Six Myths About Money & Banking (Josh Ryan-Collins)

I'm sure you're all familiar with NEF. We're, I think, one of the UK's largest think-tanks...and we're increasingly looking at this issue of money, how it works in the economy and how banks really operate rather than how people think they operate. We think it's absolutely at the core of all the problems that we face. Whether that's inequality, environmental degradation, social justice, well-being..it's at the heart of it...and that's why we decided to write this book...and Positive Money gave us a lot of support with the writing of this book..as did these two smart-looking men....Professor Richard Werner, some of you may know of. He's a professor of banking and finance at the University of Southampton. Southampton has set up a centre down there to look at this area. He's an extremely talented macroeconomist. He's been trained in orthodox economics and he's spent the rest of his life destroying it, ripping it to pieces for its failure to incorporate money and credit and how that affects the real economy. He's written two best-selling books. He was working in Japan in the 1990s..saw the debt deflation, coined the term, 'quantitative easing' and then watched the Bank of Japan implement quantitative easing in precisely the way he'd advised them not to...and he's now watching the UK and much of Europe do quite similarly. We also had help from this esteemed institution, The Bank of England. We had a mole in the Bank of England, who helped us all the way through...read various editions, commented. So the Bank of England has been through this book and take it from me, they've helped us out...and they're quite sympathetic to what we're talking about here....and the final person who helped us was Charles Goodhart, who has already been mentioned is probably in the top three most prestigious monetary economists in the UK...and is one of the main reasons lots of serious MPs and serious policy-makers are going to read this book..because he's written the forward on the front. So, I'm going to try and take you through something that is extremely difficult to explain..and you're kind of a test-run for me. So forgive me if things are not clear. I think the best thing is if I try and run through it and then take questions afterwards...because if I get all the way through it, a lot of the questions that will immediately jump up at you, might be answered by the end..and we've got very limited time. The way I'm going to frame this is to talk about six myths around how banks and money actually work...and then basically try and tell you how things really work. (Myth number one) The first myth, which I hope you know is a myth is that banks are...their essential function is as intermediaries. Now banks do play an intermediary function. If you have a savings account, a time deposit, that money is recycled to other parts of the economy..but this idea, that that's the main thing that banks do is wrong. Their primary economic function is not as an intermediary, just recycling our savings as this diagram shows. Banks are creators of credit. The create brand-new purchasing power. This is how they do it essentially. They make a loan...let's say a loan to Robert of £10,000. Banks use double-entry book-keeping. Those of you who are accountants...any accountants in the audience? Hands up...hands up..come on don't be afraid. So we've got about four or five accountants. You guys will understand this, I hope, more quickly than a lot of people and I'd advise you to get into this subject..but, essentially, when a bank creates a loan..it creates both an asset, which is the loan and it creates a liability at exactly the same time...and the liability is the deposit. A deposit is money. You can use it to pay your taxes. You can pay your taxes to the government with an I.O.U. created by a bank, a liability....and everyone else in the economy will accept that deposit, that I.O.U., because everyone knows they can pay their taxes with it. It's that simple. That is money...and the bank doesn't need anyone else's deposits to create that deposit. It's just created that £10,000 by typing a number into a computer on the basis, mainly, of its confidence that you'll pay back that loan..and in some cases not on the basis of its confidence that you'll pay back that loan, because it's packaged up that loan, securitised it and sold it on to somebody else to take the responsibility for paying back the loan..and that's why this securitisation problem is such a big issue, as well. So, there's a quote there from the Deputy Governor of the Bank of England, “Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer's current account, which can be paid away to wherever the borrower wants by the bank 'writing a cheque' on itself”..which is essentially the creation of this liability. Now, I hope that's clear to everyone, because Joseph Schumpeter, who is one of the greatest economists, I think, that ever existed and he'd be my number one choice if you want to read one of the classics...this book, 'History of Economic Analysis' 1954...observed back in 1954 that economists found it very difficult to get their heads round this simple concept that when banks create loans, they also create deposits. Funnily enough, 57 years later, we still seem to have the same problem..and this is two quotes from the Independent Commission on Banking's report. The first one as you can see...banks use the cash that is deposited with them to provide loans to businesses to allow them