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The reality of how money is created today differs from the description found in some economics textbooks:
One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.
In reality in the modern economy, commercial banks are the creators of deposit money …. Rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.
This description of money creation contrasts with the notion that banks can only lend out pre-existing money, outlined in the previous section. Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out.
Similarly, the Federal Reserve Bank of Chicago published a booklet called “Modern Money Mechanics” in the 1960s stating:[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.
Monetary expert and economics professor Randall Wray explained to Washington’s Blog that:Bank deposits are bank IOUs.
Economics professor Richard Werner – who obtained his PhD in economics from Oxford, was the first Shimomura Fellow at the Research Institute for Capital Formation at the Development Bank of Japan, Visiting Researcher at the Institute for Monetary and Economic Studies at the Bank of Japan, Visiting Scholar at the Institute for Monetary and Fiscal Studies at the Ministry of Finance, and chief economist of Jardine Fleming – was granted access to study a bank’s books, and confirmed that private banks create money when they simply create fictitious deposits into a borrower’s account.Werner explains:What banks do is to simply reclassify their accounts payable items arising from the act of lending as ‘customer deposits’, and the general public, when receiving payment in the form of a transfer of bank deposits, believes that a form of money had been paid into the bank.
No balance is drawn down to make a payment to the borrower.
The bank does not actually make any money available to the borrower: No transfer of funds from anywhere to the customer or indeed the customer’s account takes place. There is no equal reduction in the balance of another account to defray the borrower. Instead, the bank simply re-classified its liabilities, changing the ‘accounts payable’ obligation arising from the bank loan contract to another liability category called ‘customer deposits’.
While the borrower is given the impression that the bank had transferred money from its capital, reserves or other accounts to the borrower’s account (as indeed major theories of banking, the financial intermediation and fractional reserve theories, erroneously claim), in reality this is not the case. Neither the bank nor the customer deposited any money, nor were any funds from anywhere outside the bank utilised to make the deposit in the borrower’s account. Indeed, there was no depositing of any funds.
The bank’s liability is simply re-named a ‘bank deposit’.
Banks create money when they grant a loan: they invent a fictitious customer deposit, which the central bank and all users of our monetary system, consider to be ‘money’, indistinguishable from ‘real’ deposits not newly invented by the banks. Thus banks do not just grant credit, they create credit, and simultaneously they create money.
Instead of discharging their liability to pay out loans, the banks merely reclassify their liabilities originating from loan contracts from what should be an ‘accounts payable’ item to ‘customer deposit’ ….
How Can Banks DO This?Professor Werner explains the reason that banks – but no one else – can create money out of thin air is that they are the only institution exempted from normal accounting rules.Specifically, every other company would be busted for fraudulent accounting if they conjured new money out of thin air by reclassifying a liability (i.e. an accounts payable) as an asset (i.e. a deposit).But the banks have pushed through exemptions so that they don’t have to follow normal accounting rules:What enables banks to create credit and hence money is their exemption from the Client Money Rules. Thanks to this exemption they are allowed to keep customer deposits on their own balance sheet. This means that depositors who deposit their money with a bank are no longer the legal owners of this money. Instead, they are just one of the general creditors of the bank whom it owes money to. It also means that the bank is able to access the records of the customer deposits held with it and invent a new ‘customer deposit’ that had not actually been paid in, but instead is a re-classified accounts payable liability of the bank arising from a loan contract.
What makes banks unique and explains the combination of lending and deposit-taking under one roof is the more fundamental fact that they do not have to segregate client accounts, and thus are able to engage in an exercise of ‘re-labelling’ and mixing different liabilities, specifically by re-assigning their accounts payable liabilities incurred when entering into loan agreements, to another category of liability called ‘customer deposits’.
What distinguishes banks from non-banks is their ability to create credit and money through lending, which is accomplished by booking what actually are accounts payable liabilities as imaginary customer deposits, and this is in turn made possible by a particular regulation that renders banks unique: their exemption from the Client Money Rules. [Werner gives a concrete example on British law for banking and non-banking institutions.]
Sound fraudulent? Professor Werner thinks so, also:
Moreover, Werner points out that banks create the boom-bust cycle by lending too much for speculative, non-productive purposes
A wit once defined an economist as someone who, when shown that something works in practice, replies “Ah! But does it work in theory?”
And a 2016 IMF paper notes:Around [the 1960s] banks began to completely disappear from most macroeconomic models of how the economy works.
This helps explain why, when faced with the Great Recession in 2008, macroeconomics was initially unprepared to contribute much to the analysis of the interaction of banks with the macro economy. Today there is a sizable body of research on this topic, but the literature still has many difficulties.
