What I would Have Said in the Herald

I have received in the last couple of days a number of inquiries as to whether, when and how I will respond to Don Brash’s latest exposition in the Herald of his understanding (or lack of it) of the banks’ role in money creation.

The answer is that the Herald – perhaps understandably – do not want to continue what they see as a “tit for tat” exchange.  The consequence is that Don Brash is left with the last word, and no further comment from me on this subject will appear in that paper.

If I had been able to publish a response in the Herald, I would have, first, queried why they thought it was wise or helpful to publish Brash again, since he said nothing new and simply repeated his earlier errors.  It certainly did him no favours – he succeeded only in further damaging his own reputation and in compromising the Herald by ensuring that their readers were left at best confused and with the erroneous impression that the matter is not settled but is still one of contention.

I would then have gone on to specify the precise errors and misapprehensions under which Brash seems to labour.

First, he chooses to assert that the banks (or rather, he says, “the banking system”) does no more than operate in effect a Keynesian multiplier, with which all economically literate people are quite familiar, and that it is only in that sense that it “creates” money.  No one disputes that money in circulation will enable a large number of successive transactions as it passes from one hand (or deposit account) to another.  But that has nothing to do with the matter at issue, which is – how is money in circulation created in the first place, and what role do individual banks play in that process?

On that subject, Don Brash has nothing to say, other than to deny (without any evidence or countervailing argument) what is now almost universally accepted – that the act of creating credit by an individual bank through placing a credit entry in a borrower’s account creates new money.

His second error is to ask, if it is the case that banks create money, why would they bother to do anything other than write cheques to themselves?

This simply betrays a failure to understand the process of money creation described authoritatively in the Bank of England paper.  As that paper says, “Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.”

“For this reason”, says the Bank of England, “some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

Commercial banks create money, in other words, by placing loans (or credits) into the bank accounts of borrowers.  They cannot of course write cheques to themselves (the money they create is by advancing credit to borrowers) and, in asking why they don’t do so if it is the case that they can create money, Brash is merely putting up a straw man so that he can apparently knock it down.

The banks do of course need to have capital reserves of real money for prudential purposes in case of a run on the banks. They have no capacity to create money for this purpose, but, as the Bank of England explains, “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 [central] Bank.”

Brash’s third and most important error is to dismiss the increasingly weighty opinion of most of those – like the Bank of England – who have studied the role of the banks in money creation.

In its 2014 paper, for example, the Bank of England says that “in reality in the modern economy, commercial banks are the creators of deposit money…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.

Bank deposits make up the vast majority – 97% of the amount [of money] currently in circulation.  And in the modern economy, those bank deposits are mostly created by commercial banks themselves.”

The paper’s conclusions are  accepted by almost all leading economists, including Lord Adair Turner (former Chair of the Financial Services Authority in London­­­) and Professor Richard Werner of Southampton University, and were foreshadowed (in a 2008 paper) by the Reserve Bank of New Zealand itself.

Brash, however, seems unable to understand the process described by the Bank of England.  I had earlier thought that his denial that commercial banks were responsible for creating most of the money in circulation had to be either a deliberate attempt to mislead or the consequence of simple ignorance.  But, since he states that he “is aware” of the Bank of England paper (and has therefore presumably read it), I can only assume that his continued denial of what that paper tells us is the consequence of intellectual limitations.

It is very frustrating that what is now a virtually undisputed truth has been continually confused by palpable errors in Brash’s contributions and that they have been lent some unjustified credibility by their publication in the Herald.

I should be grateful if this posting could be given the widest possible circulation.

Bryan Gould

8 May 2017