Banks Lend Deposits
Misconception/Lie 4
Most people in the general public don’t really think about where the currency, that commercial banks lend to individuals and businesses, originates. If pressed, there is an assumption that banks receive deposits which build up a fund allowing the bank to then make loans. The academics have had varying conclusions about this over the years too.
Until very recently, many economics textbooks reinforced the belief that savings had to be deposited with banks before these funds could be lent out to investors. This is called the Intermediation Theory of Banking. The understanding here, is, as above, that banks provide an intermediary function in the process, matching investors with saved deposits.
The idea of a 1:1 ratio between lending and borrowing was largely superceded by the Fractional Reserve Theory. This is the idea that banks accept deposits and lend out loans but instead of a 1:1 ratio, the bank only requires to hold a portion, (a fraction) of the amount loaned-out, allowing for greater lending ability to investors, theoretically, increasing productivity and funding for research and development.
The result of such beliefs is that the availability of funds for investment is constrained to the amount of deposits at the bank. This then leads to worries of ‘crowding out’ of the private sector if the Government desires to spend heavily on fiscal policy. The Government would, in effect, use up the available deposits, leaving little for the private sector and driving up interest rates in the process, making it more expensive, or even impossible to borrow.
There is also the fear of a ‘run’ on the bank. This is the worry that the bank could default on payments if too many customers cashed in their accounts at once and too many loans meant no deposits remained to pay the customer.
Both of the theories above are wrong. In the modern fiat currency landscape, where the Government, through its Central Bank and its agents (commercial banks) create currency at the tap of a keyboard, these ideas make no sense. A currency-issuer can never, involuntarily, be forced into bankruptcy. The currency can always be created to cover any liability.
The “banks lend deposits” lie is so pernicious that it took a paper from the Bank of England, as recently as 2014, entitled Money Creation in the Modern Economy, to set the record straight. In the paper it states:
“The reality of how money is created today differs from the description found in some economics textbooks”
It also states:
“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 fact that this paper was produced by the Bank of England, and not an economic academic speaks volumes. It is indicative of how unfounded the economics discipline, and their associated “think-tanks” are in the modern economy, yet, no other sector has more influence on the Government policies that affect our day to day lives.
It may seem like an inconsequential, technical detail, however, the implications on policy space are massive. These false constraints allow government spokesmen to hide behind a veneer of economic sobriety and competent budgeting, when turning down, for example, spending on life-saving public services on the grounds of unaffordability.
The reality is, of course, that the reverse is true. Loans create savings deposits, not the other way around. Once a bank has assessed that a borrower meets its regulated criteria for creditworthiness, it creates a loan by increasing the number in the borrower’s bank account. There is no need to check the level of deposits in the bank’s reserve account.
As you’ll find often in this series, economists, the media and politicians have this back to front. What works at the household level does not hold at the macro level of a currency-issuing Government. It is a different paradigm. Alternative rules apply. This understanding provides policy space for any Government to invest into, and is extremely important in the proposals for a future independent Scotland.
Currently, Governments will often react to a drop in investment, usually caused by a drop in spending, by creating pension funds or ISA’s, or selling bonds as vehicles to encourage saving, misunderstanding that this is actually taking money out of the economy. Their thinking is that this will encourage investment as the amount of deposits rise. All it does is cause elevated levels of wealth inequality and even less spending in the economy, more unemployment and the necessity for a credit expansion in the private sector, driving the people further into debt.
Whereas, what is actually required when private sector investment drops, is either a lowering of the tax burden on the private sector, or an increase in spending by the public sector. This former option will encourage higher investment by the private sector and the latter will provide Government investment to help stimulate the economy.
Getting the correct perspective allows a whole new range of potential economic solutions to creating a balanced economy.