If banks can create money, how come Northern Rock went bust?

Banks obviously can’t create money, says Tim Worstall in his blog ‘Ms Orr succumbs to the Positive Money loons‘, in response to Deborah Orr’s article in the Guardian.

[sws_blockquote_endquote align=”left” cite=”Tim Worstall” link=”http://timworstall.com/2012/07/14/ms-orr-succumbs-to-the-positive-money-loons/” quotestyle=”style02″]Now, how to show that banks do not in fact just create money? Well, if they did then Northern Rock would not have gone bust, would it? … Think through this for a moment. If Northern Rock could just print money on its own computers then could they have gone bust in this manner?[/sws_blockquote_endquote]

Let’s see why it’s entirely possible for banks to be able to create money and still run out of the stuff in the style of Northern Rock.

The Different Types of Money Used in Banking

There are actually two types of money in the banking system.

Firstly, there’s the type of money that appears in your bank account – a number in a computer system, or in banking jargon, ‘bank credit’ or ‘bank deposits’. Banks can create this money through the accounting process they use when they make loans. A full explanation of this process showing balance sheets is available here, but for now let’s just see a couple of quotes from the Bank of England:

[sws_blockquote_endquote align=”left” cite=”Bank of England, Interpreting movements in broad money, p.377″ link=”http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb0703.pdf” quotestyle=”style02″]By far the largest role in creating broad money is played by the banking sector… When banks make loans they create additional deposits for those that have borrowed the money [/sws_blockquote_endquote]

[sws_blockquote_endquote align=”left” cite=”Paul Tucker, Deputy Governor for Financial Stability, Bank of England.  Speech: ‘Money and Credit: Banking and the Macroeconomy'” link=”http://www.bankofengland.co.uk/publications/Documents/speeches/2007/speech331.pdf” quotestyle=”style02″]Banks extend credit by simply increasing the borrowing customer’s current account … That is, banks extend credit [i.e. make loans] by creating money [/sws_blockquote_endquote]

[sws_blockquote_endquote align=”left” cite=”Paul Tucker, Deputy Governor for Financial Stability, Bank of England.  Speech: ‘Shadow Banking: thoughts for a possible policy agenda'” link=”http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech566.pdf” quotestyle=”style02″][Banks] can lend simply by expanding the two sides of their balance sheet simultaneously, creating (broad) money.[/sws_blockquote_endquote]

As the last quote explains, when a bank makes a loan it makes two balancing entries in its books: 1) the asset, which is the loan contract, and 2) a liability, which is the bank credit – or numbers in someone’s account – in the account of the borrower. This is newly-created bank credit, which functions as money and can be used to make payments.

There’s another form of money, known as ‘central bank money‘. This can either be physical cash, or an electronic equivalent held in accounts at the Bank of England. Cash is used mainly by the public, and considered to be ‘risk-free’:

[sws_blockquote_endquote align=”left” cite=”Bank of England, Quarterly Bulletin, 2010 Q4 (p302)'” link=”http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100405.pdf” quotestyle=”style02″]Bank of England notes are a form of ‘central bank money’, which the public holds without incurring credit risk. This is because the central bank is backed by the government.[/sws_blockquote_endquote]

The electronic equivalent of cash is known as ‘central bank reserves’, and in practice banks use this type of money to settle transactions between them:

[sws_blockquote_endquote align=”left” cite=”Bank of England” link=”http://www.bankofengland.co.uk/markets/Pages/money/reserves/default.aspx” quotestyle=”style02″]Reserves accounts are effectively sterling current accounts for commercial banks – they are among the safest assets a bank can hold and are the ultimate means of payment between banks. Whenever payments are made between the accounts of customers at different commercial banks, they are ultimately settled by transferring central bank money (reserves) between the reserves accounts of those banks.[/sws_blockquote_endquote]

To recap:

1. Cash is issued by the state (via the Bank of England) and is used by the public to make payments.

2. Bank credit – the numbers in your account – is used by members of the public and businesses to make payments between each other. It is created by banks whenever they make loans. But most members of the public consider that the balance of their bank account represents ‘cash in the bank’, rather than being simply a number that can lose all its value if the bank goes bust.

