Lecture02A MoneyCreationAntiFractionalReserveBanking
Summary
TLDRThe lecture challenges mainstream economic theories about money creation, arguing that textbooks' explanation of fractional reserve banking is incorrect. It highlights that contrary to popular belief, banks do not simply lend out deposits but actually create money through lending. The speaker criticizes the lack of acknowledgment of this perspective by economists and textbook authors, despite central banks like the Bank of England and the Bundesbank refuting the traditional model. The lecture emphasizes the importance of understanding the role of money and credit in economic cycles, suggesting that mainstream economists' disregard for money creation leads to flawed economic models.
Takeaways
- 📚 Mainstream economists are criticized for not understanding the true nature of money and its creation, contrary to what is taught in traditional economics courses.
- 🏦 The concept of fractional reserve banking is often misunderstood; banks do not simply lend out deposits but actually create money through the lending process.
- 📉 The Bank of England and the Bundesbank have both refuted the money multiplier model, stating that bank lending creates deposits, not the other way around.
- 🤔 Despite evidence from central banks, mainstream economic textbooks and educators have largely ignored these findings, continuing to teach outdated models.
- 💡 Money creation is a complex process involving interactions between banks, non-banks, and central banks, not just a passive multiplication of reserves.
- 📉 The importance of understanding money creation is underscored by its impact on aggregate demand, income, and the cyclical nature of economies.
- 📈 Empirical data shows a strong correlation between credit fluctuations and economic cycles, including unemployment rates, contradicting the mainstream view that money is unimportant.
- 👷♂️ The role of government in money supply is significant, as it controls the creation of cash and sets reserve requirements, yet mainstream economists often overlook this.
- 🧩 Neoclassical economists tend to separate the 'real' and 'nominal' aspects of the economy, underestimating the influence of money on real economic outcomes.
- 🛠️ An alternative model for understanding money creation is presented, emphasizing the importance of accounting principles and the role of banks in the economy.
- 💻 The software package 'Minsky' is introduced as a tool for modeling the dynamics of money using double-entry bookkeeping, providing a more accurate representation of financial transactions.
Q & A
What is the main argument of the lecture regarding mainstream economists' understanding of money?
-The lecture argues that mainstream economists do not understand money, as they often teach and adhere to the fractional reserve banking model, which has been contradicted by central banks.
What is fractional reserve banking according to the lecture?
-Fractional reserve banking is a model where banks are said to lend out a fraction of their deposits while keeping a reserve, thereby supposedly creating more money through a money multiplier effect.
How does the lecture describe the Bank of England's stance on the money multiplier model?
-The lecture mentions that the Bank of England, in a 2014 paper, stated that the money multiplier model is wrong and that banks do not act as intermediaries lending out deposits nor do they multiply up central bank money to create new loans and deposits.
What does the lecture suggest about the real process of money creation in the economy?
-The lecture suggests that bank lending creates deposits, rather than banks lending out existing deposits, which is a perspective that contradicts the traditional fractional reserve banking model.
How does the lecture characterize the mainstream economic models' treatment of money?
-The lecture characterizes mainstream economic models as treating money as a 'veil over barter,' suggesting that they view money as nominal and not affecting the real side of the economy, which is a perspective the lecture criticizes as flawed.
What role does the lecture suggest the government plays in the money supply?
-The lecture suggests that the government is seen as being in control of the money supply through the creation of cash and setting the required reserve ratio, which has been used to blame the government for monetary problems.
What is the significance of the Minsky software package mentioned in the lecture?
-The Minsky software package is significant because it is designed to model the dynamics of money using the rules of double-entry bookkeeping, providing a tool to understand and demonstrate how banks create money.
How does the lecture relate the creation of money to the cyclical nature of the economy?
-The lecture relates the creation of money to the cyclical nature of the economy by stating that fluctuations in credit, which is influenced by the creation of money through bank lending, are the dominant factor behind the booms and busts of capitalism.
What is the lecture's view on the correlation between credit and unemployment?
-The lecture suggests a strong negative correlation between credit and unemployment, indicating that as credit expands or contracts, it has a significant impact on unemployment, which contradicts the mainstream view that money doesn't matter.
What is the 'R square' value mentioned in the lecture, and what does it imply about the relationship between credit and unemployment?
-The 'R square' value mentioned in the lecture is a statistical measure of how well the variation in unemployment can be explained by variations in credit. A high R square value implies a strong relationship, contradicting the mainstream view that there should be no relationship according to their theory.
What does the lecture suggest is the fundamental flaw in mainstream economic models regarding money?
-The lecture suggests that the fundamental flaw in mainstream economic models is their naive and false models of money, which ignore the role of banks, debt, and the creation of money in the economy's cyclical nature.