to undertake productive economic activity. Well, there is a big question about the productive economic activities, as Ben has explained...but the fundamental problem here is that the way they're talking about bank lending is essentially banks are intermediaries...another quote in the final report...this was their this year's report. “Banks fund illiquid, risky loans with demand deposits”. That's a little bit closer to the truth perhaps...but essentially, there was no mention, in the 400 odd-page final report that the Independent Commission published, of credit creation...of banks function as credit creators...of their absolutely vital performance as a macroeconomic actor in the economy..and their definition of lending was wrong. This was how myself, Ben and Richard Werner and my boss Tony Greenham reacted when we went to see the Independent Commission on Banking and tried to explain to them that loans create deposits. Basically, they just didn't get it. We then wrote to them after the report was published and they told us that there was disagreement amongst the Commissioners on the Independent Commission about this whether or not banks created money. So, that's the situation we're in. This is just appalling. These are the people that are charged with recreating our banking system and they don't even understand that banks create credit, when they make loans. So, the truth on this one, rather than the myth, is that banks create deposits, which can be used to make any kind of routine payment....essentially, it is money..whenever they expand their balance sheets. That's the technical-sounding term, 'expanding the balance sheet'. What it means is the creation of an asset and a liability at the same time as the process I just explained to you...and banks expand their balance sheets when they make loans, as I've talked about, which you might call direct credit creation..when they fulfil existing overdrafts. So, if you've got an overdraft with your bank and you go into that overdraft, the bank essentially creates deposits for you when you go into that overdraft...and again that is brand-new purchasing power. It's money. It's new money that they've created...hasn't come from anyone else's savings or deposits. They've just created it, just like that. You could say that is more indirect, because that is obviously not for the bank to determine who goes into their overdraft. It's more you, or the business or whoever it might be...but, of course, it's the bank that decides whether or not you get an overdraft. So, they are still making a very important macroeconomic decision when they decide to give you an overdraft or not..and, of course, the interest rate they offer you is equally important, in terms of your likelihood of actually drawing down on that..and the third main way they create new money is by buying existing financial assets...bonds, government bonds typically...buildings count as assets..and the list goes on. (Myth number two) Now, I'm going to talk quickly about this, because, I think, most of you are, hopefully, already quite familiar with this myth of the money multiplier. This is the idea, essentially, banks are limited by the central bank according to the amount of reserves that they hold..and if there's a reserve ratio..in this case it's a 10% reserve ratio..that there's a mathematically finite amount of lending that can go on in the economy. So you start off with £100..that that's deposited..and the bank can then use that to lend £90, with a 10% reserve ratio...holding on to £10..etc etc...runs on through the economy and you end up with £900. Another way of presenting this is in this way. You've got these cycles of lending going along the bottom..and the dark green is the so-called base money, central bank reserves..and then the amount of lending upon which you can make..it gradually runs out over time..the additional lending being the grey. So, the easiest way to think about it on some ways is as this triangle. We have a monetary base, and the banks can lend upon that..but gradually their lending is reduced over time. The idea is that that creates some kind of stability. Now the truth of the matter is that this is no longer the case. In the UK, as Ben explained, there is no compulsory liquidity reserve ratio or deposit ratio. As it was described, that was completely abolished in the early 80s..and this idea, that there's a relationship between central bank reserves and actual commercial bank money..there's no evidence for it really, at all. This is a nice example to show that from the book. Figure 5..this shows the collapse of commercial bank lending..these two charts are running exactly the same calendar by the way..we're starting in June 2000 running up to January 2011. You can see this massive collapse in bank lending..and this is bank reserves at the Bank of England, central bank reserves. You see here that they're completely flat with all this high level of credit. There's this collapse, they pump £200 billion reserves into the system, into the banks..and lending just carries on going down. So, there's no relationship there....and the Bank of England, Paul Tucker again, basically admits here that base money comprises neither a target nor an instrument of policy. So, this is a better way of thinking about that relationship. It is, essentially, a balloon. There are these reserves that are required within the system..and I'll explain that in the next couple of slides. They are required for inter-bank payments...and banks, essentially, lend