Money and its role

This topic leads to impassioned debating and views range from a passive role to a key role. However, we will not contaminate the core issues we are busy with here by engaging in what is often futile debate. We will simply state our view.

The importance of the availability of bank loans / credit (from here on referred to as loans) on demand cannot be overemphasized, in a negative and positive sense. In a negative sense, a too high growth rate in the stock of money can be devastating to economic growth because of its influence on inflation. When economic units pay too much attention to inflation (when it is rising at a fast pace) it affects their spending and investment decisions and economic output and employment suffer.

In a positive sense, money creation oils the wheels of industry: the availability of new loans / money is essential for economic growth to take place, but the proviso is that it should be monitored and "controlled" so as not to outpace the capacity of the economy to satisfy the increased demand (consumption - C -and investment - I) that underlies the increase in loans / money. (Note that loans make up the majority of the asset side of the MBS and money the liability side.)

Scholars of Economics will know that C + I (needed to increase production capacity) are the main components of GDE (Gross Domestic Expenditure = domestic demand) and that GDE + exports (X) less imports (M) (X - M = net external demand) = GDP (Gross Domestic Product - expenditure on). They also know that new production capacity creation is a function of increased consumption demand, and that there is often a lag between increased demand and the increased capacity to supply. Thus if consumption demand is allowed to increase too rapidly, inflation will be the result (if not at first, because of imports satisfying the demand, then later when the poor balance of payments numbers prompt a restrictive monetary policy - in the form of higher interest rates).

As a conclusion to this section we repeat the essential element of this discussion: to a large degree new money creation underlies the increased demand (and the monetary numbers of all countries corroborate this). Therefore money does play a significant role in the economy. As we shall see, underlying money creation is the lending rate of banks (prime rate and rates related to this rate), and underlying this is the lending rate of the central bank, which has to be "made effective" to work effectively. We will return to these issues later.

Uniqueness of banks

The uniqueness of the banks lies therein that they are able to literally create money (NBPS BD) by responding to the demand for loans23 by borrowers, i.e. the government, household and corporate sectors. Providing new means making new loans and buying new evidences of debt - debt securities. It is notable that banks respond to the demand for loans without even knowing that they are creating money.

The reaction of many readers to the above and the further elucidation below may be incredulous. How can banks be in such a unique situation? Surely this must mean that banks can create their own assets (= new loans) and liabilities (= new BD = money) to an unlimited extent?

The banks are in this unique situation for a simple reason: because the public accepts their deposit as money, i.e. a means of payments / medium of exchange. And this issue has a long history starting with the goldsmiths in London in the 17th century. However, we do not have the space to delve into this interesting history.

The answer to the second question is yes, they can and do so. However, they can only do so as long as there is an increased demand for loans. This is largely a function of the lending interest rate, as we said earlier. However, there exists a major difficulty in this regard and it manifested itself on a grand scale in 2007-2009: this is, as we have said, that the banks are inherently unstable. It is the job of the monetary authorities to see that this innate weakness is kept at bay (through bank supervision). As we now know, they failed in this function in a breathtaking fashion before and in this period.

The basic functions of banks and the creation of money may be depicted as in Figure 1. It is correct to say that banks take money on deposit and lend the money to borrowers. And, certainly, the individual banks operate in these terms in their daily activities: they vie for deposits and the making of loans. However, this is an ex post situation/declaration. When new loans are made new deposits are created.

the business of banking

Figure 2: the business of banking

A simple but real life example is required. Company L produces goods required by Company B and the latter approaches the bank (for the moment we assume there is only one bank) to borrow the funds required to purchase the goods (LCC24 100 million). The bank (after a viability study) agrees, opens a current account for Company B and provides it with a loan of LCC 100 million by crediting the account with LCC 100 million. The bank has increased its loans by LCC 100 million and has a new deposit of LCC 100 million, while Company B has a new deposit and incurred a liability (loan) of the same amount, as indicated in Boxes 1 and 2.



money creation

Figure 3: money creation

Note that when we measure the money stock and changes therein we analyse the banks' balance sheets (we will add the central bank later). The money stock in the form of BD (= deposit securities) has increased by LCC 100 million, and the balance sheet counterpart (BSC) or balance sheet cause of change (BSCoC) is an increase in bank loans (= loan securities) (A denotes change):

This is illustrated in Figure 3. The actual real life cause is the additional demand for loans which was satisfied by the bank. The bank was able to create the new deposit (= M3) by an accounting entry, and rests on the fact that the public regards BD as the means of payment. Of course Company B undertook the loan in order to pay Company L for the goods. When it does so, the balance sheets appear as indicated in Boxes 3-5.

While the above can and does happen, it is more likely that the bank will provide Company B with an overdraft facility of LCC 100 million (= opens a current account with a zero balance and provides Company B with the right to overdraw the account by LCC 100 million. When Company B makes an EFT payment to Company L, its account is debited by LCC 100 million and Company L's account is credited by this amount. When Company L gets confirmation of the transfer it delivers the goods to Company B. The changes in the balance sheets are the same as indicated in the simpler example above (and indicated in Boxes 3-5).



Note that the all the balance sheets balance.

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