Neoclassical economists do not understand how money is created by the private banking system—despite decades of empirical research to the contrary, they continue to cling to the textbook vision of banks as mere intermediaries between savers and borrowers.
This is bizarre, since as long as 4 decades ago, the actual situation was put very simply by the then Senior Vice President, Federal Reserve Bank of New York, Alan Holmes. Holmes explained why the then faddish Monetarist policy of controlling inflation by controlling the growth of Base Money had failed, saying that it suffered from “a naive assumption” that:
The banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt. (Alan R. Holmes, 1969, p. 73; emphasis added)
Indeed, as I've previously documented the fact that loan demand precedes deposits:
As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:
The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.
The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.
Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.
Kydland and Prescott observed at the end of their paper that:
Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.
In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.
Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.
Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.
This angle of the banking system has actually been discussed for many years by leading experts:
“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts." - 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”
“The process by which banks create money is so simple that the mind is repelled.” - Economist John Kenneth Galbraith
"[W]hen a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower." - Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report
“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.” -Congressman Wright Patman
Indeed, the Fed is pushing to eliminate all reserve requirements. If banks can lend without having any reserves, then agreeing to extend credit obviously comes before having the reserves.
If private banks can create credit out of thin air - without actually having excess reserves - then the government could do so as well. In other words, if banks don't need to have extra money lying around before they can make loans, then states and local governments don't either.
Why do we need to spend huge sums of money to have the banks loans our own money back to us?
Indeed, a new report from Demos - a non-partisan public policy organization - in conjunction with the Center for State Innovation, issued a report in April looking at the potential for "partnership banks" across the country, including 11 states already considering such legislation.
Across the country, states are considering proposals to move general revenue deposits out of the Wall Street banks that dominate the banking business today, and use them to capitalize a new local public structure with a mission to grow the local economy. A “Main Street Partnership Bank” would be modeled on the nearly 100-year-old public Bank of North Dakota (BND). This public policy innovation—also known as a Public Bank or State Bank—could contribute to the health of local community banks, state budgets and small business job growth in an era of rapid banking concentration, budget deficits and disinvestment on Main Street.
Partnership Banks can raise revenue for states without raising taxes, and increase loans to small businesses precisely when Wall Street banks have cut back on lending and raised public borrowing costs. A Partnership Bank would act as a “banker’s bank” to in-state community banks and provide the state government with both banking services at fair terms and an annual multi-million dollar dividend.
If modeled on the successful Bank of North Dakota, Partnership Banks in other states would:
Create new jobs and spur economic growth. Partnership Banks are participation lenders, meaning they partner—never compete—with local banks to drive lending through local banks to small businesses. If Washington State had a fully-operational Partnership Bank capitalized at $100 million during the Great Recession, it would have supported $2.6 billion in new lending and helped to create 8,212 new small business jobs. A proposed Oregon bank could help community banks expand lending by $1.3 billion and help small business create 5,391 new Oregon jobs in its first three to five years. All of this would be accom- plished at a profit, which Partnership Banks should share with the state.
Generate new revenues for states directly, through annual bank dividend payments, and indirectly by creating jobs and spurring local economic growth...
Lower debt costs for local governments. Like the Bank of North Dakota, Partnership Banks can get access to low-cost funds from the regional Federal Home Loan Banks. The banks can pass savings on to local governments when they buy debt for infrastructure investments. The banks can also provide Letters of Credit for tax-exempt bonds at lower interest rates.
Strengthen local banks even out credit cycles, and preserve real competition in local credit markets. There have been no bank failures in North Dakota during the financial crisis. BND’s charter is clear that its goal is to “be helpful to and to assist in the development of [North Dakota banks]... and not, in any manner, to destroy or to be harmful to existing financial institutions.” By purchasing local bank stock, partnering with them on large loans and providing other sup- port, Partnership Banks would strengthen small banks in an era when federal policy encourages bank consolidation.
