It was with a sense of irony that I read
Will Hutton in the Comments and Debates section in a copy of Guardian Weekly
(16.10.15). It was the previous week’s
edition and the irony was that I was reading it on Back to the Future day
(21/10/15), which summed up the economic views that I was reading. Hutton wants to go back not to 1985 but to
any date before the rise of what Hutton calls the ‘Anglo-Saxon political right’ in the US and UK which put Keynesianism out
in the cold (usually identified by the left with the bogeymen of Thatcher in
Britain and Reagan in the US). Now I
thought that the political reach of Anglo-Saxons had ended a thousand years ago
but I will leave that particular question mark to one side. Hutton argues that the roots of the 2008
financial crisis and current crises in China and other ‘emerging market
economies’ lie in a ‘world financial system that has gone rogue’. At the heart of this argument is Hutton’s
claim that the power of banking to ‘create money out of nothing has been taken
to a whole new level.’
This is an up to date version of a theory
that has been doing the rounds since the early 1930s, that of fractional
reserve banking; the argument that banks by holding on to a fraction of its
deposits (to ensure that withdrawals can be met) can create multiples of
credit, that they can essentially ‘create money out of nothing’. The crude version of this theory assumes that
multiples of credit can be created from an initial deposit of £1000 with a
fractional reserve of, for example, 10%, £900 could be lent (paid out as a
cheque or transfer and deposited with the bank) expanding the initial deposit
in one act of lending to £1900 of bank deposits. If a loan of £900 was carried out 10 times
the end result of the initial £1000 deposit would be £9000 in loans and £1000
in reserve, in 10 quick steps an initial deposit of £1000 has been turned into
£10,000 – money has apparently been ‘created’ as credit from the scribble of a
pen or the tapping of a keyboard.
However, this view of banking does not hold theoretically or
empirically. Two quick examples (there
are more) will show why the theory doesn’t hold. Firstly, this model assumes that there will
not be a cash withdrawal on the initial deposit during the whole series of
transactions, a false assumption but necessary to prevent the theory’s instant
collapse. Secondly, the appearance of
the creation of credit is created by standard double-entry book-keeping where
when a bank lends, for example, £1000 this is recorded initially as a deposit
of £1000 and a loan of £1000, apparently ‘creating’ £1000 (until the loan is
withdrawn). Empirically we can also demonstrate that banks in fact do not
operate in the way described. If they
did they would be able to create immense amounts of credit from relatively
small deposits (pushing interest rates to very low levels). This does not happen and banks back their
lending not just from deposits but from money they themselves have borrowed –
something that had increased to risky levels before the 2008 crisis (and
interest rates do not fall to very low levels).
Hutton appears to hold to a less crude
version of ‘credit creationism’ as he says that ‘the system depends on the
truth that not all depositors will want their money back simultaneously… some
of the cash banks lend in one month [will] be redeposited by borrowers the
following month: a part of this cash can be re-lent, again, in a third month’
and so on. This is just saying that some
of the money that is taken out as loans will find its way back into the banking
system as deposits, which can then be used to make further loans. Unlike the crude version of ‘credit
creationism’ Hutton acknowledges that money is constantly being deposited and withdrawn but this still does not
mean that banks create money in the way that Hutton suggests. According to the economist Paul Samuelson
(who developed a more sophisticated version of credit creationism): ‘As every banker knows, he cannot invest money that he does
not have; and money that he invests in buying a security or making a loan soon
leaves his bank.’ That is, loans
can only be made from deposited or borrowed money that is currently held - a
fractional reserve in an individual bank cannot create multiples of credit. Samuelson’s theory (and Hutton’s) is that,
while multiples of credit cannot be created from a fractional reserve held by
an individual bank, an initial deposit of £1000 (again with a fractional
reserve of 10%) will eventually be multiplied to £10,000 across the whole
banking system by constituting in circulation the basis of deposits in
banks. This theory describes in a
simplified way the actual process of circulation of money and how a loan will,
in circulation, be the basis of further loans but it does not demonstrate that
money is ‘created’ as credit.
Rather than by ‘creating money’ a bank
takes money from real deposits and pays an amount of interest on it. It then lends this money at a higher rate of
interest. Hence banks compete for
customers deposits. Why bother if it is
so easy to turn a deposit into multiples of money out of thin air? Rather, banks provide credit, they advance
money at interest. Marx held to this
view that a bank ‘makes its profit in general by
borrowing at lower rates than those at which it lends.’ Banking has an intermediary function,
it does not create money but takes it from savers (from cash deposited and from
money lent between banks) to lend to borrowers at interest. By facilitating the transfer of money from
where it is accumulated to where it is required in the process of production
banks take a cut of the profits of the productive economy as interest.
Hutton is attributing to banking a power it
does not have, holding it responsible for turbulence in global finance that
results in economic dislocation – the financial tail appears to be wagging the
dog of the productive economy. The
reality is the reverse, turbulence in global finance reflects dislocation in
the productive economy…
To
be continued…
For more detailed articles on fractional
reserve credit creationism see:
CSK
Thank-you, Comrade.
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