Ignorance, amplified, creates a "lost century in economics"

“How is it possible that for the largest part of the past century erroneous and misleading theories have dominated the economics discipline?” - Richard Werner, "A Lost Century in Economics"

It’s a fact that many economists and financial writers do not fully understand money and banking. And, unlike you, when they are wrong, they rarely suffer adverse consequences. This should matter to you because their lack of knowledge could cause you to make a costly mistake.

Today’s case in point is a July 12 article in the Wall Street Journal, in which the authors fail to grasp that the money supply is a product of pure credit creation.

The article (“Banks Struggled Last Year, but Now They Are Set for Big Profits”) starts with a mostly upbeat analysis of the second-quarter earnings of US banks, attributing recent strong results to revenues from stock and bond trading. So far, so good.

But then the authors suggest that bank earnings may continue moving up because lending, which has been weak recently, could grow stronger. Why might lending increase? Because say the authors, banks have lots of money to lend.

“Banks have plenty of money to lend - more than enough, in fact. According to data from the Federal Reserve, many companies are still hoarding cash, and there is now $17 Trillion in deposits at U.S. commercial banks. That is up nearly 30% since the start of 2020, or $3.8 Trillion, equal to the size of the whole pot in 2001… This excess cash is dragging down margins because banks aren’t earning much on it….”

In other words, U.S. corporations have lots of cash sitting in low interest-bearing accounts at their banks, and the banks would bolster their earnings if they could only lend out these deposits at higher interest rates.

Clearly, the authors think banks lend out deposits. But that's not right. As I explained in Money from Nothing, banks do not lend out other peoples’ money, and banks do not need deposits to make loans. On the contrary, banks create new money (in the form of new deposits) when they make new loans or buy bonds.  

The authors point out that “there is now $17 Trillion in deposits at US commercial banks,” up by $3.8 Trillion or 30% over the last 18 months. This is true, but the article gives the impression these deposits somehow flowed into the banking system from an external source.

This is exactly backward. External sources did not deposit all these Trillions of dollars.  The banking system created all of it, including the recent addition of $3.8 Trillion that supported the Biden Administration’s pandemic spending plan. 

The only way “external” money can flow into the banking system is if customers deposit physical money that circulates outside the banking system. Today there is “only” about $2.1 Trillion in bills held outside the banks. This is the cash in your wallet that you use to tip the bartender or pay the babysitter. Clearly, $3.8 Trillion in new deposits did not come from deposits of dollar bills.

As I wrote in “Money from Nothing,” new money is created when a legally authorized bank buys an asset. Most new money comes from a few variations on this theme. The first is lending, in which a bank buys an asset called a promissory note. The second is investing, in which a bank buys securities such as Treasury bonds or mortgage-backed bonds. The third is Quantitative Easing, which the Fed engages in when they think banks are not creating enough new money independently. (1)

So, what is the makeup of the $3.8 Trillion in new deposits? A look at the Federal Reserve’s H.8 report, “Assets and Liabilities of Commercial Banks” will tell us.

The smallest part of the increase, about $370 billion, came from increased lending. This new money was created when US banks bought net assets (promissory notes) such as mortgage loans, business loans, and consumer loans.

Next, a large portion of the new money, nearly $1.5 Trillion, was created when the banks bought bonds, mostly Treasuries and mortgage-backed bonds, in the net amount of $1.5 Trillion.

Finally, the largest category of new money, nearly $2 Trillion, came from the Fed’s QE program. In this process, the banks first buy bonds from private investors, paying for these bonds by creating new deposits. The Fed then immediately purchases these bonds from the banks, paying the banks with newly created bank reserves, i.e., deposits at the Fed.

In this case, the Fed creates new bank deposits and new bank reserves in one operation, using the banks as a pass-through entity. The result is that the banks hold more deposits (money) as liabilities, and these liabilities are offset by new assets – more bank reserves.

In all three cases, we can observe the key principle behind our system of pure credit creation: Legally authorized banks create money by purchasing assets.

In fairness, the WSJ authors are not alone in their unfamiliarity with how banks work. They probably had poor instruction in college. According to economist Richard Werner, the correct theory of money and credit creation is rarely taught in economic textbooks today. “It should be repeated,” he writes, “that the credit creation theory does not feature in most contemporary economics, finance, or banking textbooks.”

Instead, he explains, banks are commonly understood as financial intermediaries that gather savings from one group to lend to another. This is true of brokerage firms, investment banks, insurance companies, mutual funds, and other investment organizations, but not commercial banks. Financial intermediaries do gather others’ savings and lend them in the capital markets, but this is not “bank lending.”  

Bank lending does not recycle existing money. Every new bank loan creates new money.

Today’s erroneous view of banks contrasts with the views prevalent a century ago when economists and financial writers widely understood and accepted the credit creation theory. As Werner explains, this knowledge was essentially lost over most of the 20th Century due to the spread of erroneous theories by prominent economists, especially Paul Samuelson, through his popular textbook, Economics.

One result of this prolonged ignorance is that the public’s knowledge of money creation is poor at best. Werner comments:

“That such important insights as bank credit creation could be made to disappear from the agenda and even knowledge of the majority of economists over the course of a century delivers a devastating verdict on the state of economics and finance today. As a result, the public understanding of money has deteriorated as well. Today, the vast majority of the public is not aware that the money supply is created by banks, that banks do not lend money, and that each bank creates new money when it extends a loan.”

In summary, it cannot be the case that US banks will increase their earnings by lending out their customers’ deposits at higher interest rates. If you invest in bank stocks thinking this, you will be doing so for the wrong reasons. US banks may indeed increase earnings by lending more at higher rates in the future, but if they do, it will be due to better conditions in the loan market, not because they have lots of deposits to lend.

With this simple insight about money creation, you now have knowledge that some experienced financial professionals, like the Wall Street Journal authors, do not have.

Given the growing stress and excesses in our monetary system, basic knowledge of money and banking will become increasingly valuable to you in the future.

I’m here to help. Stay tuned.

---

(1)Money creation in the modern economy, Bank of England quarterly bulletin, 2014, Q1:  “In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing (QE). QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.”

HardmoneyJim No.4