Outlines
📚 Misunderstanding Money Creation in Economics
This paragraph discusses the misconceptions mainstream economists have about money creation, particularly through fractional reserve banking. The speaker criticizes the teaching of money creation as a process where banks lend out a fraction of their deposits, a model popularized by economists like Greg Mankiw. The paragraph points out that central banks, including the Bank of England, have refuted this model, stating that banks do not lend out deposits but rather create deposits through lending. The speaker emphasizes the irony that despite being the subject of economics, mainstream economists often overlook the importance and function of money in the economy.
🔍 The Fallacy of Money as a 'Veil' Over Barter
The second paragraph delves into the historical perspective of neoclassical and classical economists who view money as a 'veil' that obscures the underlying barter economy. It criticizes the mainstream economic models for excluding banks, debt, and money, despite their significant roles in the economy. The speaker highlights the work of economists like Milton Friedman and Robert Lucas, who downplay the importance of money in influencing real economic outcomes, focusing instead on nominal values and inflation. The paragraph also touches on the erroneous belief that the government is solely responsible for money supply and economic stability, as reflected in statements by Ben Bernanke and the Federal Reserve's historical response to economic crises.
💼 The Real Dynamics of Money Creation and Economic Cycles
In the final paragraph, the speaker introduces an alternative view of money creation, emphasizing the role of bank lending in generating deposits and affecting aggregate demand and income. The paragraph refutes the mainstream economic belief that money is neutral and does not influence real economic variables like unemployment. The speaker presents empirical evidence showing a strong negative correlation between credit fluctuations and unemployment, contradicting the neoclassical view. The paragraph concludes with an introduction to the Minsky software package, a tool designed to model the dynamics of money using double-entry bookkeeping, which is fundamental to understanding the real-world impact of financial transactions and the cyclical nature of capitalism.
Mindmap
Keywords
💡Fractional Reserve Banking
💡Money Creation
💡Money Multiplier Model
💡Central Banks
💡Macroeconomics
💡Banking System
💡Accounting
💡Minsky
💡Economic Cycles
💡Neoclassical Economics
💡Inflation
Highlights
Mainstream economists misunderstand both production and money.
Fractional Reserve Banking is a common misconception about money creation.
Money creation is not a simple multiplier process as taught in textbooks.
Central banks have refuted the money multiplier model.
Bank lending actually creates deposits, contrary to mainstream economic theory.
Economists often ignore the role of banks, debt, and money in macroeconomic models.
Neoclassical economists treat money as a 'veil' over the real economy.
The quantity of money in nominal terms is considered unimportant by some economists.
Economists often separate the 'real' and 'nominal' sides of the economy, ignoring money's impact on the real side.
Governments are blamed for monetary problems due to their control over cash creation and reserve ratios.
The Bank of England and Bundesbank have clarified that bank lending precedes deposit creation.
Despite central bank clarifications, mainstream economics courses persist in teaching outdated models.
The creation of money is a result of interactions between banks, non-banks, and the central bank.
Private debt levels and credit fluctuations are key drivers of economic booms and busts.
An alternative model for money creation is presented using accounting principles and the Minsky software.
The Minsky software is a unique tool for modeling the dynamics of money using double-entry bookkeeping rules.
Financial transactions must balance with assets and liabilities, reflecting the principles of double-entry bookkeeping.
