Share prices with fractional reserve banking

The textbook explanation of share prices revolves around basic “supply and demand”. If the price of something has gone up it must mean that either its supply has diminished, or its demand has increased. It’s all part of a natural stable system. Wise investors are carefully evaluating companies and buying and selling shares accordingly. The government, who claim to believe in free markets, sit on the side-lines and let them get on with it.

Most people would make two assumptions when considering this market:

1.    People normally buy shares with their money.
2.    If they spend say, £1000 on shares, they will have £1000 less money to spend on other things.

If both these things were true, then share prices may be well behaved and act in the way textbooks may have you believe. But many economists have observed that share prices behave in strange ways. At least part of the reason prices appear so strange is the fact that neither assumption is correct. They are incorrect because shares are often purchased with borrowed money, or to be more accurate, part borrowed. Readers of this blog should know by now, that when £1000 is “borrowed” from a bank, that money is created out of nothing. There is nobody else in the economy that is deprived of £1000 of spending power. You should get the idea straight away that now something is screwy about the demand side of the supply and demand balance.

Textbooks say that the price of something is what you are willing to give up in order to get something, i.e. the amount of money you will pay for something equals the amount of money you are willing to have disappear from your spending power on other stuff. But if you are going to buy that thing with 10% your money and 90% borrowed money (a process known as trading on margin) then the textbook concept is busted. Now the amount of money you are willing to pay for something is enormously sensitive to the interest rate you will be charged for the money you borrow to buy that something!

So now the role of government becomes crucial in setting share prices. Instead of standing at the side-lines observing these wise investors analysing the companies, the government is now the dominating factor. The wise investors are sitting watching the government! If they lower interest rates, then the enthusiasm for borrowing to buy shares increases, this increases demand and their price will rise… and conversely If they raise interest rates, then the enthusiasm for borrowing to buy shares decreases and their price will fall. By implementing super-low interest rates for such a long time, the government is now stuck in a situation, where returning to normalised interest rates would almost certainly cause a crash in the stock market. Note that I could have made almost exactly the same argument about the housing market too.

The near-zero interest rate policy is in force precisely because of fractional reserve banking and would be entirely unnecessary had we a full reserve system.

Changing to full reserve banking is a key ingredient for making our economy work properly. If I were in charge, I would ban the practice of trading on margin too. It serves no purpose that I can figure out for the economy as a whole.

Advertising Standards Authority condone bank's lies.

The idea that banks simply "lend" money in the normal sense of the word is actually false. I wrote about this before here. You may have noticed however, that banks are happy to use the word "loan" in their advertising. So I decided to write to the Advertising Standards Authority (ASA) to see what they had to say on the matter. According to their website, the ASA's mission is to "ensure that advertising in all media is legal, decent, honest and truthful". Let's see...

In their reply, they said...

"we acknowledge that the wording could be seen as being technically inaccurate"

...interesting. Note that "technically inaccurate" is a euphemism for lie. Reminds me of terminological inexactitude!

They went on to say...

"we consider that the ads are unlikely to mislead consumers into making a transactional decision with regard to the advertisers’ services that they would not have otherwise made"

I would dispute their claim, certainly in the long run. If more people, including economists, were aware of the true workings of our crazy monetary system, the entire course of our economic history would probably have been quite different and so many of the loans that were taking place in the run up to the credit crunch would never have taken place. Allowing banks to lie in their advertising is just one more contribution to the world's misunderstanding of money. Apart from anything, what are the ASA doing, allowing any lies in adverts at all? Sure, there are many adverts that have comedy lies, or unreal events that everyone knows are unreal. But lies where the viewer will probably believe the lie to be true? Surely that can't be allowed.

I strongly suspect the ASA is a sham organisation who's main purpose is to protect advertisers from genuine regulation, just like self-regulation by the British press. The ASA are gutless and toothless.

Peter Mandelson demonstrates his ignorance of our monetary system

When Peter Mandelson appeared on the Andrew Marr show on 22 Dec 2013, he was asked about the state of economy. He said "we've got to see people earning more and their personal indebtedness reduce". Unfortunately, under our current fractional reserve monetary system, most of the money supply is created by people's personal indebtedness; reducing that, will reduce the amount of money available for people to earn! Its impossible to achieve what he's asking for without changing our monetary system.

An irritation with MMT'ers

The sectoral balance equation gives the *impression* that if the government runs a surplus of $X during one year then the money supply available to the private sector to use must be whatever it was at the start of the year minus $X.

But this is not true. Fractional reserve banking allows the private sector to increase or decrease the money supply independently of whatever the government does. So the *contribution* of the government's policy to the money supply may indeed be -X, but the size of the private sector's money supply could have changed by any amount.

Maybe an MMT'er would admit this if probed, but why don't they say it in the first place instead of misleading everyone?

PART II

After some back and forth on Twitter, and being directed to read this, I'd like to say some more...

A huge component of the current economic crisis is the size of the money supply and the amount of private debt (the two are closely related). But the debt is not debt *to* the government sector. It is debt to others within the private sector (I'll label this as internal borrowing). Note that MMT'ers favourite quantity, the "net financial assets" does not measure the private sector's internal borrowing, because it nets out as zero.

Having a conversation about what to do about the economic crisis and debts without talking about the private sector's internal debt is just leaving a huge elephant in the room. Where is an MMT article about the that? Where is the article "MMT'ers use sectoral balance equation to deduce policy to control internal private debt"?

Why our monetary system contributes to the gap between rich and poor

* We have a monetary system in which loans create money and repayments destroy money. So at any one time the amount of money in the economy is approximately equal to the amount of outstanding loans.

* Most (90% ish) of the outstanding loans in the economy have been for the purposes of buying assets (mostly housing, but also stocks and shares).

* Rich people are keen to borrow to buy assets when they have confidence that the price of those assets are going to rise.

* If the rich lose confidence that asset prices are going to rise they will be less keen to borrow money. This will shrink the money supply and lead to recession, like in the 1930's where the money supply fell by about a third.

* The only way the government know how to prevent a collapse in the money supply is to do everything in their power to give rich people the confidence that asset prices will rise. This means that the government are actively doing everything they can to ensure that the rich asset owning classes become richer at the expense of poorer people. Things like "help to buy", whose primary effect is to increase house prices.

* Making the rich richer is the only thing governments can think of to prevent a financial collapse! How long are we going to continue with this madness?

* Switching to full reserve banking means that the money supply can be held stable without handing the rich more money from the poor.

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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