Creating and destroying money

If banks have the ability to create money “out of thin air”, what is to stop them from creating unlimited amounts of money at will? 

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Pic: New banknotes being produced Source: Reserve Bank of Australia

Shouldn’t this lead to run-away inflation? Could it be responsible for the “explosion” in house prices in Australia and the West?

"Just as money is created by new loans, money is destroyed by repaying old ones.”

A good story but the ability of any individual bank to create money is not, in fact, unlimited. (The case of governments “printing money”, so called Modern Monetary Theory’ is different – but no less controversial.)

The notion that banks create money has indeed been promulgated by some great economists but there is, at least, a misconception at play here.

As Christopher Kent, Assistant Governor for the Reserve Bank of Australia, says this unfortunately leaves many with the impression the process of lending allows the banking system to create endless quantities of money at no cost.

“However, the process of money creation is constrained in numerous ways and depends on the behaviour of borrowers, banks and regulators, as well as the stance of monetary policy,” he said in a recent speech.

Destroying money

Bank money creation is the by-product of lending—it depends on willing (and creditworthy) borrowers to start the process. This willingness is largely affected by prevailing interest rates and the prospective returns on new and existing investments.

Interest rates are primarily influenced by benchmark interest rates set by central banks. If the prevailing view is that house prices, say, are going to rise by more than the cost of borrowing, then new loans to buy houses will create new bank deposits.

But just as money is created by new loans, money is destroyed by repaying old ones. If the seller of a house repays their mortgage then the money creation process – when a lender grants a loan they actually “create” a deposit in the borrower’s name - is reversed.

Also, bank money is convertible into hard currency, and this constrains the amount banks can permit through regulation and the need to avoid the risk of a bank run. Banks actively convert chequing deposits, which can be spent, into non-convertible term deposits, which cannot. This also reduces the amount of money outstanding.

To earn a profit, the interest banks charge on loans must cover the cost of the interest paid on deposits. Term deposits pay a higher rate of interest and therefore raise the cost—and reduce the appeal—of new and existing loans. Higher borrowing rates mean that more loans are repaid and fewer are taken out, reducing the supply of money still further.

Credit creation

Milton Friedman’s maxim that inflation is the result of “too much money chasing too few goods” fails to recognise that bank money can be destroyed as readily as it is created. It is not a ‘hot potato’ that passes from hand to hand spending itself until inflation cools it down. History may have lessons around “too much money” and inflation but it should be noted the hyperinflation predicted to be the consequence of Quantitative Easing has failed to materialise.

Nevertheless, the role of banks as providers of money in society is hugely significant and a good understanding our economic system cannot be achieved without an accurate appreciation of it.

Back in 1954, Joseph Schumpeter said it is much more realistic to say banks “create credit”.

“[It is more accurate to say banks] create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them. And the reason for insisting on this is that depositors should not be invested with the insignia of a role which they do not play,” he said.

“The theory to which economists clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the 'supply of credit' which they do not have.”

Schumpeter (best known for his theory of creative destruction) says the theory of “credit creation” not only recognises patent facts without obscuring them by artificial constructions, it also brings out the peculiar mechanism of saving and investment that is characteristic of full-fledged capitalist society and the true role of banks in capitalist evolution.

“With less qualification than has to be added in most cases, this theory therefore constitutes a definite advance in analysis,” he pronounced.

Sadly, the failure to appreciate the nuance of money and credit creation contributed to the ‘unfortunate uselessness’ of macroeconomic models in understanding the GFC.

James Culham is Director, Institutional Portfolio Management at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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