Transcripts
well in the last lecture I explained
that mainstream economists don't
understand production now I'm going to
explain in this lecture that they don't
understand money either so let's start
taking a look at this uh if you learn a
mainstream economics course you're going
to be taught that money is created by
what they're call fractional Reserve
banking I'm sure most of you have heard
that term already and this is from the
uh very popular for God Knows Why
macroeconomics exper by Greg Manu and uh
this is an old version because I'm
damned I'm going to pay for a new one um
but he says that the money system and
how it works uh he says the system of
fraction Reserve banking creates money
because each dollar of reserves
generates many dollars of demand
deposits and here's how he explains it
so he says we begin let's imagine a
world without banks and then suppose
there's
$1,000 and think of it actually physical
currency uh in circulation in the
economy now you introduce Banks and pay
that Banks take deposits but they don't
make loans so uh any money that is in
the bank that hasn't been LED out of
cord reserves and of course at the
moment the entire $11,000 in cash is now
in what he calls first bank and then if
you look at his accounting system he
says well they've got deposits of a
th000 which are their liabilities to
their depositors if the depositors want
their money back they've got to give
them the $1,000 and they've also got the
reserves which are the actual physical
cash that's been deposited by uh this
hypothetical Society in first
bank then let's say they start using
some of their deposits to make
loans this is fractional Reserve Banking
and the idea is that after what the bank
does is lend out
$800 uh in cash uh to somebody else uh
so now rather than having $1,000 in cash
as reserves it has $200 in cashes
reserves but $800 in loans which are
liabilities of other people towards the
bank and then if that b person has
borrowed that money deposits the money
in a second bank which he calls second
bank then Second Bank looks like this
they've got reserves of a of 800 sorry
the to total assets of 800 because they
deposited 800 then this Bank itself has
hung on to 20% of that 800 which is 160
and it's made more loans of 640 so what
you get is a process that starts off
with uh a th000 and then one minus the
Reserve ratio which is in this
particular case 20% the bank takes in
money lends out 80% hangs on 20% you
keep on doing it and ultimately through
this Chain Reaction process you create
five times as much money so you have
original 1,000 in cash which is created
by the government because nobody else is
allowed to create cash uh the reserve
ratio is also set by the government uh
so if anything goes wrong it's the
government's fault because the
government's in control of the money
supply and reserves also play an
essential role in lending but if you
talk to central banks who've looked at
this carefully now but last uh they'll
say this is wrong and this happened back
in
2014 initially with the bank of England
saying the money multiplier model is
wrong this is a paper it published in
quite a famous paper money in the modern
economy in introduction it says money
Creation in practice differs from some
popular misconceptions in other words
what the textbooks teach you Banks do
not act as intermediaries lending out
deposits nor do they multiply up central
bank money to create new loans and
deposits that's a strict a straight
contradiction of the textbook by a
central bank and then again they say
this is carrying on further rather than
Banks receiving deposits and lending
them out Bank lending creates deposits
to a very very different perspective and
the bunders bank rather more formally in
2017 says that if you look at the
creation of book money money in other
words not in the form of cash as a set
of straightforward accounting identities
to grasp that money and credit are
created as a results of interaction
between Banks non-banks and the central
bank they said A bank's ability to Grant
loans has nothing to do as whether it
has excess reserves or deposit of so
that's a complete contradiction of what
the textbook teaches so how do you think
the textbooks reacted to this this was
2014 and
2017 well they've completely ignored it
and my proof is a coners ation um on
Twitter that related around Greg manu's
blog one decade virtually after the bank
of England paper was published and
here's the blog entry he says the
importance of teaching fractional
Reserve banking which as I've said has
been contradicted in said it doesn't
happen by central banks now uh what you
find is they simply if they have read
they simply haven't comprehended more
likely they haven't read the paper at
all and if you think that's weird you're
right that's how weird economics is as a
discipline so here we have Jason Furman
who was the chairman of the U um I think
he was chairman under um Trump of the
economic advisory committee for the for
the United States government so he said
students have to learn uh how Banks
create money under fraction Reserve
banking why do they have to learn a
false model uh so I I just tweeted back
saying I simply despair if you lot ever
understanding how money is actually
created so why do they cling to a model
which central banks say is wrong uh well
this really comes back to the prehistory
of neoclassical economics and to some
extent main classical economics before
the neoc classicals they've always
treated money as something which is just
what they call a veil over barter so if
you remove the veil you'll see the
barter operations more clearly and they
also think that the amount of money uh
in the sense of it's nominal value uh
rather than a value deflated by by the
rate of inflation is what they call
money illusion and so macroeconomic
models by mainstream economists do not
include Banks or debt or money which is
ironic because most people without any
real knowledge of economic theory we
think well economists they must be
experts on money because hey that's what
economics is about it should
be one of the major issues but
ironically mainstream economists have
convinced themselves that money doesn't
matter so rather than being experts on
it they have naive models which are
false so here's fredman back in 1969
saying that nothing is so unimportant as
the quantity of money expressed in the
nominal money unit and here's Lucas who
was one of the main architects of the
microeconomics approach to macro that I
pulled apart in previous lectures um he
said it's natural to an economist to
view the cyclical relation between real
output and prices as arising from a
volatile demand schedule on a fairly
stable upward sloping Supply fairly jarg
and late and but here's the point he
says this leads to a paradox and it's
the absence of money
illusion on the part of firms and
