Banks really are magic money trees

Banks really are magic money trees. We disagree with Thomas Hale’s assessment that such a description is misleading (Are banks really magic money trees?, 20 November 2019). Rather, it’s a useful frame that offers some crucial insights into the role they play in the economy.

Banks’ ability to create money via simple accounting entries has vast macroeconomic consequences. The constraints on their power are often overstated. The failure of mainstream economics to fully appreciate that power stopped it anticipating the 2008 crisis, and is a continuing barrier to building a banking system that serves society’s interests. 

As the primary creators of money in our economy, banks have a significant impact on levels of financial instability, inequality, innovation, employment, and overall economic activity. The potential negative consequences of this were clearly demonstrated by the 2008 crisis, as banks inflated a colossal asset bubble by creating too much money for speculation in real estate and financial markets. Once the excessive growth of private debt started to prove unsustainable, they restricted credit creation, the system crashed, and the wider economy ended up suffering the consequences. Governments’ failure to provide adequate stimulus only deepened this suffering. 

It would of course be wrong to claim that banks’ money creation powers are entirely without limits. [Whether this is necessarily implied by the ‘magic money tree’ frame, we’ll leave the reader to decide]. But the constraints that exist in theory are much weaker when applied in practice.

Hale considers the constraints outlined in the 2014 Bank of England report, ‘Money Creation in the Modern Economy’. He rightly identifies that although the need for individual banks to access reserves might represent a theoretical brake on lending, this is not an issue in the real world. 

Banks’ lending decisions are made based on profit expectations, not reserves. As a result, banks tend to expand lending simultaneously, given that the circumstances that lead to higher profit expectations apply to all banks. In this situation, the banking system’s lending is not constrained by the prospect of lower profitability in the way that an individual bank’s lending would be if it were to attempt to expand its balance sheet more rapidly than other banks. 

The Bank of England unequivocally states that reserves are not a binding constraint on lending. The Bundesbank is also clear on this issue: “a bank’s ability to grant loans and create money has nothing to do with whether it already has excess reserves or deposits at its disposal.” 

Hale lists two other limits mentioned in the Bank of England report. The first is monetary policy, which he says “can change the incentives of commercial banks to make loans.” But monetary policy has a relatively weak and indirect effect on levels of lending and investment. The Bank’s policies have both failed to restrict lending pre-crisis and failed to stimulate lending in the years since. 

The other limit that the report mentions is the behaviour of companies and households, but this section is actually about what households and companies do with newly-created money – it does not outline any constraint on lending. Nonetheless, of course, there must be a demand for loans from households and companies in order for banks to make loans, but this does not contradict the fact the banks can meet this demand at will.

Lastly, Hale adds capital requirements as a further limit. Capital requirements are indeed important, but they need to be far higher in order to have any significant effect. Even then, as Lord Adair Turner (ex-Chairman of the Financial Services Authority) argues, “capital requirements do not place an absolute constraint on credit growth, since bank equity can grow whether central bank/regulators want it to or not”. Any potential constraining impact of capital requirements can also be diminished through securitisation.

Hale suggests that labeling banks as ‘magic money trees’ offers nothing new to mainstream economics. He claims that the point that bank lending creates deposits “is now generally agreed upon” by economists. 

Unfortunately, misconceptions about bank lending are present as ever in the vast majority of economics textbooks (e.g. Mankiw’s famous Macroeconomics), and have been repeatedly promoted by Paul Krugman in the Wall Street Journal. As our most recent response to this ongoing status quo, Positive Money is collaborating on a campaign with 50+ organisations and individuals to rethink the role of banks in economics education. 

The difference between the system that the Bank of England explains and the one described by most economists is not just a “linguistic disagreement” as Hale suggests. It is a very real disagreement about the role of reserves in the banking system, and the way in which banks make lending decisions. And it is the disagreement that meant the majority of mainstream economists didn’t predict the 2008 financial crisis, unlike heterodox economists such as Wynne Godley, Ann Pettifor and Steve Keen.

Mainstream economic models further display the extent to which most economists fail to understand that banks don’t lend out or ‘multiply up’ reserves. Even after the crisis that they failed to predict, most DSGE models (dominant in neoclassical economics), either assume no banks at all, or assume that banks need deposits to lend. Consequently, they still fail to accurately model banks and capture their far-reaching impact on the economy.

Compared to the flawed image of banks as ‘intermediaries’ between savers and borrowers, conveying banks as ‘magic money trees’ more effectively captures the power they have in the monetary system and questions the inherent nature of money. This, in turn, opens up discussion on the role of banks in the economy at large.