Senior economists queue up to dismiss textbook explanations of our monetary system.

For decades now, the major economic textbooks have been teaching an explanation which is not just wrong, but back to front. The textbook explanation involves the assumption that banks repeatedly lend and re-lend deposits up to a limit determined by the “reserve ratio”. This explanation is known as the “money multiplier model”, a model in which the money supply is said to be “exogenous”.

Standard & Poor's chief global economist describes the Money Multiplier Model as a "defunct idea" and that “Banks can not and do not ‘lend out’ reserves”.

Michael Kumhof, Deputy Division Chief, Modelling Unit, Research Department, International Monetary Fund  said "the textbook treatment of money in the transmission mechanism can be rejected”.

Mervyn King, Governor of the Bank of England 2003 to 2013 said “Textbooks assume that money is exogenous … in the United Kingdom, money is endogenous”.

Professor Charles Goodhart CBE, FBA, ex Monetary Policy Committee, Bank of England said of the money multiplier model: “It should be discarded immediately”.

Professor David Miles, Monetary Policy Committee, Bank of England said “The way monetary economics and banking is taught in many, maybe most, universities is very misleading”.

JP Morgan Chase, Global Data Watch: "In spite of being almost totally divorced from reality, the money multiplier is still taught in undergraduate economics textbooks, with much resulting confusion."

Despite all these quotes, textbooks (and Wikipedia) blindly carry on peddling these bullshit ideas.

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Banks don’t lend money

Professor Hyman Minsky once wrote “Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot”.

“Banking is not money lending”? Surely some mistake! Why would an economist as famous as Professor  Minsky make such an outrageous sounding statement?... Well the answer is that its perfectly true. Crazy though it sounds, banks don’t lend money at all. To understand why this is the case we must understand some technicalities about money.

Most people imagine that money is simply a system of government-created tokens (physical or electronic) that get passed form person to person as trade is carried out. Money of this kind does indeed exist, so called “central bank money” is of this type. However the vast majority of the money we spend day today is a second type, technically known as “broad money” or “cheque book money” which can best be described as “spendable bank IOUs”. The concept of a spendable IOU may sound rather strange, and in order to explain it, we must first consider some characteristics of an ordinary IOU, the kind you or I might use…

Say that Mick wanted to borrow £10 from Jim. Jim could give Mick a £10 note in return for a piece of paper with “I.O.U. £10, signed.. Mick” written on it. The IOU would then have some value to Jim as a legal record of the loan. At some later time Mick would repay the loan. At this point Jim should no longer keep the IOU because Mick would no longer owe Jim any money. The IOU has now done its job and may be disposed of. To summarise, the lifecycle of an ordinary IOU is as follows:

1. Creation (out of nothing. It did not exist previously)
2. It now has value as a legal record of the loan.
3. It expires (back out of existence) when the loan is repaid.

Note that even though the IOU has value during stage 2, it is not easily spendable. If Jim went into a grocery shop and said “I’d like to have £10 worth of food, here’s an IOU from Mick, he’ll pay you back later”, the shopkeeper would almost certainly  refuse. This is because the shopkeeper has no idea if Mick is creditworthy, the shopkeeper would be worried he may never receive £10 from Mick. Now imagine for a moment that it could somehow be arranged to have a guarantee from a famous high street bank, that Mick would indeed pay £10 to the holder of the IOU. Then the shopkeepers fears would be allayed and he would have no reason not to accept Mick’s IOU as payment for food. To summarise, a bank guarantee could convert a non-spendable IOU into a spendable IOU.

So far this has all been hypothetical, but to see a non-spendable IOU get converted into a spendable one in the real world, look no further than the process of getting a “bank loan”. The term “bank loan” is in fact highly misleading. What is actually going on is not lending at all, it is in fact an IOU swapping arrangement. If Mick went to borrow £1000 from a bank, the first thing that would happen is that the bank would asses Mick’s creditworthiness. Assuming it was good enough, then the bank would ask Mick to sign a “loan agreement” which is essentially an IOU from Mick to the bank. What the bank would give Mick would generally not be “central bank money”, but instead its own IOUs (i.e. cheque book money). And just like ordinary IOUs, bank IOUs do not have to be obtained from anybody else. They are just created on the spot. No “lending” is going on. In order to “lend”, the bank would have had to have been in possession of the money beforehand, and they were not.

