Lecture02A MoneyCreationAntiFractionalReserveBanking

Summary

The 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central banks, mainstream economic textbooks and educators have largely ignored these findings, continuing to teach outdated models.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

00:00

📚 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.

05:00

🔍 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.

10:02

💼 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.

Keywords

💡Fractional Reserve Banking

Fractional Reserve Banking is a system where banks are allowed to hold only a fraction of the total deposits in reserve, while the rest is used for lending. This concept is central to the video's theme, as it is presented as a misunderstood aspect of money creation. The script explains that mainstream economics courses often teach this model, suggesting that banks lend out a portion of deposits, creating a multiplier effect on the money supply.

💡Money Creation

Money creation is the process through which new money is introduced into an economy. In the video, it is discussed in the context of how banks operate and how they contribute to the money supply. The script challenges the traditional view that banks act as intermediaries, lending out deposits, and instead presents the idea that bank lending actually creates deposits.

💡Money Multiplier Model

The Money Multiplier Model is a theory that describes how banks can create additional money through lending, based on the reserves they hold. The video criticizes this model, citing the Bank of England's stance that it is incorrect. The script uses this model to illustrate the misconceptions in mainstream economic teaching about how money is created and expanded in the economy.

💡Central Banks

Central banks are the main monetary authority in a country, responsible for controlling the money supply and interest rates. The video references central banks, particularly the Bank of England, to highlight their disagreement with mainstream economic theories about money creation. Central banks are portrayed as having a more accurate understanding of the process, contrary to what is taught in economics courses.

💡Macroeconomics

Macroeconomics is the branch of economics that studies the behavior and performance of an economy as a whole. The video script mentions a macroeconomics expert, Greg Mankiw, and his textbook, which is criticized for perpetuating the misconception about fractional reserve banking and money creation. Macroeconomics is relevant to the video's theme as it is the field that deals with money and its role in the economy.

💡Banking System

The banking system encompasses all the institutions and processes that make up the economy's financial infrastructure. The video discusses the banking system in the context of how it creates money and contributes to economic cycles. The script explains that banks create money through lending, which is a fundamental aspect of the banking system's role in the economy.

💡Accounting

Accounting is the process of recording, summarizing, and reporting financial transactions. In the video, accounting principles are used to explain the mechanics of money creation within the banking system. The script emphasizes the importance of understanding double-entry bookkeeping to grasp how financial assets and liabilities are created and managed.

💡Minsky

Minsky refers to a software package invented by the speaker to model the dynamics of money using the rules of double-entry bookkeeping. The video mentions Minsky as a tool to help understand the process of money creation and the banking system's role in it. It is used to illustrate an alternative model to the traditional economic theories discussed in the script.

💡Economic Cycles

Economic cycles refer to the recurring periods of economic expansion and contraction in an economy. The video script argues that fluctuations in credit are the dominant factor behind these cycles. The discussion of economic cycles is tied to the role of money and credit in the economy, challenging the mainstream view that money does not affect the real side of the economy.

💡Neoclassical Economics

Neoclassical Economics is a school of economic thought that emphasizes the determination of prices by supply and demand, and the efficiency of markets. The video criticizes neoclassical economics for treating money as a 'veil' over barter and for not including banks, debt, or money in their models. The script suggests that this approach leads to a misunderstanding of the role of money in the economy.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. In the video, inflation is discussed in the context of money's nominal value versus its real value. The script contrasts the mainstream economic view that money only affects inflation and nominal values with the argument that money and credit significantly impact the real economy.

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