy Review, acknowledged that mainstream macroeconomic textbooks were flawed.
Bill Mitchell writes, “The problem is that the core of the mainstream approach is wrong – at the elemental level and economists refuse to give up these notions because if they did the whole edifice of the macroeconomic theory they preach would fall to the ground. The whole shebang is flawed and of no use for those keen to understand how the monetary system operates.”
So, one might well ask what chance is there that our central bank, The Reserve Bank of Australia, would issue a similar statement? I have scanned its website as thoroughly as I can and found nothing along those lines.
I have placed a call to their public inquiries office and await their emailed response with no small interest.
Whether it’s there or not doesn’t matter, our politicians can no longer treat us like mushrooms, assuming they are not mushrooms themselves.
My unnamed RBA friend did agree, however, that as a sovereign nation and a monopoly currency issuer, we are not constrained in our spending other than by our ability to produce goods and services, otherwise recognised as our GDP.
This renders the concept of national debt and borrowing, redundant. It renders the question, ‘How are we going to pay for it?’ redundant. It renders all the ‘debt and deficit disaster’ rhetoric redundant.
It renders the government’s case for fiscal austerity redundant.
But if you are hoping that they will now see the light and embark upon a stimulus package to get people back to work, don’t hold your breath. Old habits die hard and it will be very difficult for the neo-liberal’s side to eat humble pie.
The Bank of England’s working paper also puts the MSM economists on notice to correct the error of their ways. For that, it may not be welcomed.
It is to be hoped, however, that at the very least, they might be more open and better prepared to make a more meaningful contribution to the macroeconomic debate than they have in the past. It will be interesting to see if they take up the challenge.
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