on the basis mainly of their confidence, as we've discussed. If they think people are going to pay back their loans, or if they've got ways of de-risking the loans, for example, through securitisation, they'll make loans...and they just need to have enough reserves to clear at the end of each day, all their payments with other banks...and there's a nice quote here from Charles Goodhart, who wrote the forward to this, 'the base-multiplier model of money supply determination is such an incomplete way of describing the process that it amounts to a misinstruction.' So, when you pay some money into your bank..if you bank at HSBC and you pay some money to Barclays..it's not actually commercial bank money created by banks that moves. Effectively, what happens is that central bank reserves are moved from HSBC to Barclays. That's the only way banks can settle with each other within the closed loop of the intra-bank payment system, which is represented in this diagram on page 63 of the book. Central bank reserves can only be created by the central bank and they can only exist within the inter-bank market trading system. We can't get central bank reserves. This is just a different kind of money. It's the money of final settlement within the banking system. When a bank creates new money, as we've seen, it makes a loan. The money itself is a liability, it's an I.O.U..and banks can't use I.O.Us. between it and me or it and HSBC and you to settle with other banks. They have to use central bank reserves. The central bank is the lender of last resort. Its money is the most liquid. It's quite complicated to explain the history of how this came about, but please read chapter two and you'll find out exactly how it came about...but, essentially, each bank has to hold enough central bank reserves to pay all the other banks in the system..and what they do is they have this inter-bank market where they trade the reserves between each other, usually in exchange for government bonds, which are also a very liquid kind of asset. Every day these reserves are swapped between the banks on the inter-bank market and they charge interest upon them. The LIBOR rate, the inter-bank interest rate, shot right up during the financial crisis, because banks lost confidence in each other's solvency. They stopped believing that if they made a loan of reserves to another bank in the system that that bank would actually be able to give them back the bonds that they're exchanging in the loan and pay the interest..so, the interest rate shot right up on reserves, on the repurchase agreements that the banks have..and the whole system almost came to a complete collapse..and that was the reason the central bank pumped in £200 billion of reserves in quantitative easing to create more liquidity within the system. So, now all the banks are flush with these reserves, but as we've seen, they're still not lending. So, despite all this quantitative easing, it's still not working. A very good question that we often get asked, and I think Ben was asked it before...was that if banks can create brand-new money whenever they want, why do they need our deposits? So, why is it so important? Why are these campaigns to move your money from HSBC to a credit union or a small ethical bank...Well, banks have balance sheets, as I've explained..and this is basically what a banks balance sheet looks like. You've got loans to customers, as I've talked about..you've got reserves at the Bank of England..you've got cash..you've got other financial assets etc...and on the other side you've got customers' deposits, you've got loans from other financial institutions, including, in particular, the wholesale markets that increasingly the European banks became very dependent on and you've got capital..and capital includes retained profits from interest, as we discussed, issued in shares and provisions, which they hold too, in case some of these loans go bust. Essentially, they have to hold capital and provisions to make sure their balance sheets balance. On this balance sheet, total liabilities must equal total assets. They have to equal each other out. The reason banks like retail deposits is because retail deposits are pretty cheap. Why are they cheap? Well, you probably noticed if you've got some money in your bank at the moment, you're getting 0.5% or less interest. They're very cheap at the moment, of course, because interest rates are very low...but as a general rule, they're quite a bit cheaper than other forms of funds, such as loans from wholesale markets, for example...which suddenly became very very expensive when the sub-prime mortgage crisis erupted. So, that's why banks need deposits. They don't need them to make loans. They need them in order that their balance sheet can balance over time. Myth number three...I'm going to speed up a bit now...that the Bank of England can directly affect credit creation through changing interest rates. Well, I'm not going to spend too much time on that. You can see there's massive collapse, a massive reduction in interest rates following the financial crisis. This shows what happened to lending to SMEs. It carried on going down. If a bank doesn't have confidence in the economy..if it doesn't have confidence in its own balance sheets, it's going to stop lending. It's going to try and rebuild, try and de-leverage itself. (Myth number four) Credit allocation is demand-driven. You're hearing all these banks constantly saying, 'we'd lend more money into the economy if only small