Your money starts life as debt – Its official!

If there was any remaining doubt the Bank of England has confirmed what heterodox economists have been saying for decades. The economic text books are wrong. Banks do not accept deposits from savers and intermediate them into loans to borrowers. Nor do they rely on the multiplier effect or are limited by reserves. The loans in fact come before the deposit, indeed they create the deposit. The private banking corporations create our money supply not the government or Reserve Bank. The Reserve Bank tries to control the quantity of “credit money” in the economy indirectly by changing its price via the Overnight Cash Rate (OCR). Until the LVR restrictions on mortgages, it has had no direct control over the volume.

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits

Why does this matter?

For starters the banks are happy that most people harbour the illusion that they are just the hard working middlemen accepting working people’s savings and through  a vigorous approval process find worthy borrowers and clip the ticket. That they can create a loan with a keystroke and charge interest on it sounds less virtuous. Way less virtuous. Free money you might say.

Secondly it gives the trading banks substantial economic and political power. By deciding who does and who does not get credit, they determine not only which individuals, but also which sectors of the economy get funding and which wither. In a deregulated free market economy, far more so than the government. As property is relatively safe, offering good security, it should be no surprise that this is where most lending goes. Unfortunately this drives property prices higher in what banks consider a virtuous cycle. Higher prices mean more security, a greater volume and value of mortgages, resulting in bigger profits. If banks had to wait for people to save income before they could loan, their turnover and profits would be minuscule compared with present and property prices substantially lower. There would simply not be enough money to generate bigger mortgages.

Thirdly bank lending amplifies both booms and busts. It is pro cyclical rather than anti cyclical. Absent any formal supply restriction like deposit or large capital reserves, banks will lend as much money as individual households and the economy can absorb. They are after all private corporations whose only legal responsibility is to their shareholders. If those shareholders want to maximise profit then that’s what they will do. It most of the shareholders are foreign then the profits, instead of remaining in the domestic economy, flow offshore. Think about it. Foreign owned businesses get to create free money and charge you interest for it. Our money supply has been outsourced. They say they supply an essential service but they have been allowed to make themselves indispensible and in most cases, too big to fail. Banks hold entire nations to ransom with their financial Armageddon threat.

Now this wouldn’t be so bad if credit creation and destruction were equal, if every time a loan was made the money supply grew, and every time a loan was repaid it shrank evenly. It can’t however for two reasons.

The first is that an unlimited supply creates asset price booms and insatiable demand as sentiment drives more people to borrow and buy, driving more price rises and more borrowing. The loans are getting bigger in size and quantity as people chase capital gains. Far more is being borrowed than repaid. The wealth effect kicks in and people borrow not just to buy a house but as their paper capital gains accumulate, against their house either directly or in their head with other consumer loans to buy all sorts of things like cars and holidays. Sentiment is high and they feel like kings. Banks are happy to oblige as the security, at least on paper, has increased and after all, they make their main money from making loans, not turning them down.

The second is interest. A loan always has some amount of interest attached. To pay back both the interest and principal each year on all the loans, the economy has to grow. It can do this in two ways. Companies and countries can sell more to increase their incomes. If they do this domestically, the purchasers or consumers will need more money but as the money comes from loans made by the banks, the money supply as debt/credit has to rise.

The only way to avoid this is to export and bring in money from outside. This money from outside as payment for exports has to offset the money flowing in the other direction for imports and as profits being repatriated for foreign owned companies, foremost of which are yes, the banks. Absent high enough exports, the banks will have to lend more money into existence to pay the interest and profits on loans already made. High debt and big interest bills demand constantly increasing economic “growth”, putting constantly increasing pressure on both human and natural resources and preventing sustainability. Eventually a tipping point is reached where either a nation runs out of natural resources or as in the case of dairying, cannot stomach the side effects of growth, the externalities the “free market” does such a poor job of pricing.

In a closed economy it wouldn’t be as bad although internal inequality between savers and borrowers, asset rich and asset poor would arise. These can be addressed with tax and other forms of regulation/redistribution if so desired. As the macro level however any money and profits created would remain within the economy.

In our hyper global open economy, huge imbalances can build up if a country cannot balance its imports and exports, or better still achieve a long term trade surplus, or if repatriated profits and financial flows  outweigh even a trade surplus. This is the situation New Zealand has been in for decades as the Current Account Deficit annually outweighs the irregular trade surplus.

