Money, Debt and Damaging Half-Truths

I’m going to make a movie.  Because it’s amazing what you can get away with.  Last night, a member of Transition Cambridge was good enough to entertain me and a few other interested truth-seekers, screening and leading a discussion of “Money as Debt“.

I thought I’d explained in my previous posts on the subject of where money (or “leverage”) comes from that for every debt there must be an equal credit.  Think of this principle as a financial version of Newton’s Third Law.

But in a surreal passage(? – scene? clip? – there must be a word for a segment of a non-fiction film – maybe it’s “segment”!) – anyway, I say “surreal”, because it combined illuminating insight with astonishing misleading ignorance – “Money as Debt” explains in a series of steps how what I prefer to call “leverage” can be created.  Their bank had $1111.12 of shareholders’ capital, if I recollect accurately, and by making loans backed by this capital, which was then redeposited, the bank (or what was correctly described as the closed system of banks) was able to generate a total of around $100,000 in loans.   This is a version of the Harvard Business School (HBS) money game described on p.49-50 of Niall Ferguson’s “The Ascent of Money: A Financial History of the World“.

The HBS money game is itself obviously a gross oversimplification, since, in making a perfectly valid point, it is concerned only with bank reserve ratios, that is liquidity, and not the capital adequacy ratios necessary to manage risk.  Banks need not just (in this example) a 10% buffer in case 10% of depositors withdraw their funds at once, but also (say) a 5% buffer in case 5% of debtors default.  With this second condition the HBS money game and the example in “Money as Debt” only work if the banking system has more capital than with only the first rule.  In the “Money as Debt” example, the banking system would have needed a total of at least $5,000 to support the $100,000 lending described.  This point is crucial, because it explains why it is so important to recapitalise the banks to get lending going again – and, yes, create more money.

But the real howler in “Money as Debt” is that their Step 1 (after setting up a bank with $1111.12 capital) did not start with a deposit of $10,000 (allowing them to lend $10,000).  It started with them making a loan, which they simply would not have been able to do.

Let me take a stab at explaining why people are confused by this point.

They observe that if you go into a bank you can obtain a loan by signing a form (as in the film).  This loan represents an asset to the bank.  The bank has a call on you to repay the principal + interest.  The value of this loan to the bank depends on how likely you are to repay it, which depends on (among other things) your inclination to repay and the rules governing debts in the relevant jurisdiction.

In return for the loan the bank may deposit the value of the loan in your account (a liability to the bank, balancing the asset of the loan).  It seems as if the bank has simply created money.  But the bank could equally well give you a cheque made out to a third-party (or create an electronic payment) – to a car salesman or someone whose house you are buying, for example.  Even if the money is initially credited to your account, the bank is hardly likely to expect you to leave it there.  It may – to use the figures from an example by a fellow truth-seeker – lend you $1000 for a year at 10%, but only pay 5% interest on deposits over the same time period.  Simply leaving the money in your account would be equivalent to donating the bank $50.

The bank can only “create” money by giving you a loan and a simultaneous deposit, because it knows that there are many depositors.  It relies on the $1000 loan it has deposited in your account being replaced as soon as you withdraw it.

In reality, modern banks have literally millions of depositors, and make millions of loans.  They manage the situation, for example, by adjusting interest rates to influence demand, so that (barring catastrophes, such as a run on the bank as at Northern Rock) they limit their lending, and attract sufficient deposits, in order to stay within the liquidity and capital reserve ratios I’ve described.

I tend to think people only believe stupid things because it suits them.  In this case, painting a picture of banks creating money supports the demonisation of bankers.  It is true that money (or what I prefer to term “leverage”) is created in the lending process, and that the system is unstable, requiring careful management.  But a more accurate representation of the role of banks is as intermediaries between the depositors (lenders) and borrowers, in a highly-regulated process following rules laid down by governments and other authorities.

It is a gross oversimplification to blame the banks for the current recession.  I don’t like to see bullying, but the ongoing assault against the banks by the political classes and the media could lead to worse than we’ve seen so far.  In a different era, vilification of money-lenders was a step on the road that led to the horrors of Auschwitz.  We’re now told to expect violence on the streets of the UK.  If a long hot summer in the City does arrive, it will be in no small measure the fault of the politicians and in particular our elected – sorry, not actually elected – leader, Gordon Brown, who paints a picture to the public that “explains” it all as the fault of reckless bankers and ignores the mistakes and intellectual failure of politicians and the regulatory authorities.  Even now, the Government is using all means at its disposal to try to reverse the fall in house prices – even though the house-price bubble is a large part of our problem and needs to be permanently deflated.

I’m sorry, “Money as Debt” is in the same league as 9/11 conspiracy theories, a division below the grassy knoll, but battling against relegation with Elvis sightings.