Jesse’s Café Américain: A Primer on the Banking System and Money Creation

26 June 2012

Back Again to Money – A Primer on the Banking System and Money Creation

Money in the modern fiat sense originates from a number of sources.  Among these is the realization of credit potential in the expansion of debt.  For the sake of simplicity I simply refer to this process as ‘credit.’This does not mean that ‘credit’ is money, not in the least. Credit is a source of money, but not money itself.

In our modern world of financial innovation, ‘money’ is most often created through the expansion of credit, and its employment in the purchase of assets and in supporting real economic activity, consumption and investment.

While some central bank, either officially or de facto, most often manages the private banking system, providing additional credit where needed, largely through the discount window as lender of last resort, the real economy is able to generate enough money through its own activity to support its growth.

One measure of this activity is the velocity of money, that is, the amount of real economic activity relative to the existing money supply using some sort of measure.  The measure does not do anything of course, but it is merely a measure of what is happening in the interaction between money creation and real economic activity.

There are a number of ‘throttles’ which a central bank, and banking management for that matter, can use to manage and regulate the creation of credit and thereby the supply of money. Among these are lending standards, reserve requirements and quality, bank leverage and investment guidelines, and short term interest rates.

I will not go into these individually now, but one can see that this is how the capitalisation and activity of a bank is shaped, either by sound private management or the force of some external regulatory body.

For whatever reason, be it some exogenous event, human or natural, or the result of a period of mismanagement, the credit creation process may fail and the banks become unable to generate credit sufficient to serve the needs of the real economy. I can give any number of examples of why this might happen.

An appropriate one might be bank insolvency, that is, a sudden deterioration of the assets upon which the bank’s credit rating is based, impariing its ability to acquire money to fund its daily operations.  This funding is known as liquidity.   It might be a simple and yet not incorrect to think of solvency as net asset wealth, and liquidity as cash flow based on demands.

In a financial collapse as the result of a bubble, an entire banking system might be brought low by a natural disaster or the deterioration of assets based on some mispricing.  This is most likely if the credit creation process is concentrated in a few big banks, and/or the banking system is highly interconnected.

Concentration and interdependency are the enemies of portfolio diversification.

At the point of a credit creation failure, the central bank, and most likely the government, must step in to remedy the situation. The most effective approach seems to be the shutting down of the bank or banks, the cleansing of  balance sheets, prosecution for fraud as appropriate, and then the reopening of the banks as well-managed and functioning institutions again, as appropriate and practical.

Hopefully the unsuspecting depositors have been made whole, while serious losses are realized by management, the shareholders, and even the bondholders of the bank, who presumably have a significant interest and effect on how it had been managed.  This satisfies equitability and justice.

This resolution of the banks’ balance sheets and management is what is called a sine qua non. If this does not happen, then the situation will continue in some crippled manner until it is corrected.  Even in the case of a natural disaster or some completely exogenous event, a general banking failure is the sign of some systemic weakness and concentration in the system.

During a period of bank restructuring, the central bank will most likely be called upon to take a more active role in the supply of credit to the real economy. It does this through its lending own facilities with the banking system though an ability to inject credit by purchasing financial assets from the remaining sound banks.

This is absolutely the function of the central bank. It has little other reason to exist in the form that it does, except to stand ready as lender of last resort. If it does not perform this function, it is merely another regulator.

If the damage to the real economy is deep enough, the central government may have to intervene beyond prosecuting fraud, restoring the funds of depositors and the granted of new licenses to restructured banks.

If the central bank’s activity to sustain the money creation process is not sufficient because of a spiral of diminishing demand caused by a lack of confidence to spend and invest, it can increase its own spending thereby stimulating activity in the real economy.

This is often controversial because during a sustained economic downturn government finances should turn negative, since their income from taxes on real economic transactions fall off, and perhaps sharply, due to a decline in those transactions.

I know this is a bit of a simplification, but it does represent what happens.

The collapse of the credit system can be called a ‘deflationary event.’ It is deflationary not so much because it destroys money per se,  but because it reduces its growth rate, and sometimes significantly.

A money supply is rarely static. It grows as a population and an economy grows and expands, and seasonal demand fluctuates, and can still be called stable.

Try not to think of a money supply in purely nominal terms, but in relation to something else, like the real economy. If the economy is growing at five percent per year, the money supply would also be growing at about five percent a year just to maintain its stability and to satisfy demand.

