Turner Turns (11) Banks Get the Money Back

Banks are different from other businesses in another way. Most of the money that they lend comes back to them. The bank deposits the money in the account of the person taking out the mortgage. It will not stay there, because the borrower will write a cheque to pay the person they are buying a house from (ignoring the solicitors for simplicity). The house seller will deposit the cheque in their bank account, most likely a different bank. The borrower’s bank will have to transfers reserves to the sellers bank to cover the cheque.

The seller might need to use some of the money to pay for goods and services. They might buy some shares or units in a superannuation fund. The money will end up in the banks of the businesses selling these things.

The big difference is that the money ends up being deposited in a bank account, somewhere. Whereas, when a business gives credit to a customer, they hand over good or services to them. They do not get anything back until the loan is due. The money does not come back to their business.

The credit created by the bank issuing the mortgage would end up in accounts at other banks. However many other loan transactions would be going on at the same time. The home buyer’s bank would most likely have some money paid into the accounts of its depositors relating to these transactions. It would receive Central Bank reserves from other banks to cover these cheques. All the transactions could cancel each other it, so the bank might need to give up any reserves at all. If this happened, the bank would have received back all the money that it has loaned out.

This difference allows a bank to create immense amount of credit, provided all other banks are doing the same.

Turner Turns (10) Banks

Banks create credit. However, the structure of a bank balance sheets means that it is not so constrained as other businesses.

Due to fractional reserve banking laws, only a small part of the bank’s assets are needed for the support of its ongoing business. They do not need to use their currency to make a loan. Reserves at the central bank cannot be lent to private individuals.

When making a loan, the bank simply records a deposit in it’s clients bank account. They record this deposit as a liability on the bank’s balance sheet. The mortgage is recorded on the other side of the balance sheet as an asset.

Banks are not constrained like other businesses. Only a small part of their assets, are needed to support their ongoing business. All they have to do is keep enough reserves of currency or at the central bank to cover potential withdraws of call deposits. Deposit insurance means that their reserves can be kept quite small.

Banks are different from businesses. They do have to give up anything when giving credit to a borrower. Banking laws give them the right to give borrowers something they do not own.

Understanding this is easier, if we think about the situation when banks began as goldsmiths storing gold. People deposited their gold with the goldsmith for safekeeping. Rather than withdrawing gold when they needed to make a payment, they would exchange the goldsmith’s receipts. These receipts acted as money. The goldsmiths realise that only a fraction of the gold was withdrawn at any one time, so they began lending some of it out in return for an interest payment.

All the gold belonged to the people who deposited the gold. The goldsmith bank did not own any the gold (although it would record on its balance sheet). When it loaned gold, it was lending gold did not own. It was cheating because it was lending something that did not belong to it.

Now that we have switched to fiat money, the same situation applies. Banks can lend out money that they do not own, just as a goldsmith bank lent out gold it did not own. The law allows banks to operate in this way. No other person or business has this right. Fractional reserve laws give banks a huge capacity to expand credit. This has been a major cause of instability in economies everywhere.

Turner Turns (8) Flawed Arguments for Credit Creation

Most economists assume that private credit creation by banks is the best way to ensure sufficient aggregate demand. Several reasons have been put forward to justify the need for credit creation. They are flawed but we need to understand them.

1. Shortage of Savings
   One possible reason for credit creation might be a shortage of saving constraining capital investment. If people do not save enough, then economic growth could be slowed. Lack of savings is a seriously problem in many economies, but credit creation is not a solution.
   
   At the level of real activity, investment must be matched by savings. When an economy produces capital goods, there has to be forgone consumption as less consumer goods are being produced. If Robin Crusoe devotes time to making a net, he will have less time for fishing. He will have to consume less for a while, so he can build up a supply of fish to eat while he spends time making the net.
   
   In a complex economy, decisions about investment and saving are made by different people, so intentions about saving and investment could get out of line. Business might produce more capital goods than savers are willing to fund. If that happens, there will be a surplus of investment goods and a shortage of consumption goods.
   
   Creating credit might seem like a solution, but it is not. It actually makes the situation worse, because central banks adjust interest rates to encourage the banks to create credit. When the central bank controls interest rates, the price information that savers and entrepreneurs need to make good decision are distorted. It is better to let the interest rate adjust naturally until savings and investment comes into line. Quick money schemes have an appeal, but there is no escape from the need for saving.

