How Credit (and Money) are Created

Without considering more closely how credit and money are created in a modern financial system, we have no chance of understanding why things have gone so badly wrong this time around.

It’s not that there’s any shortage of explanations. To the contrary, we’re spoiled for choice. Some sheet the blame home to neoliberalism, to deregulation gone mad; others to the greed of bankers and distorted incentives; some to securitisation with the resulting separation of origination from ongoing responsibility; still others to globalisation or growing income equality; some even blame government interference in the workings of the market.

There’s some merit in all of these, but none of them probe deeply enough into the structural roots of this crisis. Let’s not forget that great financial failures have occurred before, under quite different systems and circumstances, and that smaller but nevertheless damaging market upheavels have been a recurring feature ever since banking became widespread.

Still, in the sheer extent of its excesses, and of overall system leverage, our attempt is without historical parallel. Clearly, whatever flaws there may be in financial systems more generally, they were brought to a sort of pitch of perfection in the last decade or two.

What’s needed, then, is to examine both; the structure of the financial system and the way in which it creates money and credit, as well as the particular circumstances that led to this crisis.

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To get started, here’s a straightforward explanation of credit creation in a fractional reserve banking system taken from the Federal Reserve Bank of New York’s website:

“Reserve requirements affect the potential of the banking system to create transaction deposits [at call deposits]. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+… =$1,000).”

This is the so-called “money multiplier” at work. Through this process, given a reserve requirement of 10%, an initial deposit can eventually (through being repeatedly lent out, redeposited in the banking system by the recipient(s) of its spending, and then in part lent out again) spawn ten times the amount in loans and deposits. We’ll return to this issue later, because it goes to the heart of what the banking system actually does, but for now simply note that calling those freshly generated deposits “savings” may be stretching the meaning of that term beyond the breaking point.

Some see the chain of causation as reversed. In other words, they claim banks effectively generate fresh deposits through their lending, with those deposits in turn being spent by the borrowers and so returning to the banking system only to be lent out again. It can get confusing and is somewhat akin to the old scholastic argument about how many angels can dance on the head of a pin. Still, it’s become an often divisive issue that needs to be addressed.

In making a loan, banks certainly credit a borrower’s account without having to first shift funds from elsewhere; the result is callable funds for the client and an IOU of some form from the client to the bank, so the books balance. As soon as the customer draws down and spends those funds, however (unless the recipient deposits the proceeds back in the same bank), the bank must be in a position to honour its commitment to pay through the clearing system, either by drawing on existing reserves, receiving fresh deposits, borrowing them from other banks or, at worst, from the central bank. In that sense, it’s freedom of action is strictly limited.

So, although as a rule loans do precede (and also actually create) deposits, there’s a danger of subtly misrepresenting things by expressing it too dogmatically in this fashion. In a fiat monetary system, there’s an unavoidably symbiotic relationship between banks and the central bank with its capacity to provide reserves and generally backstop the system. As long as a bank is operating comfortably within its reserve limits, it can of course create new loans in the knowledge that it will not be caught short. As those loans (and ones from other banks in the financial system) are drawn down and spent, each bank within the system can expect to receive its share of deposits from the recipients of that spending. In this sense, if the whole system is in an expansionary phase (and the central bank is, where necessary, willing to be accommodative) then credit creation does indeed take the lead and can proceed very rapidly without apparently straining the system. Still, either deposits (or reserves) must come first.

Before moving on, the origin of the “initial deposit” in a fractional reserve banking system also needs a closer look.

In the pre fiat money era, “money” was almost always gold. In the US, for example, early last century $20.67 was defined as one ounce of gold and currency notes could be exchanged for the equivalent amount of metal on demand. The monetary base (also known as “high-powered money”) was therefore made up of gold held within the banking system, together with gold (and sometimes other metals like silver) in circulation. It was gold held by banks that was lent, spent and redeposited and then in part lent out again in the continual process described above, thus gradually creating a much larger amount of outstanding loans and deposits.

Since the gold standard was abandoned, the monetary base consists of currency notes in circulation plus reserves held at the central bank for the credit of individual banks. Same principle, except that fiat currency has taken the place of gold. In both cases, the monetary base can usefully be viewed as the base (or bottom slice) of an inverted pyramid, the rest of which is made up of progressively larger slices of banking and nonbanking credits.

