A Reading on Money and Money Creation

Abstract

A difficulty in teaching undergraduate courses from a non-orthodox perspective is the lack of written material to draw upon. This reading, written for an introductory macroeconomics course, is an attempt to fill a small part of that void by providing a discussion of money creation from an endogenous money perspective. By focusing on the ability of banks to engage in asset and liability management, the reading makes it easy for students to comprehend why investment is never constrained by a lack of saving. For those who are compelled to also present the orthodox perspective, the question is which view to discuss first. Based on readings in cognitive science, unveiling the non-orthodox material first will greatly increase the chances students will analyze social problems from a non-orthodox perspective. Consequently, this reading is designed to be the student's first encounter with the subject of money and money creation. Orthodox textbooks usually omit from their balance sheets the two items that allow banks to make loans without excess reserves. By presenting the non-orthodox view first, students easily see the problems with the orthodox money multiplier approach.

Keywords:

• economic education
• macroeconomics
• money and banking
• endogenous money

Acknowledgements

I wish to thank Cathleen Whiting and two anonymous referees for many helpful suggestions. I also would like to thank students in my macroeconomic courses for their useful comments.

Notes

¹ Lakoff emphasizes again and again that people do not think logically; they think within frames and metaphors. If orthodox theory is good at anything, it is supplying students with a series of easily digested frameworks (e.g. supply and demand analysis, the production possibilities frontier, the money multiplier story). Since non-orthodox theory often cannot be reduced to a graph or a simple metaphor, it is at a competitive disadvantage from a pedagogical standpoint. This disadvantage becomes even greater if the orthodox theory is taught first. According to Lakoff, thought is physical, “the concepts we think with are physically instantiated in the synapses and neural circuitry of our brains” (2006a). When activated, these brain circuits are strengthened. Whichever theory/framework is taught first, the brain circuits associated with that framework will be the first to be developed in this subject area. These brain curcuits will be strengthened and reinforced not only by the repetition in teaching the first theory, but also when teaching the second theory, since it is difficult to teach a second framework without referring back to the first one. Cohn's (2007) introductory macro textbook, which is designed to be used after the orthodox material has been presented, constantly refers to the AS/AD model. Furthermore, “neural circuits, once established, do not change quickly or easily” (2006a); thus having established brain circuits of the money multiplier story, it will be difficult to get students not to think within that framework. Finally, if one is presenting the non-orthodox model second and expecting to use facts and figures to logically disprove the orthodox model, this may not be as successful as hoped. “Facts can be assimilated into the brain only if there is a frame to make sense out of them” (2006b) and, therefore, if “a fact is inconsistent with the frames and metaphors in your brain that define common sense. Then the fames or metaphor will stay, and the fact will be ignored” (2006a). Facts and figures meant to disprove orthodox theory may just confuse students if they are using the orthodox framework to process information. Bransford (2000) reinforces and elaborates on the ideas that thought is physical, and that people process new information through preexisting frameworks.

² Capital and other requirements to start a bank vary greatly from state to state. By statute you need a minimum of $1.5 million in Oregon, but as practical matter it takes a minimum of $10 million (Oregon Statues, 2007). In Florida, the suggested capital requirement is $6 million for a bank in a metropolitan area and $4 million for a bank in a rural area (Obringer, 2002). There is no stated minimum for a federal charter. The Office of the Comptroller of the Currency sets the minimum for new banks based on the risk involved (Office of the Comptroller of the Currency, 2009). The members of the organizing group must supply a certain percentage of the initial capital, generally between 10% and 25%. The rest is raised from outside investors via the sale of stock (Obringer, 2002).

³ It is not just the favorable interest rate spread which makes business loans so valuable to banks. Establishing a customer relationship with borrowers, especially corporate borrowers, can enhance bank profits because such borrowers “are associated with valuable deposit balances and the use of ancillary services that generate fee income. Banks' attempt to get existing customers to use more bank services is referred to as cross-selling” (Sinkey, 1989).

