The veil of deception over money: How central bankers and textbooks distort the nature of banking and central banking

This paper from the Real World Economics Review argues that we are being intentionally and systematically misled about the nature of money and about the role of central banks and commercial banks in the monetary system.

“We are led to believe by central bankers and by textbooks, like the ones of Krugman and Wells (2009) and Mankiw and Taylor (2011), that central banks have always been government institutions acting in the public interest. In reality, central banks’ historical origin and role had more to do with the desire of private bankers to control and coordinate the process of private sector money creation. That most money is created in the private sector is something that central bankers like to gloss over and textbooks “explain” in a distorted and unnecessarily convoluted way.”

The author Norbert Häring (economics correspondent of Handelsblatt, the German business daily and co-director of the World Economics Association and co-editor of the World Economic Review) examines the rhetoric of two central bankers, Jens Weidman and Otmar Issing, regarding the process of money creation, inflation and the role of central banks. He also examines how two widely used economics textbooks by Krugman and Wells and by Mankiw and Taylor treat the subject. He juxtaposes this rhetoric of central bankers and textbooks with the historical and current evidence. He argue that this rhetoric frames the minds of central bankers, other policy makers, academics and – through economic journalists educated with the same textbooks – the general public, in a very unfortunate way, which prevents them from understanding the current financial crisis and from drawing the right policy conclusions from it.

It’s not easy to choose a short extract from the paper – the whole paper (17 pages) is very much worth a read. Anyway, here are the highlights from the paper (our emphasis):

That most money is created in the private sector is something that central bankers like to gloss over and textbooks “explain” in a distorted and unnecessarily convoluted way.

In his speeches on money and inflation, Jens Weidmann does not utter a single word about money creation by commercial banks; he does not even mention commercial banks. Even though he is not explicitly saying so, all his remarks give the impression that only the Government via a government owned and controlled central bank issues money, and only for the benefit of the government.

Western central bankers rarely, if ever, make it explicit that commercial banks create money.

…for much of history, government was only indirectly involved in issuing banknotes, and had nothing like a monopoly on it.

…even where the government had or has this monopoly to issue notes, this is far from being a monopoly to issue money. Today, only a fraction of the money which circulates in the economy consists in cash issued by the central banks.

We make by far the largest part of our payments without using any government issued banknotes. We pay by transferring deposits at commercial banks to someone else and we receive our paychecks in the form of deposits in the bank, i.e. in electronic money, created by commercial banks.

This deposit money created by commercial banks is equivalent to legal tender for all practical purposes.

Even if the central bank were to control commercial banks’ money creation, it would still be done by commercial banks for the benefit of commercial banks (and at the risk of taxpayers who have to bail them out, if it goes wrong). Central bankers never, ever talk about the hugely profitable privilege that the ability to create legal tender means for commercial banks.

The equally apologetic treatment of commercial banks’ money creation by the textbooks is also highly misleading. 

They pretend that banks are mere financial intermediaries, collecting deposits, from a multitude of savers and passing them on as loans to companies, households and government.

[B]oth textbooks stubbornly insist that the process of money creation starts with cash being deposited in a bank. Deposits are created in the textbook examples, but they remain in the background. The textbooks rather focus on cash that is deposited in the bank and then is being lent out again as cash (with a small fraction retained in reserve), redeposited and lent out again.

In reality, the process typically will start with a bank giving credit to someone and in the process crediting this person’s bank account with the respective sum of deposit money, thus creating deposits, not intermediating them.

Mankiw and Taylor (p. 629) explicitly tackle the possible amazement of students that might arise from the fact that banks can create money out of nothing: “At first, this creation of money by fractional-reserve banking may seem too good to be true, because it appears that the bank has created money out of thin air”, they concede. Then they try to appease their readers’ minds by alerting them to the fact that no wealth is created by this creation of deposits, because “… as the bank creates the asset money, it also creates a corresponding liability for its borrowers.”

Here the explanation ends, even though here it would only start to get interesting. The bank creates “the asset money” for itself in the sense that the bank can demand interest on it. This is real wealth that the banks derive from their money creation. In the process they create a debt for someone else. For society, no wealth is created, that is true. But for themselves, their shareholders and managers, banks have created wealth and the rest of society has the debt.

There is a complete absence in all major textbooks of any mention of the pecuniary benefit, which banks derive from their role in “the money multiplier”. …If you present the money multiplier in the distorted way textbooks do, with banks appearing to be mere intermediaries, it is very hard to see this profitable privilege.

If you were to describe the process in the less convoluted, direct way, as it really happens, it would be obvious who gets to claim the value of the new money.

[C]entral bankers and prominent textbook authors share a desire to let us think that the creation of the vast majority of our means of payment by commercial banks for their own benefit is normal, harmless, without alternative and under the control of the central banks. Central bankers do so by avoiding any mention of private money creation or credit creation, and by pretending instead that central banks have a monopoly to create money. Textbook authors do so by distorting the process of money creation, using the rhetoric of the inappropriate loanable funds model. Their account of the role and legal status of central banks is highly selective and biased.

We highly recommend to read the whole paper.