Loanable Funds Theory is dead. Of that, there can be no question. The remaining stragglers who believe in this particular banking fairy tale – the mainstream – persist with their mystical ramblings about the zero lower bound which depend on loanable funds nonsense. The credit creation model is a thing these days, because it is reality. Banks simply do not lend out customer deposits, or in other words, they do not lend out reserves. The good work that Richard Werner has done demonstrates that banks do not, in fact, lend out customer deposits. However, for all of the work Werner has done to enhance our understanding, there is another side of him; a strange side which, factually, causes one’s eyebrows to lift and one’s voice box to involuntarily utter the phrase, “OMG! HE CANNOT BE SERIOUS!” But before I get to that, let’s take a look at how banking really works.
A Short Banking Primer
The basics of how banking works are really quite simple for the average person to understand. Commercial banks decide beforehand who they deem to be creditworthy and once a borrower fitting that description is found, they create their own special IOU and then denominate it in the unit of account. What this means, in layperson’s terms, is that a bank will first determine its own standard for creditworthiness, which that bank can change at any time. It can make its standards stricter or more relaxed. When a person goes into a bank to obtain a loan, the bank will look at income, past credit history, etc., and should the person be deemed worthy of credit according to those standards, the bank will approve a “loan” and simultaneously create a deposit for the borrower by simply typing numbers in an account with a “$” symbol attached. The “$” symbol is the unit of account. In the UK, banks will simply denominate loans in British Pounds. The unit of account is the exclusive product of the national government, not commercial banks. For this discussion, we will use the US as our example, so in this case, the unit of account is US Dollars. Before we continue, let’s have a word about reserves.
US Dollars, or what we refer to as High Powered Money (HPM) exist in accounts held at the Federal Reserve called “reserve accounts”, which commercial banks each possess. Commercial banks do not issue HPM nor do they lend out these reserves to customers. Reserves remain on the balance sheet of the Federal Reserve to ensure that interbank payments clear. In other words, when you write a check or swipe a debit card, if you have the funds, then the payment will clear. The Fed also stands ready to ensure that payments will clear by providing reserves to banks when the need arises. Reserves also affect monetary policy.
The Fed sets a target interest rate and seeks to maintain that desired rate. Excess reserve balances can thwart monetary policy. Contrary to popular belief, commercial banks generally do not wish to hold excess reserves over and above that which they require to ensure payments clear. Those with excess reserves will try to lend them to other banks, not customers, which are short of reserves. On the other hand, the Fed wishes to maintain a target interest rate. With the presence of excess reserves in the system, the Fed risks losing control of its target rate since the reserve lending activity between banks can cause the overnight rate to fall. So, through what is known as “open market operations” or (OMOs), the Fed buys and sells US Treasury bonds to alter the level of reserves, up or down, in the system in order to maintain its target rate. As a side note, this is why the Fed sets the target rate at or near zero prior to conducting QE. If it didn’t do this, then interbank competition would drive down the overnight rate and the Fed would only have to intervene to drain off the excess reserves that it created to begin with in order to defend the target rate. The purpose, then, of treasury bonds is to add or drain off excess reserves and the purpose of paying interest to banks on their excess reserves is to encourage commercial banks to hold onto their excess reserves. Either way, that is how the Fed maintains control of monetary policy. Now then, back to bank lending.
As we’ve discussed earlier, when a bank creates a deposit for the borrower, that deposit consists of numbers typed out of thin air and denominated in the unit of account. In short, they are bank IOUs. Let us assume a loan of $30,000. When the borrower spends the deposit, the recipient deposits the $30,000 in her bank. What happens is that the borrower’s account drops by the number 30,000 and $30,000 held in the bank’s reserve account at the Fed then shifts to the recipient’s bank’s reserve account also held at the Fed. The recipients personal bank account then rises by exactly 30,000 numbers and the payment clears. In this manner, the bank’s IOUs behave as ‘money” in the private sector. So, this reality manifests itself with the reserve shift. The spent bank’s IOUs caused US Dollars held in a reserve account to shift over to another bank’s reserve account. The reason why they behave as “money”, is because the bank denominated its IOUs in the government’s unit of account. When it did so, it made the IOU acceptable to satisfy any tax liabilities owed to the US government, because the US government will only accept its unit of account as payment for taxes.
