Tuesday, April 5, 2016

American Financing of Business and Why the Bank of England is Obviously Wrong

In a few exchanges on Twitter with various people (including economists who claim to understand money and banking like Steve Keen), I was pointed to claims that these people made which were largely wrong including the idea that most "money" that's created today occurs by commercial banks issuing loans. These people then referred to this Bank of England paper that describes a process (it's obviously wrong and I'll go into why). Of course, these are statements that cannot be accurate because when you start looking at the balance sheets of the banking system and private sector, their claims are in direct contradiction with the facts. To put simply, the numbers simply do not add up in a manner wherein their conclusions have any sort of validity or make any kind of sense.

The Bank of England (BoE) paper starts off by saying that these three points:
-"This article explains how the majority of money in the modern economy is created by commercial banks making loans."
-"Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits."
-" The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’"

While there is a little truth to the final two claims, the first claim and parts of the other two claims are blatantly wrong.

First Claim:
Most money in our economy IS NOT "created by commercial banks making loans". In fact, if we look at the total assets of the American banking system according to the Federal Reserve (as of March 23, 2016), we'll see that it amounts to $15.72 trillion. Out of those total assets of the American banking system, the assets we can clearly see that CANNOT BE loans by commercial banks are:
1. $2.5 trillion are in cash assets (most of this is reserve balances held at the Fed)
2. $2.25 trillion are in Treasury debt or agency debt (largely MBS)
3. $403 billion are in Fed Funds and reverse repos with both banks and nonbanks
4. $200 billion are in trading assets
5. $62 billion are in interbank loans

If we add all of those numbers up, we end up getting the total assets held by American banks that isn't commercial bank loans at ~$5.41 trillion. So the total remaining assets of American banks comes out to ~$10.31 trillion. Also from data kept by the Federal Reserve, we know that American national income (as approximated by GDP; annualized) was $18.13 trillion as of Q4 2015--keep in mind that GDP has gone up since 2015 and into 2016, but we're not accounting for that so our numbers are quite conservative estimates. So what this means is that the total commercial bank loans/GDP is AT MOST 57% of GDP. If we remove loans to non-depository financial institutions (this was at $398 billion) from that total, we get assets of $9.92 trillion that comes out to ~54.6% of GDP.

However, Fed data also tells us that total household debt/GDP is at ~80% and this doesn't even include non-financial business borrowing which runs at ~70% of GDP. If most money was created by "commercial banks making loans", then there's no way household debt must be <45% of GDP (loans for commercial real estate amounted to $1.82 trillion so the rest of the assets of American banks come out to <8.1 trillion or <45% of GDP).

Now if we look at the actual capital structure of American finance, we'll see that the total market capitalization of listed domestic companies was $26.33 TRILLION in 2014--according to the World Bank (I cannot find the 2015 and 2016 data)--but this amounted to 152% of GDP in 2014. Now this number has probably gone higher since 2014 and if we use the 2014 data combined with the 2016 GDP numbers, we'll see that the total size of American listed equity comes out to >145% of GDP.

If most money is created in the form of commercial banks issuing loans, then how is the amount total non-financial loans held by commercial banks LESS THAN 40% of the TOTAL LISTED EQUITY? Clearly, the BoE description of the financial system is simply not in conjunction with the facts. Hence, the first claim of the BoE is just straight up wrong.

Second Claim:
Now, if we look at the second claim of the BoE, what we realize is that it's not correct either. Banks often simply do act as intermediaries in our financial system because our financial system relies on shadow finance. As I've described in other posts, shadow finance can be thought of as capital market lending using money market funding where you have funds that hold asset backed securities (ABSs) and use these ABSs to acquire financing in via the repo (repurchase agreement) market.

With these ABS, there is certainly some financial institution (essentially a bank) acting as an intermediary. These ABSs are a liability of some financial institution that holds smaller assets which "back" a certain ABS. So in other words, we certainly have banks (a financial intermediary is usually a bank) that hold certain assets and securitize them into some kind of a security.

Third Claim:
In the third claim by the BoE, the central bank in today's financial system doesn't ultimately control the money supply or the amount of credit supplied by the financial system, except in a very limited way. It can force the financial system to contract sharply and has some ability to force it to expand, but it cannot force the financial system into expanding or contracting the money supply as I've discussed in a previously.

The money supply today can't really be put into a cohesive amount because different groups of the population view different financial instruments as money for different purposes. So the ultimate control of the money supply doesn't lie in the central bank, but instead lies wholly on the financial system. All the Federal Reserve can do is to increase/decrease the money market rate of interest or increase/decrease its holdings of longer-term securities (which do influence one another, but aren't entirely dependent). So in other words, the amount of money supply in the US doesn't depend on the central bank. The central bank can play a role, but so can the international policy of foreign governments, the domestic policy of Congress, and shifts in the policies of other federal agencies.

To put simply, there's a little truth to the last point in the BoE paper, but it's mostly false and based on a fundamental financial misunderstanding of how today's world actually operates.

In other words, all three claims made by the BoE in their paper are not only minor mistakes, but fundamental errors based on a massive conceptual misunderstanding of how financial markets and capital markets work today.

The financial system that we have today is far more complex and multi-dimensional than anything the BoE could imagine. They clearly have little grasp of it and seem to be living a world that may have existed 60-70 years ago, but certainly doesn't exist today. The entire paper they've laid out on monetary policy is nothing more than garbage.

If the British financial and policy-making elite are thinking about finance in these terms, then all it tells us is that the United Kingdom has fell far behind. This kind of financial thinking is primitive, wrong, and will really make sure the economic system lags behind. Quite frankly, it's the result of a backward view and a country that's now in decline.


  1. Hello, personally I think the recent data is not good for making good claims on how the money in "normal" time has been made. We are not in a normal period with the Central Banks’ "un-conventional" QE!

    1. Well, this has been done before, but it's done in a different way throughout every historical cycle. NIRP certainly isn't new in any way whatsoever and is really just a tax on the financial system cuz they're holding deposits at the central bank that they're paying interest on.

      Usually what happens with these types of systems where you link QE to deficit spending is that you end up with a system that uses political coalitions to come to power to either do the Chinese model that turbocharges production or you deficit spend to increase consumption. The latter generally results in inflation. Theoretically, you could cut deficits or contract monetary policy, but cutting deficits becomes really hard because of entrenched political coalitions (especially unions and other groups who have incomes tied to inflation).