⁴ Banks hold securities because they provide both returns and liquidity. T-bills are held primarily for liquidity, because they easily convert to reserves, face little price risk, but have a low return. State and local bonds and long-term T-bonds are held primarily for their returns. Medium length T-bonds play an in-between role (Sinkey, 1989).

⁵ Based on a literature search and inquiries at the Federal Reserve's Board of Governors, it appears that no data is or has been collected on the percentage of bank loans made with cash. Staff economists at the Federal Reserve with whom I spoke speculated that the percentage of loans made with cash is very small. A survey of local bankers found that the frequency of vault cash loans varied from “rarely occurs” to “never.” This certainly makes sense; loans made via the creation of new checking accounts are more convenient. In addition, to be in compliance with the Bank Secrecy Act of 1970, any loan of over $10,000 made with currency would require filling out IRS Form 8300.

⁶ In reality, loans will increase by $10 million plus the interest paid on the loan, checking accounts will increase by $10 million, and net worth will increase by the interest paid. For simplicity, interest payments are left out of these examples.

⁷ The system actually allows the economy to perform more smoothly and expand more quickly than it would otherwise. But this is not without potential costs. The benefits of the banking system depend on the vast majority of loans being repaid. If this is not the case, due to either extending loans to risky customers or a set of unexpected events, then banks and other financial firms will suffer large loan losses, and that could reduce their net worth to point where the financial firms themselves face bankruptcy. If this happens on a large enough scale, the extension of credit contracts rapidly, throwing the economy into deep and potentially long lasting recession (e.g. The Great Depression, Japan in the 1990s and 2000s and the USA from 2008 to the present). This is one reason why regulatory agencies are supposed to monitor loan quality.

⁸ Banks may wish to reduce the amount of funds they are required to borrow, or the amount of securities they are required to sell. A bank can achieve this if it can induce customers to move funds from checking to saving accounts. Since the reserve requirement on savings accounts is zero, this switch will lower the amount of reserves a bank needs to hold. Therefore, under certain conditions, it may be worthwhile for the bank to increase the interest rate gap between savings and checking accounts to induce customers to make this switch. One such time would be if a bank is approaching one of its maximum prudent leverage ratios (see footnote 9).

⁹ There are limits to how much a bank can expand its loan portfolio and hence a limit to how much money it can create. Loans are more risky than securities. Borrowed funds are more risky than deposits. During expansions, the ratio of loans/securities, borrowed funds/deposits and loans/net worth all tend to increase. This increases the level of risk and decreases the amount of liquidity in the bank's balance sheet. “Prudent leverage ratios are established by a combination of experience and rules of thumb.” If the expansion were to continue for long enough, eventually banks “will come up against the maximum ‘prudent’ leverage ratio” (Wray, 1990). The bank will, at that point, either raise interest or put the brakes on loan growth. Bank regulators also track leverage ratios and may ask the bank, before it would have done so on its own, to slow loan growth.

¹⁰ In virtually every introductory orthodox textbook, “securities” and “borrowed funds” are missing from the balance sheets. In the orthodox story of money creation, banks need excess reserve in order to make loans, and the Federal Reserve controls the level of reserves. Thus, the Fed controls both the amount of money and the number of loans in our economy. If banks could engage in asset and liability management, then this entire story would fall apart.

¹¹ Some cards are not directly issued by banks, but the issuers have agreements with banks to make the payments.

¹² The FDIC uses a risk-based system to calculate value of assets and hence the percentage of net worth. Each asset is multiplied by some number between zero and one depending on its risk. Because cash is considered perfectly safe, it is multiplied by zero. Business loans, considered risky, are multiplied by one. Mortgages are in between and are multiplied by one half (Ritter, Silber, & Udell, 2009). The point is that in the FDIC's calculation the value of assets is smaller than what we have used in our example, and therefore the bank's net worth would actually have to be less than the 2% we have calculated, before the FDIC would act to close the bank.