Build up small businesses. Surveys by the Main Street Alliance in Oregon and Washington show at least 75 percent support among small business owners. In markets increasingly dominated by large corporations and the banks that fund them, Partnership Banks would increase lending capabilities at the smaller banks that provide the majority of small business loans in America.
These various proposals would “move general revenue deposits out of the Wall Street banks that dominate the banking business today, and use them to capitalize a new local public structure with a mission to grow the local economy.”
Let's Give the Giant Banks Some Competition
Some people are understandably skeptical of state banks. Specifically, they don't trust state politicians to exercise fiscal constraint, or they think that states with their own public banks would spend money on frivolous projects.
I understand and respect both concerns.
But as financial writer Yves Smith notes, state banks - even if imperfect - would at least give some competition to the too big to fails which have driven our economy into a ditch, and which are state-supported anyway:
The most important potential use of this type of bank in our era could again be to level the playing field with powerful interests, in this case, the TBTF banks.
But consider another very useful a state bank could play (although existing in state banks would fight it tooth and nail). The Bank of North Dakota is a wholesale bank, so the lack of the costly retail branch infrastructure is one of the reasons its results are as good as they are.
But another role a state bank could play would be to apply pressure to banks in that state. For instance, one of the most important planks lost in the Consumer Financial Protection Bureau was the requirement that banks offer “plain vanilla” products, such as a simple mortgage and a low fee, low interest credit card.
In states where the TBTF banks are not very well liked and not as influential (which generally means states west of the Mississippi which lack major bank headquarters or regional operations, like Citibank’s credit card processing center in South Dakota), a state bank could serve as a wholesaler of plain vanilla products to smaller banks (or alternatively help fund a common platform to scale up existing plain vanilla products offered by credit unions so as to make them more economically attractive to other banks in state). There is no question the consumer demand exists; the trick is how to make the product for smaller banks, who would not doubt separately find it a good hook for attracting deposits from bigger banks.
I find the state bank concept intriguing, because it has the potential to operate in bank-as-utility mode, which is really all banks ought to be. And in that mode, they could apply a lot of useful pressure on nominally private banks which pay their staff and top brass handsome pay at taxpayer expense.
Big finance has an unlimited credit line with governments around the globe. “Most subsidized industry in the world” is inadequate to describe this relationship. Banks are now in the permanent role of looters, as described in the classic Akerlof/Romer paper. They run highly leveraged operations, extract compensation based on questionable accounting and officially-subsidized risk-taking, and dump their losses on the public at large.
The usual narrative, “privatized gains and socialized losses” is insufficient to describe the dynamic at work. The banking industry falsely depicts markets, and by extension, its incumbents as a bastion of capitalism. The blatant manipulations of the equity markets shows that financial activity, which used to be recognized as valuable because it supported commercial activity, is whenever possible being subverted to industry rent-seeking. And worse, these activities are state supported.
Consider Fannie and Freddie pre-conservatorship. They were at least branded more accurately as “government sponsored enterprises” and “agencies” making their public/private role explicit. Yet they were over time allowed more and more latitude to act as private enterprises, particularly as far as employee pay was concerned. We know how that movie ended…
So, the reality is that banks can no longer meaningfully be called private enterprises, yet no one in the media will challenge this fiction. And pointing out in a more direct manner that banks should not be considered capitalist ventures would also penetrate the dubious defenses of their need for lavish pay. Why should government-backed businesses run hedge funds or engage in high risk trading, or for that matter, be permitted to offer lucrative products that are valuable because they allow customers to engage in questionable activities, like regulatory arbitrage? The sort of markets that serve a public purpose should be reasonably efficient and transparent, which implies low margins for intermediaries.
Right now, we have much of the banking sector operating so as to privatize gains and socialize losses. We might as well socialize the gains, as North Dakota does. Even if this idea took hold in only a handful of states, the trend could lead to a change in the perception that big financial interests always and ever have the upper hand and thus lead to a change in the negotiating dynamics in policy and regulatory circles.