So there you have the layman’s explanation. But some people are still not convinced. Many people have heard a different explanation of the money creation process at university or from textbooks and so assume that this explanation is somehow wrong. But let me assure you that it is the textbook explanation that is wrong. I do realise that “extraordinary claims require extraordinary evidence”. So here goes…

The first thing to say is that the explanation given here is indeed a simplification of the money creation process as it occurs in the real world. The full details of which are so complex and so frequently changing that they are not taught to undergraduate students as part of economics degrees. What students are often taught instead is a toy model of reality. A not-actually-true teaching aid. The idea of using a not-actually-true teaching aid is not unique to economics, in the field of chemistry a similar thing occurs with regard the behaviour of electrons around atomic nuclei. The real world behaviour is too complex for undergraduate students, so they are taught a not-actually-true story of “electron shells”. Its in virtually all the textbooks.

The standard not-actually-true method for teaching students about the workings of our monetary system is an explanation called the “money multiplier model” in which banks appear to lend out money that has been deposited with them. When some economists finish their degrees and subsequently go on to specialise in the monetary system and finally learn the full details of the process, they occasionally have some choice words to say about the undergraduate textbook model:

• “The way monetary economics and banking is taught in many, maybe most, universities is very misleading”. Professor David Miles, Monetary Policy Committee, Bank of England.
• “The old pedagogical analytical approach that centred around the money multiplier was misleading, atheoretical and has recently been shown to be without predictive value. It should be discarded immediately.”. Professor Charles Goodhart CBE, FBA, ex Monetary Policy Committee, Bank of England.
• "The textbook treatment of money in the transmission mechanism can be rejected". Michael Kumhof, Deputy Division Chief, Modelling Unit, Research Department, International Monetary Fund.
• "Textbooks assume that money is exogenous." ... "In the United Kingdom, money is endogenous" Mervyn King, Governor of the Bank of England.

Notice the extremely high calibre of the economists being quoted. These are all economists that specialise in the workings of our monetary system.

Is this issue controversial? Well yes and no (but mainly no)... let me explain. the issue is only controversial in as much as non-experts (that have just learned the textbook story) may say things that contradict the experts that have a detailed knowledge of the system in reality. But amongst the experts, it is not controversial at all.

I shall finish with a quote form Professor  Victoria Chick, Emeritus Professor of Economics, University College London:  “Banks do not lend money. It may feel like it when you get a 'loan', but that’s not what they are doing. They don’t have a pot of money which they are passing on. What they are doing is accepting your IOU… they simply write up your account”.

So there you have it, banks do not lend money. And if you want to argue against this on academic grounds, please only quote economists that specialise in the monetary system. 

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Economists prove that the earth is flat

Subtitle (and in doing so, miss important factors affecting unemployment)

Consider the curve in the diagram below:

Now imagine a man traversing this curve from left to right in small steps of width W. Let us label the exact height (Y) of each foot as YL and YT (L stands for “leading” T stands for “trailing”). The difference in height will clearly depend on the width of the step and the gradient (G) of the slope. This can be expressed as:

 YL = YT + (W x G)

If we now consider smaller and smaller step sizes, in the limit as W approaches zero, YL becomes closer and closer to being equal to YT. If both the gradients and the step sizes are small, a poorly trained mathematician may sloppily pronounce that:

YL = YT        (warning, this equation is wrong)

Hopefully you can see that this statement is wrong, and if taken too seriously could erroneously lead people to believe that “slopes are impossible” and that therefore “the earth is flat”!

So what has all this got to do with economics?

The answer is that many economists have made the same mistake as our proverbial bad mathematician. There is an equation in economics textbooks that states:

aggregate expenditure = aggregate income*

In this case the “leading foot” is aggregate income and the “trailing foot” is aggregate expenditure. This may need some clarification:

The idea that aggregate income equals aggregate expenditure emerges from a simple model of the economy in which all the money that is earned by people is then spent on stuff that was made by people. Or to put it more precisely, the sum total of all the money earned by everyone in the country, per small unit of time (call this unit T), equals the total cost of everything purchased by everyone during that same unit of time. At this point alarm bells should be ringing because you will notice that my explanation of the meaning of the equation involved time, while the equation itself makes no mention of it. Just like the bad mathematician’s equation makes no mention of W. The economists have just said to themselves, “if we make T small enough, we can ignore its effects”. But just like ignoring W, ignoring T, does not allow for any change in the income or expenditure.

