The ‘fountain pen of money’ – Bryan Gould. 

Steven Joyce, NZ Minister of Finance, has recommended the formal establishment of a committee to help the Governor of the Reserve Bank decide on where to take interest rates, thereby following the example of other central banks around the world.

Also Grant Robertson, Labour’s shadow Finance Minister, has made a similar recommendation concerning a Monetary Policy Committee to help the Governor, but has also followed another overseas example by supporting an extension of the Governor’s remit, so that he would, in addition to restraining inflation, be required to take account of the desirability of full employment.

Most people believe, and it is a belief assiduously promoted by the banks themselves, that the banks act as intermediaries between those wishing to save and those wishing to borrow, usually on mortgage.

In this view, the banks are benefactors, bringing together those with money to spare and to deposit with them, and those who wish to borrow, often for house purchase.

The banks make their money, so it is said, by charging a higher rate of interest to the borrowers than they pay to the depositors, the equivalent of a small fee for the administrative costs of bringing the parties together.

But this benign view of their operations is inaccurate and misleading. The banks do not lend you on mortgage money deposited with them by someone else.

They lend you money that they themselves create out of nothing, through the stroke of a pen or, today, a computer entry.

The banks make their money, in other words, by charging interest on money that they themselves create. Not surprisingly, they are keen to lend as much as possible.

But the consequences of this bizarre scenario go much further. It is the willingness, not to say keenness, of the banks to lend on mortgage that provides the virtually limitless purchasing power that is constantly bidding up the prices of homes in Auckland and, now, elsewhere.

It is the banks that are fuelling the housing unaffordability crisis, a crisis that is leaving families homeless and widening the gap between rich and poor.

So far, the government has washed its hands of this aspect of the crisis.

It is content to leave the crucial decisions on monetary policy to the Reserve Bank.  That way, it can disclaim responsibility and leave the Governor, himself a banker, to carry the can.

Leaving monetary policy (which is usually just a matter of setting interest rates) to the Reserve Bank is usually applauded as ensuring that it does not become a political football. But monetary policy should have a much greater role than simply restraining inflation and has a huge influence on so many aspects of our national life.

Why should the Government be able to hide behind the Governor of the Reserve Bank and duck responsibility for a policy of the greatest importance to so many Kiwis?  Why should ministers not be held to account in Parliament and to the country for failing to deliver outcomes they were elected to deliver?

It is no surprise a former Governor of the Reserve Bank should seek to defend the banking system from its critics. But in denying the accuracy of points I made in the Herald about how the banks operate, Don Brash accused me of “peddling nonsense”.

I made two basic points. First, I asserted the banks do not, as usually believed, simply act as intermediaries, bringing together savers (or depositors) and borrowers to their mutual benefit.

Secondly, I said the vast majority of new money in circulation is created by the banks “by the stroke of a pen”, and they then make their profits by charging interest on the money they create.

If this is “nonsense”, the “peddlers” include some very distinguished economists.

In my original piece, I referred to a Bank of England research paper, published in the bank’s first Quarterly Bulletin 2014, which describes in detail the process by which banks create money.

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. That ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. Rather than banks lending out deposits that are placed with them, the act of lending creates deposits – the reverse of the sequence typically described in textbooks.

Bank deposits make up the vast majority – 97 per cent of the amount of money currently in circulation. And in the modern economy, those bank deposits are mostly created by commercial banks themselves.

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money – the so-called ‘money multiplier’ approach, but that is not an accurate description of how money is created in reality.

Banks first decide how much to lend depending on the profitable lending opportunities available to them – which will, crucially, depend on the interest rate set. 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 Central Bank.

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.

For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

Commercial banks create money, in other words, by placing loans [or credits] into the bank accounts of borrowers. They then charge interest on, and demand security for and repayment of, those loans.

They have no capacity to create money in any other way or for any other purpose [though the central bank can pursue “quantitative easing” to increase the money supply if it thinks that is needed].

Is it wise to entrust such wide-ranging powers – so significant in their impact on the whole economy – to the banks, and then to arrange that the only person able to regulate that impact was himself a banker – the Governor of the Reserve Bank.

Bryan Gould


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