In the long run the entire global economy is “closed” in as much as the cliche “infinite growth on a finite planet” is impossible. Also with global free trade one nation’s trade or current account surplus is another’s deficit. Not all countries can run surpluses simultaneously. For the deficit countries yet more money has to come into existence as debt to pay the surplus countries and the interest.

Eventually it can only end in endless recession/very low growth for most nations. Probably both as they bounce along the top of their debt servicing limit, paying off a little in a good year, re-incurring it in a bad year. If things get too bad, a major disaster strikes (like Christchurch) or a populace gets sick of it and seeks a more radical alternative, debt will be defaulted on and an economy reset at a “lower” more sustainable level.

Contrary to popular dogma, global free trade is not a panacea. As mentioned above not all countries can be in surplus and being rich in resources does not protect you from too much debt or guarantee prosperity. Asset booms generated by easy credit are usually ruinous in the long term as soon as a nation’s fortunes inevitably pause or take a turn for the worse but the debt servicing remains. New Zealand has almost reached the same private debt levels of 2008 but public debt is considerably worse, and dairy and timber prices in particular have declined substantially. Our two largest trading partners look weak. Add a severely over valued Auckland property market and a high speculative currency and the omens are not good if another financial crisis strikes in the near future. New Zealand is in a far worse financial position than 2008.

One alternative is to demand balanced trade rather than free trade. If we sell x amount to China, we reciprocate with the same amount from them. Ditto all our trading partners. This prevents persistent trade imbalances and mitigates current account imbalances. It would also mitigate the expected large drop in the exchange rate from the measures below that could cause imported inflation without foreign currency earnings.

Second to that is preventing overseas borrowing. This does not prevent overseas direct investment for restricted assets – but not residential or rural property. They are too important to the social fabric and agricultural sustainability to be driven out of reach by foreign speculators/investors. Commercial property, businesses and shares with limits. No foreign borrowing would also place limits on the banks ability to lend in association with the following.

Gradually increase banks capital ratios or even better reintroduce deposit reserve requirements. Eventually implement 100% reserve requirements as per the Chicago Plan and prevent banks from creating credit. All loans would have to come from earned savings. These earnings would be facilitated by Reserve Bank credit spent into existence rather than loaned into existence, with no interest, by the government of the day, either as payment for new infrastructure or as part of transfer payments directly to the public.

The Reserve Bank would decide how much money was required in the economy to maintain a steady state with no inflation but no growth either. The government would decide how it was spent and how much it wanted to supplement this RB money with tax receipts. Without interest on government spending in controlled amounts, the tax burden on the current and future generations can be minimised.

This Reserve Bank public credit would be introduced in proportion to the reduction in bank created credit so as not to be inflationary. Remember too the reduction in the interest burden this entails. That giant sucking sound of interest profits disappearing offshore from the banks would abate dramatically along with the current account deficit.

People would still be able to borrow from banks but it would be saved money not new money and not adding to the money supply. The RB would decide the quantity of money required to maintain its inflation targets, able to add and subtract money from circulation directly, not relying on tinkering with demand via the OCR. Indeed the banks could be free to set whatever deposit and loan rates they liked. That would be left to the market. Once it has been spent into the economy banks, savers and borrowers are free to negotiate how that money continues to circulate.

The issue is how does our nation’s money come into existence. Should money, the lubricant of the economy, be created by the Reserve Bank with no interest and be spent into the economy for new infrastructure and services; or should it be born on the computers of the trading banks, with interest attached, and with no direct means for either the RB or the government of the day to determine which sectors of the economy those loans go to. This isn’t about government control of individual freedom and telling people how to spend their money, it is about deciding how money starts its life, as a debt or as a payment.

Adair Turner pointed out that the 2008 Credit Crisis was caused by the “excess creation of private credit and money: we should be concerned if our only escape route implies building up future excess.”

Yet this is exactly what governments everywhere are doing, including New Zealand. At present the only plan seems to be allowing a debt based property bubble to inflate further and rely on a wealth effect to increase consumption. They have no plan B.



  1. […] an option, something the 1935 Labour Government used for State Housing, and which I have championed here, here and here as an option many times. (Gould below with Campbell in […]

  2. […] “money” in bank accounts is from a central or reserve bank. The remaining 95% has been created by someone taking on a debt, a mortgage, a business loan with a trading bank. There is virtually no limit to the amount of this […]

  3. […] economic beliefs and skeptical whether a university educated economist can really advocate for overdue reform of the banking and entire financial system that bought us the GFC. He rightly criticizes Labour and National as tinkerers but without […]

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