So lets see if we can fix this. Looking back at the (correct) equation for the height of the man’s two feet as he traverses x, we should expect the correct form of the expenditure & income equation to have something of the form

aggregate expenditure (at end of interval T) = aggregate income (at start of interval T) + changes in the money supply during T

Anyone that has a clear grasp of our monetary system** will know that loans create money and repayments destroy money. This means that the true state of affairs is as follows:

aggregate expenditure (at end of interval T)  = aggregate income (at start of interval T) + new loans taken out (during past T) - existing loans repaid (during past T)

So what if the original, crude version of the equation is a bit wrong, what problems may this cause?
Answer: you may miss out on the fact that a constantly falling money supply will cause a lack of demand. Aggregate expenditure may be maintained at a level just marginally less than aggregate income for perhaps months or even years.

How does a changing money supply affect the economy?

One way you can reasonably model an economy is to imagine that all the buying and selling happens at discreet intervals of duration T, with all the “sellers” of goods doing their selling at one time step and then, being newly armed with money, become buyers at the next step. This is shown in the diagram below for a scenario in which there is a constant money supply. Note the (aggregated) comments made by the parties on each side (click on image for larger version):

Under these circumstances, we can say:

aggregate expenditure (at end of interval T)  = aggregate income (at start of interval T)

Now consider what will happen in a rising money supply environment in which new money will occasionally be loaned into existence. See the following diagram. Note the comments as well as the additional money shown on the left hand side.

Under these circumstances, we can say:

aggregate expenditure (at end of interval T)  > aggregate income (at start of interval T)

And now by contrast, consider a falling money supply environment in which money will occasionally expire out of existence due to loan repayments. Note the comments as well as the disappearing money shown on the left hand side.

Under these circumstances, we can say:

aggregate expenditure (at end of interval T)  < aggregate income (at start of interval T)

A falling money supply environment is thus likely to be a miserable economic environment with high unemployment. This is why we have all these unconventional money creation schemes (like QE) going on right now. These schemes tend to be described by the media as simply “money printing”, but sadly they are not. Instead they  are all variations of “borrowing money into existence” with a consequence of raising debt levels. So economists and politicians are presenting the public with a false choice between either rising debt or a falling money supply. If economists would consider truly printing money (debt free), then we could have a rising money supply without greater debt.

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* There are actually alternate versions of this equation which add in factors like investment and foreign trade, but none of these alter the fundamental problem, so I will stick to analysing this most basic version of the equation for the rest of this article. My criticism equally applies to more complex versions of this equation you commonly see in textbooks.
** if you don’t then watch this video.

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A new video about money.

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Computer-based market trading 'beneficial' - BS!

This report claiming that high frequency trading did no harm made me angry. Its a bit like a report into the effects of placing sharp metal spikes on the outside of cars concluding that "there is no increased risks to the passengers"!!...

Well of course there isn't - but its the people outside the cars I'm worried about! The scope of the report was too narrow to be of any value.

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How the BBC is misleading the public about the financial crisis.

More than 99% of the general public think that money works as a system of tokens (real or electronic) that get passed from person to person as trade is carried out. They assume that the total amount of it would remain constant were it not for occasional money printing by government. Money could indeed work this way had governments chosen such a system, but in reality it works completely differently. Bear this in mind as when you read the following.

Here I present two tables, the first contains things the BBC say that are either false or misleading, and the second is a table of important things they don't say but should.