¹³ Banks can borrow overseas on the Eurodollar market (dollars held in overseas banks), and they can borrow from the Federal Reserve via the discount window. Both will increase the amount of reserves in the USA. More information on discount window borrowing is provided in footnote 15.

¹⁴ Our initial inclination is to believe that a firm that is growing faster than its rivals is doing well, but this is not necessarily true for banks. The faster expansion could be a result of superior advertising and/or customer service, but it could also reflect a lowering of standards of creditworthiness below that of its competitors. In this case, the bank's growth results from taking on riskier loans.

¹⁵ Economics textbooks often have a section entitled “the three tools of the Fed,” in which they discuss the ways the Fed can affect the level of reserves in the system. Open market operations is one tool; the other two are the setting of reserve requirements and discount window borrowing.

Currently, the Fed has a 10% reserve requirement on checking accounts and 0% on all other liabilities. In the past, the reserve requirement on checking accounts was higher and other types of liabilities had small reserve requirements; e.g. saving accounts had a reserve requirement of 3%. However, the Fed rarely changes its reserve requirements, the last time was in 1990.

It is also possible for banks to borrow directly from the Fed, referred to as discount window borrowing. In the past, some have theorized (Moore, 1988) that discount window borrowing played an important role in the Fed targeting of interest rates. However, in 2003, the Fed changed the interest rate on discount window borrowing from below the fed funds rate to above it; typically, the discount rate runs between a quarter to 1% above the fed funds rate. As a result, banks no longer see borrowing at the discount window as a cheap alternative to borrowing fed funds.

¹⁶ In actuality, the Fed's trading of securities is with a short list of primary security dealers (approximately 20). The reserves and securities are exchanged electronically. Most of the dealers are themselves banks.

¹⁷ In textbooks and elsewhere, one often sees discussions of the Fed choosing to “accommodate” or “not accommodate” a surge in loan demand or an issuance of US Treasury bonds. In those instances, “accommodate” means the Fed increases reserves as a reaction to an increase in the demand for credit, although the writers often phrase it as the Fed increases the money supply. But this is essentially a false framework. For all practical purposes, the Fed does not have discretion over whether to “accommodate” or “not accommodate” any particular event or government action. Historically, the Federal Reserve has chosen a policy of interest rate targeting or money targeting. If The Fed chooses a policy of interest rate targeting, as it has for 65 of 68 years in the post WWII era, then it will automatically accommodate all changes in loan demand. If the Fed chooses to target money, then it will automatically not accommodate any change in loan demand, and must endure potentially large swings in interest rates. (In 1980, during the one period the Fed did target money, the three-month T-bill rate went from 15.02% in mid-March to 6.9% in mid-June and then back to 15.39% in mid-December.)

¹⁸ Wolfson (2003) presents a clear and straightforward model of credit rationing that is consistent with the views expressed in this reading.

¹⁹ We can use a metaphor of teenagers skating on a partially frozen lake to illustrate this part of Minsky's argument. In order to impress the girls with his bravery, a young male skates out onto the unproven ice. In financial markets, assets and strategies with higher returns have greater risk. Once one person has successfully skated out on the unproved ice, others will follow. So, to distinguish oneself one must skate out even further. Financial firms compete for business, and once a risky-high return strategy is used without disaster others are compelled to follow. To out-do their competitors, financial firms will therefore engage in even riskier strategies. Without a barrier, skaters will tend to go too far, and when one falls through, cracks in the ice will spread toward shore, imperiling all skaters. Without regulation and the active enforcement of those regulations, financial firms will take on too much risk and, when one collapses, it will often imperil the whole system.

²⁰ The freezing of financial markets is one reason why creditworthy businesses might not receive loans. There are other reasons that revolve around, either the decisions of regulators or the need to meet certain regulations. In these cases, the bank would like to give certain businesses loans, but is prevented from expanding its loan portfolio. But these events, like the freezing of financial markets, are infrequent.