Text 1–5 and 9–11 October 2012.
Ideas 25 and 27 September and 5/6 October.
Most people are familiar with money from early childhood. So they know what money is and understand how it works.
When they read about money creation and money destruction, they think they understand that too.
Money creation is when afterwards there is more money than there was before.
Money destruction is when afterwards there is less money than there was before.
Simple. But is it? No, it’s not!
Money creation and money destruction are notions from monetary theory, a subbranch of economics. They are based on definitions of various kinds of money. Those definitions are used by central banks, non-central banks, economists and statisticians, to measure the money supply. And they are what they are for a reason.
Those definitions of money largely correspond to what people in everyday life think money is. But not quite! There are important differences!
If you deposit money in a long-term savings account, it is no longer money. (This is true in the eurozone, but not in the USA.)
Coins and banknotes are money, but they are not money while they are in a bank.
If you take out a bank loan, that loan itself (the claim of the bank on the borrower) is not money. The amount being available to the borrower, however, is money.
If that loan is a mortgage loan (home-equity loan), the loan amount is used to pay the former owner of the house which is purchased. That former owner will usually use part of the amount to redeem his mortgage loan. In doing so, that part of the money stops being money.
Shares and bonds are not money. But they do have value, and they are assets on the balance sheet of a company that owns them.
Money in an account that a bank has with another bank, is not money. That is true regardless of whether either bank is the central bank or a non-central bank.
So the reserves that banks keep with the central bank, under the minimum reserve requirement, are not money. They do however play a vital role in regulating the quantity of money, in other words, the money supply.
So what are those definitions in monetary theory, that have such seemingly weird consequences? Why is money so counter-intuitive and so often different from money?
In May 1961 the Federal Reserve Bank of Chicago issued a document called Modern Money Mechanics. It was revised several times, most recently in June 1992.
I quote from the top of page 14 in the PDF:
“Money has been defined as the sum of transaction accounts in depository institutions, and currency and travelers checks in the hands of the public.”
And in the Introduction, in the right column of page 2 (see here in Wikisource) we read:
“Today, in the United States,
money used in transactions is mainly of three kinds —
currency (paper money and coins in the pockets and purses
of the public); demand deposits (non-interest bearing
checking accounts in banks); and other checkable deposits,
such as negotiable order of withdrawal (NOW) accounts, at
all depository institutions, including commercial and
savings banks, savings and loan associations, and credit
Since $1 in currency and $1 in checkable deposits are freely convertible into each other and both can be used directly for expenditures, they are money in equal degree. However, only the cash and balances held by the nonbank public are counted in the money supply. Deposits of the U.S. Treasury, depository institutions, foreign banks and official institutions, as well as vault cash in depository institutions are excluded.”
The Board of Governors of the Federal Reserve System defines the money supply here, and I quote:
“The money supply is commonly defined to be a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, U.S. currency and balances held in checking accounts and savings accounts are included in many measures of the money supply.”
The European Central Bank (ECB) gives the following explanation of money aggregates: (click on “Background”), from which I quote:
“Monetary aggregates comprise
monetary liabilities of MFIs and central government
(post office, treasury) vis-à-vis non-MFI euro area
residents excluding central government.
M1 is the sum of currency in circulation and overnight deposits; M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months; and M3 is the sum of M2, repurchase agreements, money market fund shares/units and debt securities up to two years.”
MFI means Monetary financial institution. Probably roughly the same as what FEDs call a ‘depository institution’.
The bottom line is this:
Money in the monetary sense is the money that the public (i.e. households and companies) have available for spending.
What is immediately available is M1. What can become available immediately and after some time is M2/M3. What is unavailable or only available after a long time, is not money at all!
These definitions make sense, because they define the quantity of money, the money supply, the quantity of money people can spend.
And it is that quantity that is vital for inflation. Keeping the inflation low, by controlling the money supply, is one of the most important tasks of any central bank. Therefore what central banks want to know and need to monitor, is the quantity of money supply and not money supply!
Now let’s check some of the above examples, to see if they are really according to the definitions of money.
This will also give us a better insight into what money creation really is!
If you have money in a checking account (i.e. an on demand account) and transfer it to a savings account, it is no longer M1 money. So in a way, money destruction has taken place.
