Money and Banks

payments, systems

How do governments create money? What does it mean when the abundance mindset is that the economy will grow so that everybody gets wealthier, and not transfer of wealth from one to the other?

This is a simplified summary of the book ‘Where does money come from’, a brilliant book by Josh Ryan-Collins, peppered with my own annotations.

In contrast to the popular mental image that physical money is printed when a government infuses more money into the economy during a recession, it sets off the system in motion, hoping to reinforce the positive feedback loops in favour of growth.

Where is money created? #

The form of money currently in circulation is predominantly digital, and physical currency in the form of notes and coins form a minor percentage. The commercial banks that we all know and maintain deposits in, are the creators of money! How? Banks follow double book-keeping, with deposits being marked as ‘liabilities’, since the bank owes this money to the depositor and loans as ‘assets’ since this is money owed by a borrower in the future.

Let’s follow this with an over simplified example. When person P1 deposits 100INR into bank B1, the bank’s now eligible to lend 90INR, if the reserves to be maintained, as per the Central Bank, is 10%. The bank creates a deposit into P1’s account and the balance sheet now says [Assets - 90INR, Liabilities - 100INR], with the entire system actually containing 190INR. The bank just created 90INR, which the borrower P2 can spend towards productive activities - say manufacture lamps, hence pay vendors for raw materials and employees, pushing the borrowed money into circulation for consumption. Say the borrower P2 pays a vendor P3, who deposits in his account B2, who’s now eligibile to lend 81INR to borrower P4. This cycle goes on until the value diminishes for a single deposit’s lifecycle, effectively creating money through circulation. In the same vein, money is destroyed when the credit is repaid. For example, when you repay your credit card bill, money is effectively destroyed.

How is money creation controlled? #

There has to be a central traffic controller, ensuring this money creation system doesn’t go out of hand. The Central Banks enforce this not through a binding constraint on lending, but by moderating the interest rates on reserves. Bad economy? Central bank reduces interest rates making money cheaper, inducing more supply to nudge towards productivity. Banks can purchase Central Bank reserves at lower cost to maintain reserve requirements, hence having a higher capacity to lend.

The commercial banks determine their capacity to lend, based on its profitability, which is a trickle-down effect of the central bank’s lending rate. This is turn determines how many deposits are created by the commercial banks via lending. The amount of bank deposits then influences how much reserve the commercial bank needs to hold to maintain requirements in terms of liquidity and insolvency.

Case against lowering interest rates #

Does lowering interest rates automatically stimulate borrowing by people, or just infuse more supply thereby creating inflation, since the value of money is reduced by abundance? Rather, when there’s demand for credit from the people for productive operations, that ensures non-inflationary growth, since the value for money is maintained by a match in supply and demand. Credit controls in the Asian hyper-growth countries into the right productive sectors, rather than into speculative sectors, helped achieve the desired nominal GDP growth rates.

Is credit the wealth creator? #

Credit then, is not borrowing from one person to the other, rather it’s borrowing from the future, to produce something now, in order to expedite meeting that future. Wealth continues to grow if the future money that’s been pulled into the present, is invested into science and tech, or things that propel humanity, instead of getting locked up in speculative or illiquid assets like housing(?).

Quantitative Easing (QE) #

What if the central bank hit the lower bound of interest rates, to stimulate economy (For example, Zero Interest Rate Policy)? QE has been used as an aggressive method to further stimulate the economy by the increasing private sector spending. We’ve heard that the governments have been printing money at will for the past few years. What actually happens? Since this system is regulated by the amount of central bank reserves, creating new money is effectively increasing the quantity of reserves.

The Bank of England 2014 Q1 Bulletin lays this out clearly, so to quote,

Consider, for example, the purchase of £1 billion of government bonds from a pension fund. One way in which the Bank could carry out the purchase would be to print £1 billion of banknotes and swap these directly with the pension fund. But transacting in such large quantities of banknotes is impractical. These sorts of transactions are therefore carried out using electronic forms of money. As the pension fund does not hold a reserves account with the Bank of England, the commercial bank with whom they hold a bank account is used as an intermediary. The pension fund’s bank credits the pension fund’s account with £1 billion of deposits in exchange for the government bonds. The Bank of England finances its purchase by crediting reserves to the pension fund’s bank — it gives the commercial bank an IOU.The commercial bank’s balance sheet expands: new deposit liabilities are matched with an asset in the form of new reserves.

Hmmm… #

I’m not sure if all of the above could by applied to the Indian banking system as well. But on a different note, most of the large banks’ lending entities operate as separate NBFC businesses.