In my last column, I explained how both governments and banks create money. The basics are incredibly simple—so simple, in fact, that the great non-mainstream economist John Kenneth Galbraith once commented that:
“The process by which banks create money is so simple that the mind is repelled. Where something so important is involved, a deeper mystery seems only decent.”
Figure 1 shows the almost offensively simple actions that create money. Banks put dollars, per year, into the deposit accounts of their customers, matched dollar for dollar by recording dollars, per year, additional debt owed by their customers. Governments put dollars, per year, into the bank accounts of their citizens, and the same funds, dollar for dollar, into the reserve accounts of the banks.
There are more steps involved, as I explained in my last column, but there is no “deeper mystery”: banks and governments can both create money simply because they can both enter numbers into bank deposit accounts. That’s it.
This wouldn’t matter if these were just witless stories believed by people of no consequence. But, unfortunately, they’re stories believed by economists who often have substantial power over economic policy. These stories can, then, have incredibly detrimental effects on the real economy.
For instance, guess what Charles Plosser, former president of the Federal Reserve Bank of Philadelphia, was most worried about during the depths of the Great Recession in December 2009, when unemployment in the United States reached 10 percent?
Laid out this way, it’s easy to see why QE did very little to increase the money supply, while COVID-19 payments radically increased it.
Quantitative easing with banks creates no money: it simply reduces the value of the bonds held by the banking sector and increases the value of their reserves by just as much. In this way, it reverses the standard process of the Treasury issuing bonds equal to the deficit. The only way this could create money would be if banks lent out these excess reserves—which neoclassical economists like Plosser and former Fed chair Ben Bernanke thought would happen. As Bernanke put it:
This was a false hope, born of a bad model of how money is created, as I’ll explain shortly.
Quantitative easing with NBFIs does create money—but NBFIs aren’t free to spend this money on goods and services from the physical economy. Instead, their first use of the funds must be to buy what they are permitted to buy when they receive money: shares, properties, etc.—i.e., financial assets. This increased money dramatically affected asset prices, but there was only a small spillover effect into the real economy, such as increased salaries of NBFI staff, NBFI profits, purchases of goods from the physical economy (computers, data services, etc.). So, this aspect of QE directly increased the amount of money in the financial system and indirectly increased the amount of money in the physical economy by a much smaller amount.
COVID-19 payments, on the other hand, created money that went directly to households and corporations in the physical economy—as opposed to the FIRE (finance, insurance, and real estate) sector. They were free to spend this money as they wished—and we got a sudden boom as a result, with the rate of growth of the money supply jumping abruptly, from 7 percent per annum in February 2020 to 23 percent per annum in June 2020, and reaching a peak rate of growth of 27 percent per annum in March 2021.
- By showing reserves going down and deposits going up, which breaks the fundamental law of accounting (see the first row of Figure 5); and
- By showing reserves going down and loans going up (see the second row of Figure 5).
Cash loans may have been commonplace in the 19th century, but this is the 21st century. Banks lend, very simply (as shown in Figure 1), by increasing their loans and deposits by the same amount. Reserves are irrelevant—or, rather, they’re an afterthought.
If policymakers had simply understood the accounting of money back in 2008, rather than believing in mainstream economic theory, then fiscal policy could have been used strongly to stimulate the economy out of its slump. But because they believed these false, mainstream economic models, America struggled through the slowest recovery in its economic history.
There are serious consequences to being wrong about how money is created.
Notes1. John Kenneth Galbraith, “Money: Whence It Came, Where It Went” (Houghton Mifflin: Boston, 1975, p. 22).
2. Ben Bernanke, “The Federal Reserve’s Balance Sheet: An Update,” in “Federal Reserve Board Conference on Key Developments in Monetary Policy” (Washington, D.C.: Board of Governors of the Federal Reserve System, 2009, p.5).