guardian | Back in the 1930s, Henry Ford is supposed to have remarked that
it was a good thing that most Americans didn't know how banking really
works, because if they did, "there'd be a revolution before tomorrow
morning".
Last week, something remarkable happened. The Bank of England let the cat out of the bag. In a paper called "Money Creation in the Modern Economy",
co-authored by three economists from the Bank's Monetary Analysis
Directorate, they stated outright that most common assumptions of how
banking works are simply wrong, and that the kind of populist, heterodox
positions more ordinarily associated with groups such as Occupy Wall Street are correct. In doing so, they have effectively thrown the entire theoretical basis for austerity out of the window.
To
get a sense of how radical the Bank's new position is, consider the
conventional view, which continues to be the basis of all respectable
debate on public policy. People put their money in banks. Banks then
lend that money out at interest – either to consumers, or to
entrepreneurs willing to invest it in some profitable enterprise. True,
the fractional reserve system does allow banks to lend out considerably
more than they hold in reserve, and true, if savings don't suffice,
private banks can seek to borrow more from the central bank.
The
central bank can print as much money as it wishes. But it is also
careful not to print too much. In fact, we are often told this is why
independent central banks exist in the first place. If governments could
print money themselves, they would surely put out too much of it, and
the resulting inflation would throw the economy into chaos. Institutions
such as the Bank of England or US Federal Reserve were created to
carefully regulate the money supply to prevent inflation. This is why
they are forbidden to directly fund the government, say, by buying
treasury bonds, but instead fund private economic activity that the
government merely taxes.
It's this understanding that allows us to
continue to talk about money as if it were a limited resource like
bauxite or petroleum, to say "there's just not enough money" to fund
social programmes, to speak of the immorality of government debt or of
public spending "crowding out" the private sector. What the Bank of
England admitted this week is that none of this is really true. To quote
from its own initial summary: "Rather than banks receiving deposits
when households save and then lending them out, bank lending creates
deposits" … "In normal times, the central bank does not fix the amount
of money in circulation, nor is central bank money 'multiplied up' into
more loans and deposits."
In other words, everything we know is
not just wrong – it's backwards. When banks make loans, they create
money. This is because money is really just an IOU. The role of the
central bank is to preside over a legal order that effectively grants
banks the exclusive right to create IOUs of a certain kind, ones that
the government will recognise as legal tender by its willingness to
accept them in payment of taxes. There's really no limit on how much
banks could create, provided they can find someone willing to borrow it.
They will never get caught short, for the simple reason that borrowers
do not, generally speaking, take the cash and put it under their
mattresses; ultimately, any money a bank loans out will just end up back
in some bank again. So for the banking system as a whole, every loan
just becomes another deposit. What's more, insofar as banks do need to
acquire funds from the central bank, they can borrow as much as they
like; all the latter really does is set the rate of interest, the cost
of money, not its quantity. Since the beginning of the recession, the US
and British central banks have reduced that cost to almost nothing. In
fact, with "quantitative easing" they've been effectively pumping as
much money as they can into the banks, without producing any
inflationary effects.
What this means is that the real limit on
the amount of money in circulation is not how much the central bank is
willing to lend, but how much government, firms, and ordinary citizens,
are willing to borrow. Government spending is the main driver in all
this (and the paper does admit, if you read it carefully, that the
central bank does fund the government after all). So there's no question
of public spending "crowding out" private investment. It's exactly the
opposite.
Why did the Bank of England suddenly admit all this?
Well, one reason is because it's obviously true. The Bank's job is to
actually run the system, and of late, the system has not been running
especially well. It's possible that it decided that maintaining the
fantasy-land version of economics that has proved so convenient to the
rich is simply a luxury it can no longer afford.
But politically,
this is taking an enormous risk. Just consider what might happen if
mortgage holders realised the money the bank lent them is not, really,
the life savings of some thrifty pensioner, but something the bank just
whisked into existence through its possession of a magic wand which we,
the public, handed over to it.
Historically, the Bank of England
has tended to be a bellwether, staking out seeming radical positions
that ultimately become new orthodoxies. If that's what's happening here,
we might soon be in a position to learn if Henry Ford was right.
