Former Top Regulator: Mainstream Economics Doesn’t Understand Banks

November 15, 2015 Updated: November 17, 2015

Economics as a science has a terrible track record. Time and again the “dismal science” misses predictions or whole financial crises altogether.

The problem: Mainstream economics ignores the fact banks create and manage our money, and the whole system stands and falls with the process.

Regulators like the Federal Reserve or the Securities and Exchange Commission do as well. They are still making up reasons today why the financial crisis of 2008 was impossible to predict.

That is, all regulators except for one: Lord Adair Turner, the former head of the British Financial Services Authority (FSA) is confronting this problem head on in his book “Between Debt and the Devil,” following economists outside the mainstream like Steve Keen and Hyman Minsky.

Banks create credit money and purchasing power.
— Adair Turner, chairman, Institute of New Economic Thinking

“[Mainstream economics] is mathematically very sophisticated, but totally unrealistic. One of the ways that it’s totally unrealistic is in its representation of the banking system,” he said.

Most people believe banks attract money from depositors and then lend out that money. This is not true.

“Banks create credit money and purchasing power. It’s mathematically the case that once a bank creates a loan, there is a bank liability and there is purchasing power,” said Turner.

When somebody takes out a mortgage, the bank creates a deposit for the consumer with the push of a button. It does not have to get this money from somewhere else and the consumer can go and buy a house with the deposit. This is why the process creates purchasing power.

On the other side of the balance sheet, the consumer now owes the bank the amount he spent on the house and has to pay it back over time and with interest.

Nobody Knows

Why does mainstream economics ignore this crucial method of money creation? “I think it developed a desire to model the system in a highly mathematical fashion and it turns out it is much easier to do if you just ignore the banking system,” Turner said.

“This concept is something very well understood by early 20th century economists such as Knut Wicksell or Friedrich von Hayek, but it went out of the way of thinking from about the 1960s onward,” he said.

Why do regulators ignore this factor when it has been proven to be an accurate predictor of financial crises?  

“Experts are very slightly detached from real economic theory as well as from reality. I find it a bit of a mystery because it has become very obvious that this is a fundamental understanding of the economic process,” said Turner who also didn’t know about this problem when he started as the head of the FSA in 2008.

But he began to ask questions and eventually did enough research to come to the conclusion, “There is a huge difference between what our textbooks said banks did, and what they actually do.”

In addition to regulators and academics he also said most bankers don’t have a clue.

“Whether the banks directly influenced the academia on this particular issue of ‘let’s cover the fact that we create credit, money, and purchasing power,’ I’m not so sure because I think the funny thing is a lot of bankers themselves don’t understand that’s what they do.” Each is just a cog in the wheel of a system the totality of which they don’t grasp, according to Turner.

Imperfect System

But not only do people not know about the system, it’s also very inefficient. Aside from the fact it causes financial bubbles, like subprime, it also hurts the very people it is supposed to benefit—even in normal times.

You had politicians who wanted the banking system or the capital market system to lend as much money as easily as possible.
— Adair Turner, chairman, Institute of New Economic Thinking

“Lots of easy credit is terrible for the person who doesn’t yet own a house because it pushes up the price of houses to a level where they can only afford it by taking on levels of debt, which are a threat to their sustainability,” said Turner. The relentless creation of new mortgages either pushes people to rent or creates a financial bubble.

This did not concern banks, however, which only care about expanding their balance sheets, nor did it concern politicians.

“You had politicians who wanted the banking system or the capital market system to lend as much money as easily as possible to householders to enable people to feel like they were participating in the American Dream despite not receiving any increase in real wages,” Turner said.

An efficient system looks different.

Controlling Bank Money

In order to control banks’ creation of money, Turner suggests using two different methods.

On the one hand, regulators can force banks to increase their statutory capital, or the money shareholders have to put up. Currently it’s 4.5 percent of risk-weighted assets, according to Basel III regulations. If increased to 10 or 20 percent, more money would be taken up by idle capital instead of new loans.

This means banks would have to raise new capital by issuing new shares and diluting old shareholders.

“If you can get that new equity issue from the private market, very well, if you can’t, the government will subscribe to that equity, which you may not want,” said Turner. By increasing capital this way, the economy could avoid a credit crunch.

On the other side of the balance sheet, regulators can control how much cash needs to be parked at the central bank, which limits new money creation.

At this moment, banks holding more than $100 million in assets can loan out or “create” up to 10 times as much money.

Turner suggests a reserve ratio of 15 percent. So instead of creating $9 for every dollar deposited at the Fed, banks could only create $5.66, a significant reduction in bank credit.

“On the reserve asset side, which basically says we’ve got to control what’s called the banking multiplier—that’s the relationship between the monetary base and the credit money—we couldn’t suddenly put it to a 20 percent ratio, but gradually increase it to 15 percent” said Turner.

That would be a first step toward reining in bank credit.