What is very important for you to understand is that the lending bank did not worry about the level of reserves that it had on hand prior to creating a loan. It simply lent out its IOU. Later on down the road, if that bank found that its reserves were too low to handle interbank payments, guess what? As we’ve discussed, it will either seek reserves from banks who have excess or simply get them from the Fed itself, which must stand ready to ensure that payments will always clear by providing reserves when needed. Even though a bank might be lending and so, reserves are shifting out of its reserve account into the reserve accounts of other banks, we must not forget that it is also receiving reserves too through deposits and other transactions throughout the business day. So, reserves go up and down all the time, regardless of lending activity. For instance, a customer might swipe their debit card and buy a $1,200 refrigerator and so, $1,200 in reserves will shift over to another bank’s reserve account. An employer will direct deposit an employee’s pay in their employee’s account, shifting reserves from the employer’s bank’s reserve account to the employee’s bank’s. It is only when both lending and typical daily transactions result in reserves being short, that the bank will worry about its level of reserves on hand.
For the privilege of using the bank’s IOU to make purchases, the bank charges you a fee, called “interest”. Not only do you have to pay back the loan amount, but also extra. Hence, bank credit results in private debt. Whereas, when the US government deposits a $5,000 tax refund in your account you do not incur private debt, a bank IOU is a different beast entirely. So, why then does a bank charge interest? Obviously, because that is how a bank makes a profit. This, then, explains why a bank lends: a bank does not lend to act as an intermediary, bringing savers and investors together, but to make a profit.
Because the government’s unit of account (US Dollars) exists, a commercial bank will then take what we call “an asset position” by lending its IOU to you, which is the act of leveraging US Dollars to earn a profit. The interest it charges over and above the amount lent to you is then profit for the bank. So, by creating an IOU, the bank shifts the government’s HPM to another bank’s reserve account and then waits for you to shift HPM back plus extra by making regular payments. Clever, right? Maybe, but it’s not exactly a good thing. If, at the same time all of this lending is going on, the fiscal stance of the US government is one of deficit reduction, that means that additional US Dollars created by the US government and spent into the domestic economy are being deliberately reduced and so, private debt to consume goods and services is rising. In other words, the US government is forcing the population into using credit cards and loans to live beyond its means. As the level of bank credit rises to consume production, the domestic populace becomes increasingly indebted until it simply cannot continue spending more than its income. At that point, consumer spending contracts and business then loses income. As a result, business begins laying off employees and unemployment then rises. Without their former income, the unemployed contract their spending as well and finally, a recession occurs. Reversing the situation requires the US government to abandon deficit reduction and begin deliberately reducing taxes or crediting bank accounts with its own IOU (the US Dollar), whether that be purchasing goods and services in order to provision itself or simply giving people US Dollars in order to take the pressure off of consumer savings, thus allowing them to begin spending again.
That is the reality of banking and how it affects the domestic economy. Over reliance on low wages and part-time employment in the face of deficit reduction leaves a spending gap that must be filled. Filling that gap with bank credit to consume goods and services is particularly dangerous and makes for unsuitable macroeconomic policy. Richard Werner understands how banks lend, but he doesn’t understand the unit of account. And because he and others of a similar opinion do not understand the unit of account, two things happen:
1.) Bizarre Federal Reserve private banking conspiracy theories
2.) Positive Money
Positive Money requires a dedicated article to understand why it’s nonsensical, so we won’t discuss the subject here.
Weird New York Fed Conspiracy Theories Long Debunked
Once upon a time in the Land of Make-Believe, there was a private banking cartel called the New York Fed that consisted, primarily, of Wall Street banks. Some of those banks were even controlled by foreign entities. Gosh! Golly gee! Oh, my goodness me! One day, the US government was convinced by the cartel to hand over control of all money creation to the New York Fed, and the US government lost its monetary sovereignty forever and ever. The Federal Open Market Committee, or FOMC, relinquished all power to Wall Street banks in the cartel becoming nothing more than a side show to hide what was really going on.
Thus, the evil New York Fed controlled the Federal Reserve system and lent “money” to the US government at interest, causing the government to go deep into debt every time it spent. The poor taxpayer shouldered the burden of this debt, handing over their hard-earned private “money” to make everyone who owned a Wall Street bank rich, even though, according to Richard Werner, they supposedly create everyone’s “money” at will and therefore, Wall Street banks don’t need an income, but what the hell ever, right?