2. Lack of Nominal Demand
   The most common argument in favour of credit creation is that nominal demand is sometime insufficient to produce economic growth. Central banks believe they can increase growth by increasing the supply of money. This argument is flawed, because the demand does not cause production of goods and services. Rather production creates demand for the goods and services. This is summarised by Says Law, which says that supply of goods and services creates it own demand. In a barter economy, if I have produce something for exchange, that creates a demand for something that someone else has produced.
   
   In a complex economy, the wages and salaries and profits earned through the production process create the demand for the goods and services produced.

   Say claimed that production is the source of demand. One’s ability to demand goods and services from others derives from the income produced by one’s own acts of production. Wealth is created by production not by consumption. My ability to demand food, clothing, and shelter derives from the productivity of my labor or my nonlabor assets. The higher or lower that productivity is, the higher or lower is my power to demand other goods and services (Says Law).

   What can happen is that entrepreneurs make the wrong types of goods and services. They might produce to many cabbages when people are wanting more pumpkins. These problems are easily solved. Prices will adjust and businesses will adjust their production to clear the market. Credit creations just exacerbates the problem by making it seem as if there is demand for the things that people did not really want. This rewards the entrepreneurs who made bad decisions, which is like to make the situation worse in the future.

3. Short Term Liquidity
   A common argument for allowing banks to engage in credit creation that liquidity is needed for markets to function.
   
   You cannot buy what I have produced, until you have sold what you have produced. However, Jack cannot buy what you have produced until I buy what he has to sell. Trade appears to be stymied.
   
   This is an old problem, but people have always found a problem to solve it buy offering credit to each other. All it takes to get trade moving is for someone to say to someone they trust, you can pay me when you have sold what you have produced. People do this all the time. Societies have found various ways to make sure trade take place, without the need for banks to create credit.

4. Seasonal Finance.
   A common argument for increased money supply is that it is needed to finance seasonal production. This is an illusion. If I sow wheat in the ground, I will not reap a harvest until six months later. If I do not have any spare grain, then I have to get some grain from another person to avoid starving. That grain will not be available for someone else to consume. This shows that season activities, where production take a long time to be complete, has to be supported by real saving. Creating credit to for seasonal finance will distort supply and demand.

Not Needed
The accepted wisdom that credit creation is needed to foster economic growth is flawed. Credit creation, whether by banks or governments, is theft. It allows the people who get the created credit to buy something that really belongs to someone else. While economists are stuck with the idea that growth in nominal demand must be funded by credit creation, they will continue to create problems for their economy. The GFC is the most recent example.

Turner Turns (7) Moral Flaw

My turn now.

The basic flaw in Adair Turner's talk is his assumption that a gradually increasing supply of money is needed to ensure that economic growth is not constrained. Turner says that a problem with metallic money is that it does not grow fast enough. The implication is that as the economy grows, prices and wages have to slowly decline. He says that this was the situation during much of the nineteenth century. This statement is a bit odd, because this was a time of rapid economic growth arising from the industrial revolution.

Turner says that most economists believe that it is difficult to get downward flexibility and that it is more sensible to run an economy with nominal GDP growth of 4-5% price inflation of 2-2½ and real GDP growth of 2-2½. Monetary growth is needed to ensure GDP growth is not constrained.

There is a moral flaw to this argument. Monetary inflation robs savers of their wealth. Over twenty years, the purchasing power of savings is halved, if inflation averages 3% per year. That is painful, if you are living on your savings, as many people do. Over the last few decades, inflation has been much greater than 3%, so the loss have been even greater. This is theft, so it is morally wrong.

The argument that prices are sticky downward is wrong. Every time we go shopping, we see specials and offers of discounts. Clearly, retailers are quite happy lowering prices. Prices of electronic goods have declined continuously over the last few decades, without any disruption of the market.

Wages are sticky downward, but that does not matter. If all prices are declining slowly, and nominal wages are unchanged, then real wages are increasing. This is what should be happening in a vibrant economy. Improvements in productivity due to technological advances should allow business to reduce their prices. So over time, prices should be declining slowly. This increases the real value of wages, without any need for industrial pressure. This is the true trickle down.

Gradual inflation robs workers of this technology dividend. If prices are rising slowly, real wages will decline, unless employees can persuade employers to pay more. This is hard, because the truth is that wages are sticky upwards too. Under inflation the benefits of technology are captured by the richer people whose income comes from capital gains, which benefit from price inflation.

Contrary to Turner and other economists, an economy with gradually falling prices would be better for wage earners and people on fixed incomes. They would share in the benefits of technology and improvements in productivity without having to use industrial muscle of political power.