Returning to the credit creation process, transforming a given monetary base into a multiple of itself takes time. It’s spread out over decades, generations even. The expansion of credit, and its mirror image, money (since the proceeds of loans in effect become additional, fresh money) accelerates in boom times and slows in down times. The pace is linked to the prevailing social mood, and in turn affects that mood. It expands most quickly when people are optimistic and the apparently beneficial effects of credit expansion (increased economic activity and rising asset prices) in turn heighten the sense of limitless opportunity. When the authorities who should be restraining this self-reinforcing process by “taking away the punchbowl when the party gets going” either fail in their duties (or worse still, as happened quite often in recent decades, actually spike the punchbowl), it can finally mutate into a full-blown credit mania. Some of the more notable examples are Japan in the 1980s, a good part of the world in the 1920s, and almost all of it in the last decade.

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This overview of credit and money creation, as has already been implied in the discussion of whether loans in fact precede deposits, is of course highly stylised. In the real world, it’s somewhat more complicated. The Federal Reserve Bank of New York acknowledges as much in the paragraph that follows the above quote:

“In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.”

Similar changes have taken place in most other countries. In practice, therefore, there have been few restrictions on the growth of credit other than the need for a sufficiently optimistic zeitgeist to produce a willing stream of borrowers and lenders. Mandated capital requirements (which vary from country to country) did act as a minor constraint, but because of both their complexity and their reliance upon risk weighted measures, they were subject to incessant gaming by the financial industry and its advisers.

As if this weren’t enough, recent decades also saw the rapid growth of what came to be called the “shadow banking system”, made up of financial intermediaries outside the banking system and hence subject to even fewer regulations and constraints. In the US, the principal vehicles were the GSEs (Government Sponsored Enterprises) like Fannie Mae, and their fully private sector equivalent, the many issuers of asset backed securities (ABS). Although still reliant on clearing through the banking system (hence the need for the adjective “shadow”), they greatly accelerated the multiplier effect. By purchasing loans from banks (and others) and bundling them into securities (which could in turn either be sold or funded through various short-term means), they constantly restored the banks’ capacity and willingness to generate fresh loans. Some also moved into originating their own raw loans for securitisation.

As this shadow system grew, the formal banking sector shrank in relative terms. Thus, in the US, total assets of the commercial banking sector are now equal to about 99% of GDP, while the combined assets of the GSEs, Agency and GSE backed mortgage pools, together with issuers of ABS, total some 85% of GDP (two decades ago, the equivalent figure was a mere 28%). In Australia, by way of contrast, banking sector assets have mushroomed to 233% of GDP and in Europe, they are at similar or even higher levels with banks still playing an overwhelmingly central role.

Disintermediation (financial activity outside the banking system) is far more common in the US than elsewhere. Not only through securitisation, but also because of the greater reliance by large corporations on the bond market rather than on banks. (As an aside, there’s every reason to think this exponential growth in securitisation is a good part of the reason why the epicentre of the financial crisis was in the US).

Nor should we forget derivatives, in particular all those traded over-the-counter (OTC) rather than on formal exchanges. They don’t directly generate credit or money, but by encouraging the view that risk can be handily managed they were handmaidens in the creation of a far greater quantity of such securities than would have otherwise existed. What was generally missed in the excitement is that while risk can be controlled (within reason, of course) at the firm level, it can’t for the system as a whole. After all, when all the derivatives, short trades and general financial jiggery-pokery are netted out, every single outstanding underlying security must still, by definition, be owned by someone. Derivatives, directly and indirectly, also played their part in the alchemy by which average, or even terrible, mortgages and other loans were transfigured into AAA rated securities. It was, as can be all too easily imagined, like pouring petrol on a fire.

The financial system finally became, and still is, a witch’s brew: opaque, incestuously interlinked in dangerous and often unpredictable ways, continually slipping between the cracks of (admittedly feeble) official efforts to exercise control. So long as the credit expansion lasted, it generated its own apparent justification. Certainly, very few in a position to do something (assuming they understood what was going on) had either the desire, or the motivation, to rein it in.

In times of great excess (which is of course precisely when it’s most needed), the constituency for prudence is vanishingly small.

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