More exchanges with an "Expert" in Banking and Finance

I have already posted some of the comments on my blog and videos made by a very well placed representative of the international banking system during a fascinating email exchange that we had a few weeks ago - see "At last - a real expert in banking and finance reacts to my proposals!"

I did actually reply to all those criticisms. And my comments actually led to quite a debate. In this posting I'll just give a few examples of the debate.

For example, the first points the "expert" raised were these:

[Expert] " - Mr. Thorpe ignores that 100% of the money base is indeed already create by central banks. And that’s it.

[Expert]- ‘Money’ (which loosely speaking is = N times the monetary base) is indeed ‘created’ by financial intermediaries (not only commercial  banks as he said) but still (at least in normal times) the central bank controls (directly or indirectly) the money in circulation (typically by setting the interest rates.. actually one specific interest rate - the ‘repo’, or overnight - and trying to influence the long term ones)."

Clearly, the "expert" was trying to fob me off with the usual story that Central Banks control the amount of money in the economy using the "Multiplier Model", well known to economics students. Here's my first reply:

I think that it is fair to say that this is now a subject where there are plenty of well-educated economists who would disagree with you very strongly.

Take, for example, a document published by the Bank of England last March. 

It states (for example):

" “Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves…  When a bank makes a loan to one of its customers it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created…”

"Whenever a bank mades a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money.

 The reality of how money is created today differs from the description found in some economics textbooks:

· Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits

"Broad money is made up of bank deposits - which are essentially IOUs from commercial banks and companies - and currency - mostly IOUs from the central banks. Of the two types of broad money, bank deposits make up the vast majority  - 97% of the amount currently in circulation. And in the modern economy, those bank deposits are mostly created by commercial banks themsleves."

"Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created."

 “…the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them…It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.”

All very interesting, I hope you agree. In other words, you are presumably going to have to argue that the people at the Bank of England haven't a clue either – it's clearly not just me.

At this point, I suspect that our expert began to realize that maybe he was not up against the usual ill-informed member of the public for whom the "trust me, I'm an expert" gambit will almost certainly work.

My friend Niko Kriegeskorte, another "brain scientist" chipped in with with a few other comments, with which our expert was apparently happy to agree. 

[NK] Simon’s specific ideas  and X’s critcism (if we can look beyond ... sophistry and posturing) aside, i think the following points are well established:
·        private banks create money (in the form of deposits) when they make loans.

[Expert] Yes, this is correct.

[NK] · this is in contrast to the widely held misconception that each loan given uses money deposited by a bank’s other clients. however, it’s not controversial at all among experts on banking.

[Expert] Yes, this is correct. That’s why it’s called ‘FIAT’ money (the one created by central banks) and that’s why it’s called ‘money multiplier’. It’s not a secret, it’s well known.

[NK] ·   money created in the form of deposits accounts for the vast majority of the money supply (97% according to one estimate).

[Expert] Yes, this is correct although the exact % varies from country to country according to a large number of factors (which influence the multiplier)

Later on in the exchanges, Niko makes the following point

[NK] the larger issue is not the validity of Simon’s specific proposals (of which he has many), but whether a fundamental rethinking of the way our economy works, and in particular of the creation of money, is in order.

[Expert] Well, economics is a very open science. These days you can come up with whatever, really whatever. There are people working on behavioural economics, people working on neuronomics, people working on you-name-it. The point is that we all (as in other sciences) agreed about some basic methodological aspects. We do not use rats but models. We don’t make experiments (at least not in macroeconomics) but simulations.

If you want to challenge whether the money creation process (at least in the current form) is optimal or not (or it’s disaster), you’re welcome! However, as I already told you in a previous e-mail you have two options: 1) scream-what-ever-you-have-in-mind 2) play according to the rules of the game.

Go for option 2. Sit down, write a small model and think about the economy.
In this world money is created by a central bank and is then transmitted to the private sector.
Write down the most basic model of this economy.
Then think what you don’t like (banks making money out of this? ok).
Write down a mickey-mouse model of the economy in which banks do *not* create money. Here you can be creative, you can choose (as I told you) to let private agents to borrow from the central bank. Or you can eliminate the central bank from the economy. Or what-ever..
Finally, try to understand what you want to maximise in each economy. Is it welfare? In this case, what is the loss-function you want to minimise? Also, what are the trade-offs of the agents in the model? What kind of insurance mechanisms you assume against idiosyncratic shocks? Feel free, you can say nothing here (in which case you live in autarky). What are the optimality conditions? What kind of frictions do you want to put in the model? Do you assume flex-prices (in this case monetary policy is irrelevant)? Or maybe sticky-prices? Etc…

Once you have your 2 rats (the 2 economies), shock them (what ever the shock is… you can simulate a financial crisis… or a fiscal crisis… or a positive productivity shock… etc..) and see what happens in the model.

Again, we are here to listen to good ideas. We are here to learn from good models. We are here to listen to science.

However, we don’t talk to magicians or priests. We let them to the past millennium.

At this point, I came in with a recommendation for everyone to take a look at a very detailed state of the art economic simulation.

7 December 2014

Dear Everyone,

I  would strongly recommend reading the paper by Jaromir Benes and Michael Kumhof from the IMF called "The Chicago Plan Revisited". It critically examines the proposal made by several prominent economists in the 1930s, notably Irving Fisher, to end fractional reserve banking and move to a 100% reserve system in which banks can only lend money that they actually have.

You can download it here https://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

Here's the abstract

"At the height of the Great Depression a number of leading U.S. economist advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher's claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy."

I presume that few people would want to argue that they used a mickey-mouse model here. Their paper is 70 pages long, is stuffed full of equations and, at least to a naive Brain Scientist, looks serious. But I'm ooking forward to hear [our expert's] critique.

The text is full of interesting material. For example, when discussing the idea that central banks have can influence the amount of money creation by the commercial bank sector, the authors note that, "the “deposit multiplier” of the undergraduate economics textbook, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through bank lending... is simply, in the words of Kydland and Prescott (1990), a myth. And because of this, private banks are almost fully in control of the money creation process."

For info, Kydland and Prescott's paper was published here
Kydland, F. and Prescott, E. (1990), “Business Cycles: Real Facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review, 14(2), 3-18

It has been cited over 1000 times. You can download it here
http://dl1.cuni.cz/pluginfile.php/102856/mod_resource/content/0/8Kydlan_Prescott1990.pdf

Best wishes

Simon

 

It was at this point that our Expert trashed the paper by the two IMF economists - see the exchange in my previous post (7 December). Amusingly, our expert suggested we read a paper called "Many roads lead to Rome - not all by the shortest path. Comments and reflections on The Chicago Plan Revisited" that supposedly refutes the Benes and Kumhoff study.  It's very amusing that this paper was written by Joseph Huber. For those who don't know,  Joseph Huber is a staunch opponent of the current money creation process, and one of the most prominent proponents of Sovereign Money Creation, having written a classic paper on the idea of "Plain Money" in 1999 and also coauthor (with James Robertson) of the book "Creating New Money - A monetary reform for the inormation age". 

If the best rebuttal of the Chicago plan is the one by Joseph Huber, then the "Experts" defending the status quo are really in a bad way!