consumers implies a vertical aggregate
supply schedule which means that
aggregate demand fuctions which are
purely nominal should only change prices
they shouldn't change real magnitudes so
they divide the world into real and
nominal and say that uh money affects
the inflation and nominal side of the
economy but it doesn't affect the real
side of the economy and and again coming
back to that idea I mentioned earlier
that they see the government as being in
control well the government creates cash
which is mainly a major part of N1 and
depositors put that in bank accounts and
the government also sets the required
Reserve ratio and by the way this has
been abolished in most countries on the
planet so we put those two together and
that means you can blame the government
for any monetary problems and this is
what they've done so here's Ben banki uh
who was governor of the D governor of
the Federal Reserve during the global
financial crisis he said the cause in
the decline during of M1 during the
Great Depression was a contraction in
the ratio of basa reserves which
reinforced rather than offset declines
in the money multiplier and this means
you can blame most of the pre- 1931
slowdown in the economy on the Federal
Reserve and then amusingly uh he was uh
a speaker at a 90th birthday party for
Milton fredman and here he says uh when
he was to a Deputy Governor rather than
full Governor uh regarding the Great
Depression you're right we did it we're
very sorry but thanks to you we won't do
it again and of course five years later
they did it again uh so let's look at
the real world in the real world and
I'll explain this in this particular set
of lectures Bank lending creates money
that adds to aggregate demand and income
and fluctuations in credit which is the
annual change in private debt are the
dominant factor of the behind the booms
and busts of capitalism so by ignoring
money mainstream economists are ignoring
the most fundamental part the cyclical
part of the economy so here I'm just
showing a a data on the level of private
debt which is the top graph up there
again I'll go go to my other screen to
show that so you have private debt going
from 50% of GDP right back at the end of
the second world war up to
170% at the financial crisis then
declining and then going up and down
during Co and when you look at the graph
below which shows credit which is the
colored line uh and unemployment they
are obviously negatively correlated one
goes up the other goes down and that
strongly contradicts the neoclassical
argument that money doesn't matter
because unemployment is clearly a real
phenomenon in the economy and the
variations in credit should not have any
relationship according to their Theory
but if you do a simple regression and
say what's the correlation uh the ask
squar between uh credit and unemployment
you get an extremely high R squar uh one
that should roughly be zero according to
the mainstream is over
0.5 so I can't just criticize I have to
have an alternative model and that is to
take a look at the creation of money as
they say is a straightforward set of
accounting entries so you have to
understand accounting and that's why I
invented the software package Minsky
which I'm hope you're having a chance to
play with already uh in the course so
here's the uh interface of Minsky and
it's what's called a System Dynamics
program but it's unique feature and it
really is the only program in the world
that does this it can model the Dynamics
of money using the rules of double entry
bookkeeping which are the foundation of
accounting and they are fundamentally uh
that you keep track of a person's assets
which are the things U that somebody
owns and that includes non-financial
assets by the way uh which I'll talk
about in a bit more detail detail later
and financial assets a non-financial
asset is something you own that is not a
which is your asset but it's not anybody
else's liability where a financial asset
is something a claim you have on
somebody else so when you look at
Financial assets your claim and which is
your asset and the liability you put
them together you get zero but of course
the real world impact is much larger
than zero so liabilities are promises
you've made to somebody else and your
financial assets your claims on other
entities other people other companies
and so on your financial liabilities are
what other entities have in claims on
you and the difference between the two
in your individual case is your net
worth your Equity as the accountant is
call it so that means there's a simple
rule saying assets minus liabilities
equals Equity or if you take liabilities
and Equity away from assets this is
financial assets you're going to get a
zero so what you've got going on in a
monetary economy is that any financial
transaction is going to have somebody
who buys and somebody who sells somebody
who creates somebody who receives uh
that money and so if you look in the
case of a buyer and a seller if you are
buying something then your deposit
account goes down and your sellers
account the sellers account goes up so
the liabilities and assets match each
other in that way when you have a
Creator and a receiver a bank can create
a loan and a bank receives gives an
identical deposit and I'll go into more
detail about this further on in other
parts of the col lecture so if you look
at the case of financial assets and you
look at the bank's assets going up and
the bank's liabilities going up or a
buyer and a seller uh when you put the
two together you get zero so when you
look at a bank in its assets and
liabilities and Equity it's assets of
things like reserves which we've
discussed already loans it makes to
private individuals and companies
government bonds that it buys and its
liabilities are primarily the deposit
accounts of non-banks people like things
like your your account my account
Amazon's account and so on so our bank's
accounts look roughly like this it's
just a fairly simple example reserves
and loans and bonds make up most of its
assets its liabilities to bank accounts
owned by individuals and also companies
and the gap between its assets and its
liabilities or its Equity so that's the
basic idea of a banking system what
Minsky does is reproduce this using what
we call Godly tables and they were named
after the great non-orthodox Economist
wind Godly so this is our little view of
the same thing and you can see that I've
changed it over to firms and workers and
shareholders in terms of liabilities we
have reserves loans and bonds and we
divide um the situation the the the
accounts for the bank into what things
which are its assets things which
liability and the balance which is its
its equity
and I'll show you how I use that to show
how Banks create money in the next
lecture
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