3. Central bank reserves are an electronic equivalent of cash, held in accounts at the Bank of England. But central bank reserves can only be used by banks to make payments between themselves; no member of the public can get an account at the Bank of England.

Why Northern Rock Went Bust

In normal times, the payments between customers of different banks (using bank-created bank credit) tend to cancel each other out, and only a small amount of central bank money would be needed to settle the differences between banks at the end of each day. As a prime example of this, before quantitative easing, the total amount of central bank reserves that were used by the banks to settle between themselves was around the £20bn mark ((Bank of England figures for Central Bank sterling reserve balances)). This was enough to settle over £704billion of daily transactions((See the 2006 Payments Systems Oversight Report for figures on average payment flows)).

But Northern Rock went on a lending binge. Every new loan made created new money in the form of numbers in people’s accounts. These numbers could be used to make purchases, with payments using central bank reserves via payments systems such as Visa, Mastercard, BACS, direct debit, Faster Payments or any electronic funds transfer. Because Northern Rock was expanding its lending faster than other banks, at the end of each day it ended up having a net outflow of central bank reserves. That is why it had to borrow money (in the form of central bank reserves) from other banks, and indirectly from pension funds and other large investors. The borrowing was a way of bringing in central bank reserves to settle the huge outflows that lending at such a rate would have caused.

Northern Rock eventually went bust when, for a variety of reasons, no-one would lend central bank reserves back to it, and it was unable to make its outward payments through the settlement system. In this situation, the Bank of England lent Northern Rock more central bank reserves, in its role as lender of last resort.

Had Northern Rock instead expanded its lending – and created the type of money used by the public  – at the same rate as other banks, it would have found that its daily inflows of central bank reserves roughly matched its outflows (since the payments from its customers to other banks would be cancelled out by payments from other banks to customers of Northern Rock). It is unlikely that it would have become so dependent then on interbank lending to be able to make its payments. The very reason why Northern Rock went bust was the sheer speed at which it was creating money through issuing loans, which created a massive outflow of deposits which had to be settled by securing the reserves from somewhere.

Why Tim Worstall (and many others) get it wrong

Banking is a complex subject,  especially when liquidity, inter-bank settlement, and solvency issues come into play. Not many economists – and even fewer journalists – actually understand it.

Because it is such a complex subject, facile thought experiments like the one Tim Worstall gives below can be completely misleading.

[sws_blockquote_endquote align=”left” cite=”Tim Worstall” link=”http://timworstall.com/2012/07/14/ms-orr-succumbs-to-the-positive-money-loons/” quotestyle=”style02″]Think through this for a moment. If Northern Rock could just print money on its own computers then could they have gone bust in this manner?

No, clearly not.

Did Northern Rock go bust in this manner?

Yes, clearly so.

Therefore, Northern Rock could not print money on its own computers.

Death of the Positive Money thesis.[/sws_blockquote_endquote]

Misleading and logically flawed, but very convincing, especially to the slightly confused commentors who follow Tim’s post. One even goes to great lengths to argue that banks don’t create money, but concludes that ‘all electronic money that ordinary people use is FR bank-created leverage. Therfore 97% of the money used by ordinary people is indeed created by bank lending.  But that’s not the same as the money supply.” Bizarre.

It’s worth considering who’s most likely to be accurate: a Daily Telegraph journalist and the commenters on his blog, or the Deputy Governor of the Bank of England and other banking officials quoted here.

One final quote relevant to the issue under discussion:

[sws_blockquote_endquote align=”left” cite=”Anyone, anywhere, before anyone checked” link=”http://www.amazon.co.uk/Flat-Earth-News-Award-winning-Distortion/dp/0701181451″ quotestyle=”style02″]The world is flat.[/sws_blockquote_endquote]

Where To Learn More

The book Where Does Money Come From? is the most accurate account of the UK monetary system available at the moment, with a foreword by Professor Charles Goodhart, one of the UK’s leading monetary economists. The rear cover includes recommendations from Professor Victoria Chick, Emeritus Professor at University College London, and Professor David Miles, current member of the Monetary Policy Committee. One has to wonder if Tim also considers these people to be ‘loons’.

And in a couple of days I’ll release a paper answering the common objections and questions to the idea that banks create money. Watch this space.