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."

Banks are not intermediaries, the loan comes before the deposit

20130323_LDP001_0A key thing missing in last week’s coverage of the Cyprus crisis is that banks create a loan before they create a deposit.  Almost all journalists and commentators all fall into the trap, believing that banks are true intermediaries between saver and borrower. Michael Kumhof, a former bank manager at Barclays, disposes of this myth in his article with Jaromir Benes called the Chicago Plan Revisited, and in subsequent lectures and papers. Kumhof, an IMF economist, says clearly; "The loan precedes the deposit. I know because I did it and if anyone like Paul Krugman tells you otherwise he doesn’t know what he is talking about.” I was explaining to a friend the other day that if banks have 100% backing for their deposits there is no risk of a run on the bank. Her reply was “But then they would have nothing left to lend out.” This friend was believing, as is fed to her in the daily media, that banks lend out their deposits. Kumhof goes further than this by saying “The chief function of banks is to create the nation’s money supply. They are solely in charge of it.” So when rich Russians deposit their money in the Laiki Bank in Cyprus the deposits are not lent out at all. The bank itself decides who will have loans, issues the loan and at the same time writes an equivalent deposit on the other side of the ledger. How do you think the size of the banking sector in Cyprus reached eight times the size of the economy in 2011?  The banks made loans and were solely in charge of the credit blowout. And it is the same with the rapid expansion of the Iceland banking system. Banks made loans for houses, cars, aeroplanes, condominiums and seldom asked questions. In fact as Hordur Torfason the Iceland activist explained, he was called into the manager’s office and offered a big loan when he didn’t even want one. We know that the bank staff have incentives for issuing more loans. They are paid more if they do. The tragedy of all this is that the universities are not teaching it honestly to each generation of students of economics. The economists tell the journalists and so the myth continues. Hopefully Cyprus will help the public understand the whole horrible faults of the way we rely on banks to create and decide on the country's supply of credit. A transcript of the first seven minutes of Michael Kumhof's talk is here.  

Green Monetary Reform

GREEN MONETARY REFORM Nearly every relationship essential to life depends on money. This gives ultimate power to those who control the creation and allocation of money. Most of our money is issued by private banks that manage it for the exclusive benefit of their top managers and largest shareholders. It is issued as debt to be repaid with interest. Not all borrowers can repay their loans with interest at the same time because there is not enough money in the system. So this requires at least one borrower to raise a new loan and so the total money supply must keep on increasing. This system leads to growing debt, a growing money supply and therefore the imperative for perpetual economic growth. This imposes an ever-increasing demand on the natural resources required for productivity growth - not to mention the social harm that results from a system of ‘winners and losers’. It widens the gap between the rich who are net lenders and the poor who are net borrowers. Few people in the New Zealand realise that they are using privately created money without knowing it – and using a private service always comes with a price tag. Any properly functioning economic system has as its purpose the provision of goods and services for a community. It is putting the cart before the horse if money supply is allowed to govern production. The financial needs of production and distribution should determine the money supply. It is only when there is enough money (whether national, regional or local) in the system that there can be full employment. If we don't have full employment there is no hope for our youth and a complete breakdown of systems may be just around the corner. Full employment is not possible with a centralised money system linked to a global system dominated and tightly controlled by big banks, investment banks and wealth management companies. A central service of governments — supplying money — has been privatised and it has been done by stealth in the western world. The private interest-bearing money must be abolished and replaced by public money put into circulation by public bodies at all levels.  We would vest this money creation power throughout the community at different levels of organisation. There would be continuing negotiation between the levels to create a dynamic equilibrium.