Gradual inflation encourages people to go into debt. If prices were slowly falling, people would thing twice about going into debt, because the real value of their debt would gradually increase over time. The inflationists have taken away one of the best protections against excessive data.

Turner Turns (6) Inequality

Like everyone these days, Adair Turner is concerned is about inequality.

Within any society, richer people have a higher propensity to save. If there is a dramatic increase in inequality, there can be a situation where intended savings are not matched by investment decision. This would normally create a deflationary impetus, except that rich put their money in the bank, and they lent it out subprime mortgages to people trying to make up for deficiencies of income.

Inequality will have to be eliminated to prevent this problem.

His concern about inequality comes from a Keynsian dislike of saving. I am concerned about inequality too, but saving is not the problem. Saving is essential for supporting capital formation. Without capital funded by real saving an economy cannot grow. If savers want to save more than entrepreneurs want to invest, interest rates will fall (provided central banks are not meddling) and more capital projects will be viable and the excess savings will be absorbed. So excess saving is not a serious problem. While poverty is a problem, it is foolish to say that there is too much saving.

Turner Turns (5) De-leveraging

Adair Turner explains that during the upswing, debt contracts fool us.

The mode of the frequency distribution of returns is getting all your money back. People start to believe that the mode is the entire distribution of possible returns. Prior to the GFC, banks lent money where there was not a reasonable expectation of return. Risks of default were neglected. Subprime lending is the worst example.

In the downswing, debt contracts exacerbate the problem. Irving Fisher’s article covered three problems.

1. Bankruptcy and Default
   Debt contracts do not respond to downturns in the economy, because they are non-state contingent. Adjustments occur in a jumpy fashion through bankruptcy and default. Real estate fire sales occur. Bankruptcy and default were missing from the DSGE models used by central banks.

2. Roll-over needs and Impaired Lending Capacity
   An equity contract goes on forever. It may decrease in value, but it does not have to be repaid. Debt contracts have a specific term and have to be rolled over. If banks stop lending, there is a problem.

3. Debt Overhang
   People feel shocked at their level of leverage and try to repay debt. Companies stop investing. Households stop consuming. These effects exacerbate the economic downturn.

The debt overhang is the reason why we have had such a slow and weak recovery from the GFC.

We do not know how to get rid of leverage in an economy. We just know how to shift it around, mostly from the private sector to the public sector. Excessive private debt is shifted from the private sector to the public sector or from one country to another. The rise of Chinese debt is the natural consequence of de-leveraging in the west, which was driving a deflation in china. We do not know how to get rid of leverage.

The accepted wisdom does not produce the optimal quantity of credit. The reason is that there is not one natural rate on interest. Natural interest rates are heterogeneous through time, and across sectors and categories of lending. In a real estate boom, shifting the interest rate from 5% to 5½% will do nothing. Increasing the interest rate to 10% will wreck the real economy long before the boom is slowed. There is heterogeneous interest rate elasticity of response.

This last paragraph explains why orthodox monetary policy does not work in New Zealand. When low interest rate cause a housing boom, the Reserve Bank of NZ pushes up interest rates. The carry trade responds by bringing funds to New Zealand to get the higher rates. This strengthens the NZ dollar, which creates problem for the export sector. This policy hurts the export sector long before it cools the housing market.

Turner Turns (4) Credit Misallocation

Adair Turner explains that during the last couple of decades, too much credit was produced due to problems with credit allocation.

Economic textbooks say that banks lend the savings of households to businesses to fund new capital projects. Banks choose between alternative projects to find the most productive. This view is misleading. In the UK, only 15 percent of bank credit goes to fund new capital projects.

1. Bank credit is lent to households to fund increased consumption.
   

   • Some may be logical optimisers rebalancing consumption over a lifecycle within a budget constraint. That is sensible.

   • Some may be impatient people trying to spend money now that they cannot afford to repay. Often these are the poorer people.

2. Most bank credit goes to purchase existing assets, often real estate. When the growth in credit goes into residential real estate, the only thing that can give is prices. The increase in price validates the decisions of borrowers and lenders. The net worth of the borrower is increased. This increases their incentive and ability to borrow more. Credit against real estate is a cause of economic instability.
   
   The iron law of banking is that every 15 years somewhere in the world, a commercial banking system goes mad lending to real estate. This builds up a problem when the cycle changes from growth to decline.

The GFC demonstrated that a society can produce too much credit. To much leverage is dangerous.