But clearly not money destruction, because the money in that savings account still has value, and the depositor is still the owner – meaning the depositor has a claim on the bank in the amount of the deposit.
Under ECB definitions, if the savings account has a maturity of up to two years or a notice period of up to three months (following ECB definitions), the money in the account, although no longer M1, is still M2/M3. So in a way, this money is still money, because M2/M3 is also a form of money.
If however the savings account has a maturity period of more than two years, or a notice period of more than three months, depositing money in it, means it is no longer M1 and also not M2/M3. In other words, it is no longer money at all. It is however still money, it still has value and the bank didn’t steal it.
(The US Fed does not make a distinction based on the maturity period or notice period, but does consider deposits below 100,000 dollars as M2, and above that only as M3. Since March 26, 2006, the Fed no longer publishes the M3 monetary aggregate.)
Coins and banknotes (which are both clearly money and have value) are not money when they are in a bank’s till of vault.
So if you deposit cash money in a bank, you destroy money. However, in return for that deposit, you get a higher claim on the bank, because the bank credits the amount to your transaction account.
That claim is money, so in addition to the money destruction just mentioned, there is money creation to the same amount. The net effect for the money supply (which is the total quantity of money) is nil.
In fact, this was Step 1 in my very first article in this series.
That cash in bank is not money also has consequences for Step 2 in that article. In Step 2, cash money leaves the bank and gets into the borrower’s wallet.
According to the monetary definitions of money, that is the moment when that money becomes money (M1)! So that is the time of the money creation: there is more M1 than there was before.
But this money creation is not money creation: the physical coins or banknotes exist now as they existed before. They only changed position, from ‘in the bank’ to ‘in the hands of the public’, and that causes money creation, due to a definition of money that makes sense.
With a different way in which banks create money, which I described in my 10th article, we see a similar effect as what was explained right above.
In terms of money (the intuitive, everyday kind) as much financial value is added to the debit side as to the credit side of the bank’s balance sheet.
The bank makes the loan amount available to the borrower, i.e. the bank promises to supply that money whenever the borrower needs it and want to spend it. This is recorded in the bank’s book at the credit side, because it is a promise, a pledge, an obligation, a liability by the bank.
The same amount is also recorded at the debit side, the asset side. There it represents the fact that the borrower, at some point in time will have to pay the amount back to the bank. This debit posting represents the loan. It is a claim of the bank on the borrower, so it is an asset from the point of view of the bank (and a liability as seen from the borrower).
So in terms of money, debit is offset by credit.
In terms of money however (the monetary, technical kind), only the credit side counts. The claim of the borrower on the bank is M1. The claim of the bank on the borrower is not M1. Hence: money creation. But not money creation!
That’s why what I said in that previous article (no. 10), is true: money creation is a reality, but it doesn’t make the bank any richer!
The monetary definitions of money aggregates make sense for the purposes they are used for. However, they do not correspond to what people in everyday life intuitively understand as money.
Money creation is intimately tied to those monetary definitions. Most people do know what money is, but misunderstand money. Consequently, they also misunderstand money creation.
They think it is also money creation, but it isn’t. Therefore they think banks that create money are fraudulent.
In reality, banks that create money (automatically and inadvertently, as an unavoidable side-effect of credit granting!) do not also create money.
In fact, in hindsight, the two interpretations of the notion of ‘money’ I distinguished in this article, are two of the well-known functions of money:
What I typeset as money represents money as a medium of exchange.
What I typeset as money largely represents money as a unit of account (also in a way as a standard of deferred payment and as a measure of value).
For example, you can estimate the value of a house as an amount of dollars or euros. But that doesn’t make that amount a medium of exchange (as long as the house does not actually change owners) and it isn’t part of the money supply.
Also, the remaining principal of a bank loan can be expressed in dollars or euros etc., as the case may be. But that doesn’t make that amount (how much the borrower still owes the bank) a medium of exchange.
So we could also say that money creation is so ill-understood by many, because they do not properly distinguish between the various functions of money. Money creation involves an enlargement of the money supply, and in the notion of money supply, money is only looked at as a medium of exchange, not in any of its other possible roles.
Copyright © 2012 R. Harmsen. All rights reserved.