businesses really wanted the money, but they're scared, they're worried that things will go wrong'. I think it's a load of rubbish myself...and the Bank of England has come up with lots of data to show that ok maybe there's less small businesses applying for loans..but the reason they're not applying for loans is because the interest rates are so high or because they want to hold money back because they think that the bank is going to remove their overdraft facility or put up interest on their overdraft facility. So, of course they're not applying for loans. Credit is driven by banks. It's rationed by banks..and some of the best economists in the world, who have worked on this stuff, including Joseph Stiglitz. This is another quote from Mr Tucker. He's my favourite man at the Bank of England..just explaining how this system works..It's an information asymmetry, essentially, which economists don't like...they like the idea that everybody has got perfect information..so that the bank knows exactly what the risk is of this business or that person..but as Ben explained...basically, for a bank..it's a much less risky loan to loan against a house, where they can get the collateral if the loan goes wrong, than it is to lend to a small businessman who has got limited liability..if the loan goes wrong, the bank is shafted. It's not going to get the money back. So, of course, it's incentivised to lend towards property..and it's incentivised to lend into financial speculation, because the short-term returns are much faster. (Myth number five)..and Ben's talked about this..they're much happier going for the mortgages and the consumer loans and the commodity speculation than the small businesses. This is just a chart from the book showing what Ben was talking about. This is his 8% going into the productive sector. You'll see this massive growth in secured lending to individuals..that's this green here..that's basically mortgages..and you see all this financial intermediation, it's called..and you'll see this massive growth since '97..in this speculative lending activity. I think Jasper it was, is right that some of this money that goes into mortgages does find its way back into the real economy, but the broad pattern is a move away from productive lending towards speculative and consumptive lending. (Myth number six) Final myth..if we start trying to control credit, we'll turn into some sort of communist regime. These are the words that were used by a guy, who I went to talk to at the treasury, when we started talking about credit controls..went there with Richard, who was talking about the history of credit controls..and he basically said, 'well, that's communist, isn't it? We can't do that, we can't turn into a communist country.” This system is so recent, so historically recent. It's only been around for thirty years. Before then it was quite normal for governments to have systemic controls on different types of bank credit creation, which sectors it went into, how much credit was created. These are all the examples. I think we showed this slide last year...and I think that people are waking up to this..including the establishment, including the few financial journalists like Martin Wolf, who do get this point...and John Kay...and you can see that from these quotes. John Kay said, “a suitable requirement might be that a high proportion – 90% or more – of retail bank assets be in these kinds of areas”...a quote there from Adair Turner...he's talking about differential leverage ratios for different kinds of lending...and Martin Wolf there finally talking about the government directly creating money. I just want to make one final point before I finish, which is about the debt crisis and how this all ties into it...the global debt crisis. It's very important to understand that when a government that's already in debt, as virtually every government is, spends money into the economy, it issues bonds. That's the only way it can do that...and those bonds are bought by the private sector. The private sector could spend that money on something else. It could invest that money in productive business activity. So, you have this kind of crowding-out effect when the government spends money. There's a big debate about whether or not the government spending money could be more effective in terms of the multiplier effect into the wider economy or not..and we don't need to get into that here..but the fundamental point is that governments do not create new purchasing power through issuing bonds. They can only create new purchasing power if they directly put money into circulation in the way that Ben's reforms are talking about. So, just a very simple step. If we're going to do nothing else..governments should stop issuing bonds and borrow directly from these banks..who have these horrific balance sheets. They'd like nothing more than the government to borrow from them because the government is the least risky debtor you can possibly get. They would create brand-new purchasing power in the economy. The government can spend it on whatever they want...infrastructure, transport, building houses, loans to small businesses or buy debt from small businesses directly. So, I just wanted to finish on that point..and just say..keep up the pressure, as I said...get out there...lobby your MPs...we'll send them the book...get down to St Paul's..educate the people down there..I don't think many people down there know what we're talking about..and let's keep going...thank you very much.