Virtually all recent mainstream neoclassical economic research is based on the highly misleading “intermediation of loanable funds” description of banking …
In modern neoclassical intermediation of loanable funds theories, banks are seen as intermediating real savings. Lending, in this narrative, starts with banks collecting deposits of previously saved real resources (perishable consumer goods, consumer durables, machines and equipment, etc.) from savers and ends with the lending of those same real resources to borrowers. But such institutions simply do not exist in the real world. There are no loanable funds of real resources that bankers can collect and then lend out. Banks do of course collect checks or similar financial instruments, but because such instruments—to have any value—must be drawn on funds from elsewhere in the financial system, they cannot be deposits of new funds from outside the financial system. New funds are produced only with new bank loans (or when banks purchase additional financial or real assets), through book entries made by keystrokes on the banker’s keyboard at the time of disbursement. This means that the funds do not exist before the loan and that they are in the form of electronic entries—or, historically, paper ledger entries—rather than real resources.
This “financing through money creation” function of banks has been repeatedly described in publications of the world’s leading central banks—see McLeay, Radia, and Thomas (2014a, 2014b) for excellent summaries. What has been much more challenging, however, is the incorporation of these insights into macroeconomic models [how true].
What’s the Solution?We’ve seen the problems created by failing to take into account the fact that private banks create money.But there are solutions …Initially, Professor Werner notes that preventing banks from creating new money to loan for speculation and mere personal consumption would prevent booms and busts:
We’re all used to having to identify ourselves as we enter a country. It is the only way we can hope to have any attempt at a secure border. But, so-called “exit controls,” where documents are checked as travelers are leaving the country, were popularized last century by Nazi Germany as a great way to ensure that they could control, round up, and exterminate the Jews and other “undesirables.” It can obviously serve no purpose of keeping terrorists out, because it only affects those who are already in. The U.S. has never had exit controls, although they remain popular in Europe, Russia, and China.
Last week, privacy advocate and blogger Jeffrey Tucker posted his experience before a flight from Atlanta to Mexico:
Halfway down the jetbridge, there was a new layer of security. Two US Marshals, heavily armed and dressed in dystopian-style black regalia, stood next to an upright machine with a glowing green eye. Every passenger, one by one, was told to step on a mat and look into the green scanner. It was scanning our eyes and matching that scan with the passport, which was also scanned (yet again).
“Welcome Aboard, But First U.S. Marshals Will Scan Your Retina,” published 2/25/2017.
A bit of research uncovered that CBP announced a 2-month pilot program last year for flights between Atlanta and Japan in which they would be doing facial scans as passengers were about to board their flights:.
As part of the testing, travelers will present their boarding pass while their digital photo is taken. The process will take less than three seconds before travelers proceed to the passenger loading bridge to board their flight. Travelers over the age of 14 and under 79 will be required to participate in the test. The test will evaluate CBP’s ability to successfully compare the image of a traveler taken during departure against an image the traveler previously provided, in an automated fashion and without impacting airport operations.
This was, apparently, announced sufficiently quietly that I had not before heard of the program. The 2 month window has expired, and there is no mention on their Web site, that I can find, of a new program between Atlanta and Mexico. But, it seems to me that the likely scenario is that CBP has re-started this program and Mr. Tucker confused U.S. Marshals with CBP officers, and retinal scanning with face recognition scanners (not that it makes a difference in terms of our privacy).
What exactly is the point of this? Are we hoping to catch someone who has overstayed their visa so that we can stop them from leaving, then take them into custody so that the taxpayer can fund their leaving? It may simply be a dumb idea, or it may be a far more sinister plan to further control the movements of everyone in the country, citizen or otherwise.
Either way, count me out, and I encourage you to refuse as well.
Eurozone Target2 imbalances have touched or exceeded the crisis levels hit in 2012 when Greece was on the verge of leaving the Eurozone. Others have noted the growing imbalances as well.
I had a couple of questions for the ECB regarding Target2, which they have answered, I believe disingenuously.
First, we will explain Target2, then we will take a look at various charts, viewpoints, and the email exchange with the ECB.
Target2 stands for Trans-European Automated Real-time Gross Settlement System. It is a reflection of capital flight from the “Club-Med” countries in Southern Europe (Greece, Spain, and Italy) to banks in Northern Europe.
Pater Tenebrarum at the Acting Man blog provides this easy to understand example: “Spain imports German goods, but no Spanish goods or capital have been acquired by any private party in Germany in return. The only thing that has been ‘acquired’ is an IOU issued by the Spanish commercial bank to the Bank of Spain in return for funding the payment.”
This is not the same as an auto loan from a dealer or a bank. In the case of Target2, central banks are guaranteeing the IOU.
Target2 also encompasses people yanking deposits from a bank in their country and parking them in a bank in another country. Greece is a nice example, and the result was capital controls.
