Dynamicland has a neighbour, Multiplyland – and they’ve invented banks. It’s such a great innovation that Bob moved to Multiplyland, so he can put his savings in one. Because Dynamicland has inflation, Bob’s savings stored in a shoebox under his bed gradually become worth less and less – as prices rise, he can buy less with them – but in Multiplyland he can put the savings in a bank and earn a little bit of interest that keeps the value of his savings at least in line with the prices of his goods.
But how do the banks afford to pay this interest? The banks are taking in deposits from many savers, and ending up with a large stock of cash. They then lend some of this cash to the firms that want to invest (or consumers that want to buy now and pay later), and charge them a higher rate of interest, making a profit in the difference between the two rates.
But how can they lend out other people’s money? Simple – they know that their customers are not all going to turn up on the same day and want their money. They just need to keep a fraction of these deposits in reserve, and the rest can be loaned out – hence this is known as “fractional reserve banking”.
This means that savings can become investment funding for others. So in fact, the Government doesn’t need to lend the money to businesses, it can stay right out of it. If we count the money supply as the value of people’s bank accounts, and also the cash in circulation outside banks (and we do in the real world, by the way), then this process is actually increasing the money supply – when Bob deposits £100 in his savings account it is counted as part of the money supply, but so is the proportion of those savings that the bank then lends out to another customer.
However, there is a limit to how much money can be created. The bank cannot lend out all of its deposits, it needs to keep some in reserve – let’s say it keeps 10%. So if Bob deposits £100, the bank puts £10 in reserve and lends out £90. Suppose the recipient of this loan spends this £90 and the shopkeeper banks it. The banks now keeps £9 in reserve and lends out £81… And so it carries on, until the original £100 saving multiplies up to £1,000 in the money supply. So to control the quantity of money in the money supply, the Government needs to control the amount of cash it prints, assuming it will be multiplied by the reserve ratio – it could even set a legal limit to the reserve ratio to stop the money supply growing uncontrollably.
What a great model! Rather than causing the paradox of thrift, personal saving is essential as it becomes the source of credit that is so vital to the functioning of the economy (as explained in this post). This is known as “intermediation” – banks are said to intermediate between savers and borrowers, lending out people’s savings to those who need credit, thereby keeping the money flowing in the economy. And the Government doesn’t have to get involved in the question of making loans to businesses or households, it can leave that to the private sector in the form of the banks – the market will regulate everything. The Government just has to keep an eye on the size of the money supply, regulating the amount of cash in circulation, which is then multiplied up by the banks.
And this is the model that economics textbooks present – fractional reserve banking and intermediation is presented as how banking and money creation work in the modern economy. All these weeks we’ve been working with highly unrealistic models, and now here we are with a textbook model. Unfortunately, this model is equally unrealistic – banking and the creation of money do not work like this. Some would say that the textbooks present a simplified model for the purposes of instruction, while Charles Goodhart, a member of the Bank of England Monetary Policy Committee for 13 years, described it as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.”
In about 4 weeks I will explain how the money and banking system actually works in the real world (providing authoritative references), but for now, a couple of quick points.
First of all, the description given here (which I have based on Mankiw’s Principles of Economics, one of the best-selling textbooks) describes a bank physically receiving notes, keeping some and loaning out others. But in today’s economy money is electronic (cash is about 3% of the money supply). There was a time when cash was more dominant – money was physical. But when real money was gold coin, UK banks would keep the gold in reserve and then print their own banknotes promising to pay that gold to the bearer – it wasn’t the Government controlling the money supply. When the Government made this practice illegal (in a phased manner, with the Bank of England Act 1844), the cheque gradually became more important. This may seem pedantic, but it actually makes a big difference – so we will look at this in 2 weeks, as grasping the significance of this will be helpful when we look at how banking actually works.
Secondly, no Government/Central Bank has ever actually sought to control the quantity of money in the money supply. This is a myth perpetuated by textbooks. See, for example, this paper by the Bank of England, page 8, first column. Having described how the system actually works, note that they state:
“This description of the relationship between monetary policy and money differs from the description in many introductory textbooks, where central banks determine the quantity of broad money via a ‘money multiplier’ by actively varying the quantity of reserves… Neither step in that story represents an accurate description of the relationship between money and monetary policy in the modern economy.”
In the future I will write a series of posts looking at how monetary policy actually works, and how it has evolved historically, taking in quantitative easing and the massive changes brought about by the financial crash. It’s a really fascinating area and critical to understanding how the monetary system works, but I’m afraid you won’t find any detailed (or indeed accurate) account in a standard textbook.
Coming back to our analogy of the engine, we’ve picked up the banking component, fitted it according to the textbook instructions, and now we’ve discovered that we’ve fitted it wrong. But it’s still interesting to reflect on what impact such a system would have on the process of saving. We will look at this next week, and we will gain insights that will be useful in understanding the real world economy.