Turner Turns (9) Creating Credit

Adair Turner explains that Banks can create credit. What he does not explain is why they are able to do it so freely. Is this legal? Is it right?

Banks are not unique in being able create credit. Any individual can create credit too. If I supply you with goods or services and say that you can pay me in a year’s time, I have create credit. However, I can only give away stuff that I do not need for the next year, so there is a serious limit on how much credit I can create. I have to give some goods or services that I have produced or bought in exchange for an IOU from the borrower. Unless I am rich in resources, I will not be able to give much credit.

Businesses can create credit, too. If it supplies goods or services to person or another business, and agrees that no payment is required until a year later. This credit becomes money, because the person can use the money he would have paid to the business to buy something else.

However, a business has the same constraint on the amount of credit that it can create, as a person. It has to supply some goods or services to the borrower in exchange for the security it receives from the borrower. Creating credit will reduce it stock of goods or supply of cash in the bank. It can only lend stuff that it does not need for the ongoing operation of its business. The amount of credit created will be small, because most of its resources will be needed to keep the business operating.

A businesses balance sheet looks like this.

The business needs its capital equipment and building for ongoing production. Therefore, unless the business is willing to borrow the money it lends, it has to turn some of its cash at the bank or stocks of inventory into loans to debtors. This significantly limits the amount of credit it can give.

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 (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.