If Italy or Greece (any country) were to leave the Eurozone and default on the target2 balance, the rest of the countries would have to make up the default according to their percentage weight in the Eurozone.
Those numbers are as of December 2016. A check of the Bundesbank Target2 Balance as of January 31, 2017 shows a new record high of €797 billion.
As of December 2016, if Italy were to exit the Eurozone, Italy would owe €356.6 billion to Germany, Luxembourg, and a couple other small creditors.
What’s the likelihood Italy could ever pay back €356.6 billion?
Ambrose Evans-Pritchard at the Telegraph notes the unpayable debts then asks Are Eurozone Central Banks Still Solvent?
Vast liabilities are being switched quietly from private banks and investment funds onto the shoulders of taxpayers across southern Europe. It is a variant of the tragic episode in Greece, but this time on a far larger scale, and with systemic global implications.
There has been no democratic decision by any parliament to take on these fiscal debts, rapidly approaching €1 trillion. They are the unintended side-effect of quantitative easing by the European Central Bank, which has degenerated into a conduit for capital flight from the Club Med bloc to Germany, Luxembourg, and The Netherlands.
This ‘socialization of risk’ is happening by stealth, a mechanical effect of the ECB’s Target2 payments system. If a political upset in France or Italy triggers an existential euro crisis over coming months, citizens from both the eurozone’s debtor and creditor countries will discover to their horror what has been done to them.
As always, the debt markets are the barometer of stress. Yields on two-year German debt fell to an all-time low of minus 0.92pc on Wednesday, a sign that something very strange is happening. “Alarm bells are starting to ring again. Our flow data is picking up serious capital flight into German safe-haven assets. It feels like the build-up to the eurozone crisis in 2011,” said Simon Derrick from BNY Mellon.
The Target2 system is designed to adjust accounts automatically between the branches of the ECB’s family of central banks, self-correcting with each ebb and flow. In reality, it has become a cloak for chronic one-way capital outflows.
Private investors sell their holdings of Italian or Portuguese sovereign debt to the ECB at a profit, and rotate the proceeds into mutual funds Germany or Luxembourg. “What it basically shows is that monetary union is slowly disintegrating despite the best efforts of Mario Draghi,” said a former ECB governor.
The Banca d’Italia alone now owes a record €364bn to the ECB – 22pc of GDP – and the figure keeps rising.
Spain’s Target2 liabilities are €328bn, almost 30pc of GDP. Portugal and Greece are both at €72bn. All are either insolvent or dangerously close if these debts are crystallized.
On the other side of the ledger, the German Bundesbank has built up Target2 credits of €796bn. Luxembourg has credits of €187bn, reflecting its role as a financial hub. This is roughly 350pc of the tiny Duchy’s GDP, and fourteen times the annual budget.
Mish Questions for the ECB – January 27, 2017
Many media reports suggest the growing target2 imbalance in Italy is a sign of capital flight. ECB president Mario Draghi said it was a function of ECB asset purchases. Can you explain why Draghi is right or wrong?
Please also explain the growing target2 imbalance at the ECB itself.
ECB Response – February 15, 2017
Dear Mr. Shedlock,
Thank you for your email and please accept our apologies for the late reply.
The implementation of the APP affects TARGET balances through cross-border settlement of our purchases. For more information on this particular mechanism, please see ECB Economic Bulletin, Issue 7 / 2016 – Box 2: TARGET balances and the asset purchase programme (pages 21-24).
As regards the ECB’s own Target balance, when the ECB purchases securities under the APP, the ECB credits the account of the respective counterparty. Such counterparties are credit institutions, which cannot hold accounts with the ECB, but instead, hold accounts with national central banks. Therefore, payment for a security by the ECB automatically increases the ECB’s TARGET liability (but not necessarily the overall TARGET balance). This is discussed in the Bundesbank’s March 2016 Monthly Report (pages 53-55).
With best regards,
EUROPEAN CENTRAL BANK
Disingenuous ECB Response
I have been talking about Target2 imbalances for years, and I do not accept ECB’s response straight up.
Euro intelligence also discussed this very question recently. They have it correct, as follows, emphasis mine:
One of the barometers of tension in the Eurozone is the number of articles in the German press questioning the euro’s advantages to the country. The publication of the latest Target2 imbalances is not helping soothe nerves. As of end January, the German surplus was at an all-time record of €796 billion, while Italy’s deficit was at a record €364 billion. The ECB argues that the reason for the gap is not the same as it was during the Eurozone crisis when the imbalances reflected capital flight.
