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Seven restrictions to money creation

22 May 2017

Introduction

People often worry about credit granting by banks, and so about money creation, which is its automatic consequence, thinking both will get out of hand. But that is unlikely, because no less than seven factors or mechanisms exist, that can and will limit and restrict bank credit and money creation.

I mentioned those seven brake systems in the context of a series of responses to a debate, required as a result of a petition, held in Dutch Parliament in March 2016. I neither have the time nor the motivation to translate all of those articles (12 in number; a thirteenth article did appear in Dutch and English already).

But those 7 restrictions to money creation are interesting enough to have them described in English as well, also because they were relevant in a English-language discussion in which I took part, in reaction to an article by Simon Thorpe on his blog.

Seven brake systems

  1. The cash reserve requirement. This money creation limitation mechanism is not currently used by most central banks, but they can use it, if needed.

    QE (Quantitative Easing) in fact has the opposite effect: this policy creates extra cash reserves for banks, hoping that will enable them to grant more credit and thus stimulate economic growth. I personally do not think that will work, not on the scale on which it is done now, because of the other limiting effects that exist. See the following items.

    See also MMM (Modern Money Mechanics) from 1961–1992, for how central banks can increase bank reserves by buying securities.

  2. Capital reserve requirements. Banks should have more capital buffers to become safer and more stable, such is the general idea. The consequence is that either the interest margins (difference between interest received and paid by banks) must go up, and/or dividend must decrease, and/or there will be less room for credit granting.

    Another important point to consider is that increasing capital reserves sucks away money from circulation. It is the only form of profit appropriation that has his effect, all the other forms mean that bank profits (largely from interest) return to circulation, so they return to the economy, landing in the hands of other parties than banks.

  3. Central banks can discourage credits, and thereby try to decrease the money supply, by increasing the interest rate. In the other direction, lower interest rates may stimulate credits and enlarge the money supply.

  4. Credit granting always involves a risk for the bank. If perverse incentives are adequately eliminated, this risk will cause a healthy reservedness. Only households and firms with a sound revenue model and a good plan for paying interest and redemption terms, will get a loan. Others won’t. That may be disappointing, but it is better.

  5. For the borrower too there is a risk exposure. Not being able to pay is painful and disgraceful, and can have serious consequences: bank­ruptcy, mortgage foreclosure, residual debt, debt rescheduling. So sensible people only take out a loan if it is really necessary and only if they can afford it.

    Even then, you never know: losing your job, getting divorced, falling ill, these are all facts of life that happen to some, unpredictably.

  6. All loans need funding. Although money creation is a real phenomenon, a loan (at the left of the balance sheet) must have something at the right to back it.

    That can consist of savings. It means that if people are less willing and able to save money, savings become scarcer and more expensive for banks to collect. That can brake credit granting.

  7. Equity capital can also serve as funding for credits. If investors are less willing to buy new bank shares or want higher dividend, that type of funding becomes more expensive, which can discourage the extension of credit.


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