What the BBC say	How the public perceive this information	Why this is wrong
There is a “credit crunch”	There is a problem specifically for those people who want to borrow money. There is no impact on the money supply.	Because “credit” is money (technically “broad money”). When you buy something with a debit card, what you are spending is (97%) “credit” even if you personally have not borrowed any money. A "credit crunch" is in fact a money crunch. See here for more info.
Contagion is due to “interconnectedness”.	Some kind of financial disaster may happen because of “interconnectedness”.	The contagion effect has very little to do with “interconnectedness” and everything to with our highly leveraged monetary system. See here.
QE is “printing money”	The money supply must therefore be going up.	Without QE the money supply would be falling fast. QE is being done to slow down its rate of fall. In all the years of this crisis I have only heard this on the BBC once.The money supply, even after QE, is falling. See Mervyn King confirm what I’m saying here.
QE is “printing money”	More money is created, and that’s the end of the story.	Because it is compulsory that the money created through QE is extracted from the economy in the future. This will be painful. It is “kicking the can down the road”.
QE is “printing money”	QE is “printing money”	Money printing is in fact against EU regulations.
Let’s listen to esteemed mainstream economist X	This economist understands the crisis.	Mainstream economics spectacularly failed to foresee the crisis. Economist X doesn’t have a clue why its happening. If this was football, this economist has just been relegated to the Vauxhall conference league and yet the BBC will talk to him/her with reverence and won’t even ask them to explain why they missed the crisis.
Let’s listen to a non-mainstream “controversial” economist Steve Keen.	Lets not take him too seriously.	If this was football, this guy has just won the premiership. Yet the BBC didn’t have him on until years after the crisis began.
“Only the Bank of England can create money in the UK.” See here.	“Only the Bank of England can create money in the UK.”	This is flat out wrong. Private banks create almost all of the money supply, the BOE only create a tiny proportion.

What the BBC don’t say	Why they should
The money supply can shrink	More than 99% of the population are unaware that it is even possible for the money supply to shrink. They have no idea that this possibility has anything to do with the financial crisis, yet this phenomena is at the heart of it. No wonder the population at large do not understand the crisis. See here for more info.
Anything about Irving Fisher	During the great depression in the 30’s… famous economist Irving Fisher developed an alternative monetary system known as Full Reserve Banking (in which the money supply can not shrink). The plan was endorsed by hundreds of academic economists and was probably the most significant economic idea to arise from the depression. Sadly the (tiny number of) people in government that had the power to implement the plan at the time, didn’t have the courage to do so. Then the war broke out and the plan was mothballed.This financial crisis is an almost exact repeat of the depression of the 30’s and yet there is no discussion of him or his plan on the BBC.
Banks behaving better shrinks money supply. And makes banks go bust or need more bailouts.	This is a tragedy not mentioned on the BBC. See here for details.
People taking economics at university are either not taught about the monetary system at all, or are taught an oversimplified and FALSE model of it.	For proof of this, look no further than this quote from Professor Charles Goodhart, who describes standard university teaching of our monetary system as “…such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction”. So anyone reading this who has a degree in economics - please note that your understanding of the way our monetary system works is probably wrong.
Over 90% of bank lending in the past years has been for the purchase of non-productive assets.	The BBC are constantly referring to investing in “risky assets”. But the public has little idea of what this term means. They may think that it means investing in businesses that make products that may or may not sell. But it actually means non-productive assets. Not “businesses” of any kind.Sadly the suppression of this kind of lending shrinks the money supply for the rest of us - so it would be a disaster to suppress it so long as we keep our current "fractional reserve" monetary system.

Banks behaving better shrinks the money supply!

The population at large are demanding that banks behave better. In turn, this is encouraging some politicians to demand that banks behave better. So presumably a raft of strict new rules and regulations will swiftly be put in to place to control the banks… won’t they? Well not as long as we keep hold of our crazy fractional reserve system.

You may have noticed that the new rules and regulations to control bank excesses appear to be both rather timid and slow to be applied. For example the recommendations put forward by the much trumpeted Independent Commission on Banking were rather weak to start with, have since been watered down, and even then are not due to come into force until 2019!

Most people are assuming that the reason for all this timidity is that the politicians are in the pockets of the banks. The political parties receive significant bribes, oops sorry, I mean campaign contributions from the banks and so are reluctant to do anything that may upset them. But there is a second, more significant reason that is scarcely mentioned in the media or known about by the public. Namely that in a fractional reserve system, banks behaving better shrinks the money supply.

Much of the bad behaviour of the banks involves the lending of money for non-productive purposes, like the purchasing of houses or the purchasing “on margin” of shares on the secondary market or derivatives. But as we know, lending creates money and repaying loans destroys money. So any curtailing of lending, even bad landing, simultaneously shrinks the money supply. What’s more, a smaller amount of money creation for purchasing assets reduces the value of those assets. If banks are holding these in order to comply with capital adequacy regulations then this will result either in banks going bust, or banks having to receive even more bailouts than they have already.

Now you can see that the idea of making banks behave better has a double-whammy of resistance.

As I have said many times before, if we instead had a system of full reserve banking, then none of this nonsense would be going on. The money supply could be held constant… Maybe I should make this my catchphrase?

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