If it has been growing rather quickly for whatever reason, and then suddenly the money supply growth stops without regard to anything in the real economy, it will have a severely and artifical dampening effect on the real economy.

If the real economy is growing at five percent, and the money supply has no growth, then it will being to act as a constricting force on the economy unless investments can be obtained from some external source if that is possible.

So why are the developed economies in such trouble today?

Because for whatever reason, the central bank and the government have failed to take that most important step in reforming and restructuring the financial system.

It is really that simple.

The imbalance that gripped the banking system, the oversized growth of financialisation through innovations in fraudulent conveyances, is still in place. The bloated and overpaid financial sector is largely unchanged, except that the names on their business cards may be different and fewer.

What we have now is an oversized financial bureaucracy sucking the remaining life out of the real economy which itselfhas decreased in size.

In those countries that have taken the necessary steps to cleanse the debt and corruption out of their banking systems and restore a balance that favors real growth rather than financial manipulation and speculation, there has been a recovery. Iceland is one recent example. The US in the 1930’s is another very good example.

And almost every one of the protections that the people put in place in the 1930’s, based on their sad experience in the financial collapse of the 1920’s speculative bubble in fraudulent financial instruments, was struck down.

The approach of ‘bailing out the banks’ and then shifting the pain of economic adjustment from the bank management, shareholders, and bondholders to the public is not only unjust, it is also ineffective, because it merely perpetuates the problems and distortions that caused the banks to fail in the first place and makes them much worse.

The result of this is most likely to be a prolonged period of significant stagflation, if the country has a sovereign currency sound enough to continue on supporting it. In Japan this presented itself as a prolonged period of economic stagnation but not private deprivation for some reasons peculiar to the structure of their real economy and the nature of their political system.

So here we are. What happens next will be a policy decision.

On one hand we have a powerful set of monied interests who have been the primary beneficiaries of the distortions in monetary and fiscal policy for the past twenty years or so.  And on the other hand we have the bulk of the real economy and the public, including the somewhat fortunate to the newly destitute.

There is a quiet power struggle taking place behind the scenes today over the policy decisions that have been and will be made in response to the crisis.

Huge sums are being spent, and much talent and energy expended, to shape and influence and frame the attitude and context of the policy debates, including the outright buying of power and influence in the political process. And even more money is being spent on selling those outcomes to the public.

The people are confused, and in their confusion often become angry, and even hysterically reactive.  These are periods often rich in demagogues, scapegoating, nativisim, and nationalism.

So here we are.  Where we go next is substantially up to us.

Significant discussions need to occur, and someone or some group must stand up for the right, the greater good.  There should be no doubt that some groups will quickly stand up for the wrong, the narrowly beneficial and broadly destructive, with passionate intensity.

Europe is a much more difficult situation, because their euro is controlled by a fortunate few who are politically separate from those who are feeling the brunt of the pain in the short term. The entire system as it is now constructed is inherently unstable, and cannot stand the stress.

And the same can be said for the ‘success stories’ like China and the Asian tigers, whose economies are based on an unstable global export growth and currency regime.

The first reaction of most people,  besides theose who just skip the tutorial about how things work and reflexively chime in with a slogan like ‘government is the problem so we must eliminate it’ and say ‘first’ is to understandably ask ‘how can I protect myself and my family.’ Complete self-sufficiency is not obtainable for most, so one must settle for self-sufficiency as is practical. Preserving one’s wealth from a rapacious financial system is key. Providing some practical form of food, shelter and protection for one’s family is obvious. How to do that depends on one’s means and abilities.

I will caution though, that if things progress as I think they might, there will be no place of complete safety to hide. Obviously some local situations might deteriorate badly, and one would not want to be there. But all things being equal, I would rather be amongst friends and in familiar territory, than a stranger in a strange land.

As Walter Bagehot observed, “Life is a school of probabilities.”   There is a difference, and often significantly so, between what is possible and what is probable.  One needs be aware of the possibilities, but plan and act based on the evolving probabilities.  A plan based on extreme outcomes is often an extremely impractical plan.

We live in interesting times.   Changes are coming at us, and so flexibility is an important component of preparedness.  But the best outcome would be for a return to more normal economic growth and stability, and this is not possible without significant reform.

The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained growth and recovery.

Posted by Jesse at 1:27 PM

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