Philip Plickert writes in FAZ that this argument does not tell the full story. It is true, of course, that international banks based in London sell bonds to the Bank of Italy from their Frankfurt-based branches – so that the asset purchases result in transfers of central bank money from Italy to Germany. But why do the sellers not replenish their portfolios with purchases of Italian bonds, shares or other assets? Instead, they take the money and invest in Germany. So this is still capital flight – except that it works indirectly through the asset purchase programme.
Simple Target2 Explanation
Reader Lars writes: “Target 2 is a settlement system. When imbalances arise it’s because transactions are not settled. For example, Luigi in Italy transfers his €1 million from his Monte dei Paschi (MdP) account to his new Deutsche Bank account. MdP does not have the €1 million and has to borrow it from Bank of Italy. The Bank of Italy has to borrow the €1 million from Bundesbank. So at the end of the day, Luigi gets the €1 million into his account in DB but the Bank of Italy now owes €1 million to Bundesbank.”
Do that long enough and this is what happens:
Pater Tenebrarum at the Acting Man blog commented via Email “I agree with the eurointelligence view that the steep Italian and Spanish deficits are still a testament to capital shunning various countries. To put it very simply: people managing large sums of Other People’s Money for institutions subject to fiduciary duty continue to have doubts about the euro’s survival, and rightly so.
Reader Lars replied: “It seems to me that the ECB is trying to complicate matters and kick the ball into the tall grass. In regards to the ECBs €160 billion Target2 deficit, it might be the case that the ECB has borrowed from Bundesbank and then lent the money to other national central banks (NCBs) because the Bundesbank has not been willing to do all the heavy lifting itself. Is the Bundesbank shunning risk at local NCBs?”
Rating Agencies Where Art Thou?
The rating agencies should be all over this issue but they are not. Here are two possible explanations.
Huge Insurmountable Problem
Target 2 is one of the least discussed and least understood problems in the Eurozone.
Jens Weidmann, Bundesbank president, allowed nearly €800 billion in credit to build on his watch. One has to wonder: Is Weidmann moving into illegal territory?
Egon von Greyerz, Founder & Managing Partner, Matterhorn Asset Management AG, made a comment similar to what I have stated many times: “Germany is in bigger trouble than Italy, Spain, or Portugal. Those countries can’t pay so Germany will have to foot the bill.”
Alternatively, the Bundesbank and the ECB are going to print money to cover those losses!
Greece alone is unlikely to trigger a crisis now, but Italy, Spain, or France could.
Fuse is Lit
The fuse is lit, multiple fuses actually.
Recent strength in gold is likely based on increasing doubts central banks are once again out of control.
Of course, central banks were never really in control, but appearances matter.
For further discussion, please consider Rate Hike Cycles vs. the US Dollar: Rate Hikes Bad for Gold?
By: Mike “Mish” Shedlock
The report was circulated among MPs ahead of the crucial vote held in Westminster earlier this month and repeatedly referred to Article 49 which allows for the re-joining of the EU.
Today Downing Street has officially slapped down the report called “Brexit: how does the Article 50 process work?” which clearly points to a re-entry strategy developed by mandarins.
The report states: “There is no provision for withdrawing the notification, but many analysts believe Article 50 is revocable and that the UK could change its mind about leaving the EU after notification and before actually withdrawing.
“The revocability of Article 50 TEU was not raised in the Miller case before the High Court, but could be important.
“If the UK wanted to re-join the EU in the future, it would have to re-apply under Article 49 TEU”.
He said: “We have been clear that we are committed to delivering on the will of the people and leaving the European Union.
“There can be no attempts to remain inside the EU and no attempt to re-join it.
“We want the best deal for the whole of the UK.
“We want a phased process of implementation, in which both Britain and the EU institutions and member states prepare for the new arrangements that exist between us.”
Theresa May is currently buoyed after the Conservatives shock election victory in the Copeland by-election.
Tory Trudy Harrison won with 13,748 votes to 11,601 for Labour’s Gillian Troughton.
Mrs May is also riding high with positive approval ratings as Jeremy Corbyn continues to fight off controversy in the crumbling Labour party.
During the Article 50 Commons Vote two weeks ago there was drama with high profile resignations from the Labour front benches.
The Conservative government sailed through the process with a comfortable win with 494 votes in favour to 122 against.
The only Tory rebel to vote against the Government was Ken Clarke who had previously announced he enjoyed the limelight he’d been receiving as a result of his stance.
No one from the SNP denied party orders to vote against the bill after Nicola Sturgeon’s posturing however it has already been ruled that devolved assemblies do not have a say after the Supreme Court judgement.
In terms of percentages the Government won the vote by 80.2 per cent to 19.8 per cent. The draft legislation is now set to move to the House of Lords but is a comfortable win for the Conservative party who will now be buoyed in their Brexit negotiations with the EU.
By: Siobhan McFadyen