IMF economist Michael Kumhof says the key function of banks is to create money

imfToday I made the mistake of going to a website where there was a sentence which made me mad. It said that in New Zealand, banks like finance companies can only lend out deposits made with them. Well I rarely get mad these days but I don't like untruths being perpetrated. So I thought the best way to recover would go and transcribe the first seven minutes of a talk Michael Kumhof, economist from the IMF made to a seminar in January 2013.  It is on youtube here and here is my transcript, give or take the odd aside I left out.

"Virtually all money is bank deposits.

The key function of banks is money creation not intermediation. The entire economics literature that you see out there today is that it is intermediation, taking the money from granny, storing it up and then when someone comes and needs it I can lend it out to them. That is complete nonsense. Intermediation of course exists, but it is incidental and secondary and it comes after the actual money creation. Banks do not have to attract deposits before they create money. I’m a former bank manager. I worked for Barclays for five years. I’ve created those book entries. That is how it works. And if a leading light economist like Paul Krugman tries to tell you otherwise, he does not know what he is talking about.

When you approve a loan, as a bank manager you enter on the asset side of your balance sheet the loan, which is your claim against this guy and at the exact same time you create a new deposit on the liability side. You have created new money because this gives this guy purchasing power to go out and buy something with it. Banks have created money at that point. No intermediation, because the asset and liability are in the same name at that moment. What happens afterwards is that that guy can spend it somewhere else later but it is still in the banking system. I care about the aggregate banking system. Looking at the microeconomy and transferring the logic to the macroeconomy is really wrong. Someone will accept that payment.

money

What that means is that it becomes very, very easy for banks to start or lead a lending boom even though policy makers might not, because if they feel that the time is right, they simply expand the money supply. There is no third party involved, just the bank and the customer and I make the loan. The only thing that is required is that someone else will accept that deposit, say as payment for a machine, and he knows that is acceptable because it is legal fiat.

There is an important corollary to this story. A lot of loans are not for investment purposes, in physical capital. Loans that are for investment purposes are a small fraction. The story that is often told in development economics is that first you need to have savings, then once you have the savings, you can have investment. So a country needs to have sufficient savings in order to have enough investment. Nonsense too – at least for the part of investment that is financed through banks because when a bank makes a new loan it creates new purchasing power for the investment to go ahead. The investment goes ahead. Then the investor takes his new bank deposit and gives it to someone else In the end someone is going to leave that new deposit in the bank. That is saving.  The saving is created along with the investment. It’s not that saving has to come before investment. Saving comes after investment, not before. This is important for development economics.

The deposit multiplier that is taught in economics textbooks is a fairytale. I could use less polite terms. The story goes that central bank creates narrow money and there is a multiplier because banks can lend out a fraction. It is actually exactly the opposite. Broad monetary aggregates lead the cycle and narrow monetary aggregates lag the cycle."

To tell the public or not to tell the public that they might have to help bailout their bank

Petition on Banking Reform A friend has emailed me with her concerns about making Open Bank Resolution  public. That is when the banks demand their customers bail out a failing bank and it is coming to a bank near you soon. See website of Reserve Bank of New Zealand.  She said if everyone knew, they would take their money out of the bank and they would collapse. My friend has drafted a great letter to the Dominion Post but has qualms about sending it. Well that is exactly why we have launched a petition asking for a Parliamentary Enquiry into the best ways of making banks stable. You see right now, because banks create loans and control the amount of credit in the economy, only 8% of the deposits now in banks could be redeemed at any time. (That is if everyone went to the bank at the same time for their deposits. What an incredible dilemma. No wonder the Government isn't telling us that as customers we might, after June 30 be required to help bailout a bank. Join our FB page at http://www.facebook.com/pages/Petition-for-a-Parliamentary-Enquiry-into-making-banks-stable/420764948002065 What we are suggesting is that Government takes the recent IMF paper by Jaromir Benes and Michael Kumhof seriously. It is called The Chicago Plan Revisited. It designs a system where banks have 100% backing for deposits, not just 8%. All the good economists who nutted out solutions after the Great Depression seemed to agree this was necessary. Ones like Milton Friedman, Henry Simons, Irving Fisher. So back to the dilemma of to tell or not to tell the public. The banking system is inherently instable because it relies on fractional reserve banking, where the bank creates credit but doesn't have a supply of what the authors call "indestructible money" to back it up with. This used to be gold. But it can be the type of money created by the Reserve Bank, the notes and coins we use. They don't carry debt. Is the current banking system inherently unstable? Yes. According to IMF data, there were 145 banking crises, 208 monetary crashes and 72 sovereign debt crises between 1970 and 2010. This represents a total of 425 systemic crises, an average of more than 10 countries getting into trouble every year. How are we going to reform it if the public doesn't have the knowledge? In countries like Argentina, Greece and Iceland they learn fast after a crisis.

We write to the Minister of Finance about the IMF paper The Chicago Plan Revisited

This week we wrote a letter to the Minister of Finance and look forward to the response Dear Mr English Re The IMF Paper ‘The Chicago Plan Revisited’ Our attention has been drawn to a working paper published on the website of the International Monetary Fund entitled The Chicago Plan Revisited by Jaromir Benes and Michael Kumhof and dated August 2012. Its abstract reads as follows:- At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve banking for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1)           Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2)           Complete elimination of bank runs. (3)           Dramatic reduction of the (net) public debt. (4)           Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy. (There has also been a recent paper from the Bank of International Settlements site by the economist Borio http://www.bis.org/publ/work395.pdf, which calls for a rethink of the business cycle model and for significant adjustments to macroeconomic policies, and to an article in the Economist Dec 14, 2012, discussing that paper at http://www.economist.com/blogs/freeexchange/2012/12/reforming-macroeconomics) We therefore ask you, as Minister of Finance:- a) Are you aware of the existence of the IMF paper, the Chicago Plan Revisited? b) Does your government agree that the four results outlined in this paper are desirable? c) Does your government support the method used to achieve these four goals? d) If you differ from the method outlined in the paper to achieve these four goals or argue with it in any way, could you outline your disagreement and how would you achieve these goals differently? Yours sincerely Deirdre Kent and Phil Stevens New Economics Party