Turner Turns (3) Pre-crisis Orthodoxy

Turner describes the orthodox approach by central banks prior to the Global Financial Crisis (GFC)

• On their monetary theory side, low and stable inflation was considered to be desirable and sufficient as an objective. Low inflation indicates an economy in balance, so by definition, the right amount of credit would be created. Central banks did not have to pay attention to where the credit was going. The only concern was whether enough credit would be produced.
• On the financial theory side, debt contracts were considered to be essential Free markets will produce an optimal balance between supply and demand.

This orthodoxy was seriously exposed by the GFC. The crisis came about through too much of the wrong sort of debt. Both sides of the orthodoxy were wrong.

We actually have a system that can produce too much credit, if left to itself.

Turner Turns (2) Debt Contracts

Adair Turner explains that banks create ongoing debt contracts.

Economists have argued that an all-equity economy would be more smoothly operating. However, human beings cannot deal with the resulting uncertainty. They want apparent certainty, especially in wage and debt contracts. They prefer fixed flows of revenue to partnership shares in business projects.

A debt contract is non-state contingent. Payments are not contingent on a future state of the world or on the success of a particular business project. This is good for capitalisation, because it overcomes the problem of costly state verification, the difficulty of working out both ex ante and ex post whether a business project is profitable or not. Asymmetric information makes lenders powerless compared to the borrower.

Turner Turns (1) Credit Creation

The London School of Economics makes its public lectures available on MP3. Some interesting lectures are available. I have just listened to a talk given by Adair Turner at the London School of Economics called Creating Money – For What Purpose.

Adair Turner was the Chairman of the United Kingdom Financial Services Authority when the financial crisis broke in September 2008, and played a leading role in the redesign of the global banking and shadow banking regulation. He is now a Senior Fellow of the Institute for New Economic Thinking.

Apart from his accent, Adair Turner is an excellent communicator. This talk is a easy-to-understand summary of the latest thinking of economists about Monetary Policy. There is a basic flaw in this thinking, but it is good to understand how economists and central bankers are responding to the Global Economic Crisis. The comments are a summary of more detailed talks given at Frankfurt and Stockholm.

Credit creation by Banks
Turner began his talk by explaining the role of banks. He says,

Banks do not intermediate already existing money. The create money and credit ex nihilo de novo. When a bank makes a loan, it puts the loan on the asset side of its balance sheet. At the same time, it puts the money in the borrowers account. At that point, they have created money and credit. There may be constraints on how much due to the need for reserves at the central bank or to maintain equity.

The critical thing that created the credit is maturity transformation. If the tenor of the deposit and the loan was the same, nothing has happened. If both are instantaneous, nothing is achieved. If the borrower has a loan for a year that is available now, maturity transformation has occurred and money is created.

This is very different from the standard textbook explanation of money creation. It is good to get this clarified.

Turner says that the benefit of private credit creation is that is disciplined by the market, which allows credit to be allocated efficiently.

Orthodoxy says that if the interest rate is set to equal the natural rate of interest, the right amount of credit will be produced.

Adair Turner on Finance

The Future of Finance and The Theory That Underpins It is a talk given by Adair Turner at the London School of Economics. It is available on a podcast here. It is a bit technical at time, but is worth a listen for those who want to understand the GFC.

Turner described the problems with the modern banking system very clearly, which is unusual for an insider. They usually pretend that the system is better than it is. Unfortunately, although he understands the problem well, Turner believes that the problems with the system can be managed. I think he is wrong. A more radical solution will be required.

Banks facilitate unmatched intermediation between lenders and borrowers. Lenders and borrower can obtain credit and debt contracts for different terms, risk and return. This mismatch is managed through the bank's balance sheet. On the liabilities side of the balance are short-term deposits. On the assets side are long-term loans, often twenty to thirty year mortgages. This creates a huge risk, as the bank ends up with many short-term debt contracts, which it could not honour, if all the depositors wanted to withdraw their funds at the same time. Banks depend on the central bank to act as a lender of last resort whenever this happens.

In addition to this liquidity risk, banks also carry the default risk. If a borrower default, the depositors still expect to get their money back. A bank needs sufficient capital to cover this default risk.

In the UK, business lending and borrowing net out. This means that most savings by households go in residential and commercial mortgages. This can create a self-reinforcing credit/asset price cycle. When real estate prices rise, banks are willing to lend more to mortgage holders. More mortgage money allows household to bid up prices. This self-reinforcing cycle creates frequent housing booms.

I describe a better solution to the liquidity problems of banks at Deposits and Loans and Money