Where money comes from… the leveraging process – afterthoughts

My previous post and the one before that tried to explain where money comes from.  I described a process – leveraging – whereby banks and an economy as a whole creates more and more credit.

One point I omitted was to explain what happens when you are loaned money from a bank.  I noted in my first post on this topic, that banks must have sufficient funds at the central bank to cover any (electronic) payments made by their customers.  Sophisticated computer systems now control this process.

But what I didn’t mention was that money loaned to you by your bank doesn’t come out of thin air.  If they loan you money then this credit is balanced by a corresponding debit on one of the bank’s own accounts.  Thus the quantum rules governing the process are enforced.

And if you pay interest on a bank account, this money must come from somewhere. It must be credited to your account from another bank.

Perhaps it seems as if a bank is somehow creating money by charging you interest, but it’s not.  If you don’t pay it (say you only pay off the original debt), the bank will make no profit on the transaction (in fact it will make a loss, as the money paid to you is not free, but itself is subject to an interest rate).  Its capital to support further lending will not increase.

What might be confusing is that a bank will report (in terms of “balance-sheet money”, not “real money”) that its assets (loans it’s made) have a certain value based on the likelihood they will be repaid with interest, not repaid at all, partially repaid and so on.  This value can change abruptly depending on the economic climate and sentiment.  This is what happened to provoke the Great Crunch.  All of a sudden a lot of loans on banks’ books were perceived as worth a lot less than before.

This meant that banks suddenly had a lot less capital to support lending.  The problem was compounded by (at least) two catastrophic mistakes by regulators:

(1) The daft idea of mark-to-market, an accounting principle that banks must mark down the value of their assets to current market prices.  So, if a bank had some mortgages (an asset) that no-one wanted then it was forced to mark the value of these down dramatically – below the value they may have if held to term (i.e. until everyone has either paid off their loans or declared bankruptcy).

Mark-to-market is particularly insane, because it implies that the risk of one or more banks concealing the fact that they are insolvent is worse than that of banks failing (or having to be nationalised) when they are technically insolvent, but, if allowed some breathing space would be able to pull through.  There have been periods before when banks have been technically insolvent – e.g. due to the “Third World” Debt Crisis – but have muddled their way through.  As is now painfully obvious, a loss of confidence in the banking system as a whole is a lot worse than the occasional BCCI.

(2) Allowing banks to hold assets in off balance-sheet vehicles (e.g. SIVs, “conduits”).  At least some of these assets were “really” on balance-sheet, since the banks concerned could not walk away from their responsibility for them without destroying their own reputation.

The correct action at the outset of the Crunch was to order the banks to raise more capital, a prescription obvious at least a year ago.  In the case of Northern Rock King and Darling will no doubt rot in Hell for all eternity for not having the courage to shout from the rooftops at the outset that the Bank of England stood behind the Rock.  Instead of kow-towing to the queues of savers, they should (if necessary) have just shut the doors for a few days until they’d got this message across.

The whole Crunch could have been avoided if governments had:

(1) Made it clear that no bank would be allowed to fail – they are heavily regulated (e.g. by the FSA) and all solvent.  Central banks would lend to them without limit.

(2) Ordering the banks to recapitalise just in case.

(3) Ordering them to recapitalise again if confidence didn’t return.

(4) Repeat step 3 as long as necessary.

Now, of course, rapid deleveraging has led to a disastrous recession.


Now, at last we’re in a position to understand the discussions of leverage.

Some – Niall Ferguson in a somewhat incoherent piece in the FT, for example, and Willem Buiter on his Maverecon blog, argue that lending (aka leverage) should be reduced.  I don’t doubt they are right.  The problem is this can’t happen overnight.  The plan is, or should be:

(1) To try to maintain lending levels to reduce disorderly deleveraging through bankruptcies and further bank failures.

(2) Address the causes of excessive indebtedness (though there’s no prescribed optimum level – the idea that it is excessive is subjective).  These causes include:

– trade imbalances and consequent surpluses and hot money (“The Chinese Mistake”);

– shocking levels of inequality (a contributor to “The American Mistake”);

– incorrect inflation targeting (“The Universal Mistake”) allowing asset bubbles to develop, particularly in the property market (“The British Mistake” and a cause of “The Spanish Mistake”).

Note that the undoubted failures of banking regulation, and even less the behaviour of “reckless bankers” are at best contributing factors, and arguably irrelevant – not just an insufficient cause, but also unnecessary.

I’m planning a series of posts addressing these causes of the Crunch in a little more detail.  Watch this space!