The Bank of England dismisses the ‘money multiplier’ theory

The Bank of England has just published probably the most accurate and clear accounts of how the modern monetary system works ever written by a major central bank. The two articles are published in the Bank’s prestigious 54 year-old Quarterly Bulletin series – the main channel it uses to communicate its thinking to the public– writes Josh Ryan Collins, Senior Researcher at New Economics Foundation in this excellent article.

Here are few highlights:

[T]he Bank lays to rest two of the great ‘money myths’. First, it dismisses the commonly held view that when a bank makes a loan it is simply recycling someone else’s savings. In fact, it is the other way round: “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.”

The Bank also dismisses the ‘money multiplier’ theory, whereby the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money:

“…the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them…It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.”

The first article explains that “commercial banks can create new money because bank deposits are just IOUs of the bank; banks’ ability to create IOUs is no different to anyone else in the economy…” (page 8). But what makes bank IOUs different is that they are widely accepted as a medium of exchange. Why? Because the State guarantees every person holding a bank account the first £80,000 of these Bank IOUs. This “ensures that bank deposits are trusted to be easily convertible into currency and can act as a medium of exchange in its place.”

The Bank does not explain why private bank IOUs get this special treatment, however.

Modern money creation can thus be seen as something of an accident of history. As we point out in Where Does Money Come From?, there are serious questions as to whether a relatively unregulated system dominated by private money creation in the form of interest bearing debt is best suited to the challenges facing modern humanity.

Perhaps it is time for a return to the quantitative  controls on private money creation that were standard in the 1950s and 1960s; or perhaps it is time to consider whether the power to create money really should reside with private companies at all – the UK banks’ record since 2008 begs the question.

Whatever the future though, the Bank of England should be congratulated for setting the record straight on how the modern monetary system works. These articles will stand the test of time as a reference for anyone interested in both understanding and reforming our financial system. They can be seen as a victory for those – like NEF, Positive Money, Michael Kumhof, Adair Turner, Richard Werner and many others – who have been working to educate policy makers and the general public about the realities of our monetary system. And let’s hope they lead to a few textbooks being ripped up.

Read the whole article