Workers could be heard singing songs, “Swing that hammer down, son! Yes, Lord. I’m swinging my hammer down” as they toiled in the hot sun, sweating away their lives to fund yet another mansion in the Hamptons for members of the Illuminati and those elevated persons in charge of JP Morgan Chase, even though, again, Chase doesn’t need the money because it creates the money. Look, I can’t stand it anymore, frankly. If you want to read about this silly, age-old conspiracy theory, you can do so here. The link is not meant by me to be a tutorial for you on how the Federal Reserve system works, but merely to provide you with background on the conspiracy theory.
I don’t know, really. Richard Werner is an intelligent, friendly, accesible guy who understands that banks create money, and here, Werner is 100% correct. However, he simply acts as though he does not understand that the unit of account is the exclusive product of the US government, and that is where Werner gets lost in a fog. Werner is convinced that in a clever move called “The Federal Reserve Act”, commercial banks have usurped the US Constitution and now have total control over the US government – never mind the fact that they still have to lobby and beg politicians for favors and for deregulation. But, I guess that’s all a side show too. It’s just more “Fed PR”.
As we’ve discussed, the unit of account is the chosen product of the national government in question. Again, to review: In the UK, it is Pounds; in the US, US Dollars; in Canada, Canadian Dollars; in Japan, Yen; in Australia, Australian Dollars. The unit of account defines what is, essentially, nothing more than a number which forms the basis of various national currencies. At the very basic level, currency is just a number and then a national government attaches a fancy symbol to the number in order to say, “this number belongs to me and nobody else”. So,
“1,000” could mean just about anything. Anyone can issue it: You, me, “MMT shills”, the US government, the UK government, the Canadian government, the Australian government, Grandpa Jones and the entire cast of “Hee Haw” and yes, even the CIA.
“£1,000” on the other hand, means that this particular number is called “British Pounds” and belongs to the government of the United Kingdom and not the United States, nor commercial banks in the UK. Why? Because the government of the United Kingdom is the supreme authority over the nation called “The United Kingdom” and it will not allow the US government, or any other government or private entity which includes Barclays, the Pope, Justin Bieber, the Rothschilds and little grey aliens to issue Pounds Sterling. Only the UK government can issue and control the unit of account called “British Pounds”.
$1,000 means that this particular number is called “Dollars“, and if we are discussing the United States, then it belongs to the government of the United States and not the United Kingdom. Why? Because the government of the United States is the supreme authority over the nation called “The United States” and it will not allow the UK government, or any other government or entity which includes member banks of the New York Fed, the Pope, Justin Bieber, the Rothschilds and little grey aliens to issue US Dollars. Only the US government can issue and control the unit of account called “US Dollars”. But why the demand for US Dollars?
The US government lays a tax payable only in US Dollars which then causes a need for private entities to obtain US Dollars to pay the tax. Private entities sell goods to the US government and then the US government chooses the price that it will pay for those goods in its own unit of account (US Dollars). Once it does this, the US government sets the price, regulates the market and controls the entire monetary system, because everything hinges on the US government’s unit of account (US Dollars).
So, since US commercial banks cannot issue the unit of account, they can do something that the US government cannot do – they can go broke. The Federal Reserve cannot go broke. Commercial banks are members of the Federal Reserve system. The Federal Reserve system itself is operated by the Board of Governors which is, in fact, an agency of the US government. The reserve banks are divided into regions and the New York Fed is but one of them. The commercial banks that make up these regions then hold shares, not corporate shares that denote ownership, but shares that denote “membership” in the Federal Reserve system. The Federal Open Market Committee determines monetary policy. The FOMC does not bow to the demands of the New York Fed. It issues directives to the New York Fed and the New York Fed obeys:
“At the conclusion of each FOMC meeting, the Committee issues a directive instructing the Federal Reserve System’s domestic open market desk at the New York Fed to carry out the policy decision through the use of open market operations. In addition, the FOMC announces its monetary policy decision and states whether economic conditions pose a greater risk to its goal of price stability or to its goal of sustainable growth or whether the risks are equal. The post-FOMC-meeting announcements also report on discount rate changes, which are less frequent than changes in the target for the federal funds rate.”
Since none of these commercial banks control the unit of account, and since they exist, in part, to make a profit, they take asset positions by leveraging the unit of account in order to realize profits. When they lend out their IOUs, they are betting on one, simply thing: that in return, they will earn the US government’s IOU (US Dollars). End of story. So, then, if the US government is in charge and politicians decide to ignorantly encourage bank lending for consumption rather than to allow the government to do its damn job and deficit spend and also choose to accept bribes from large commercial banks to deregulate banking, then that is the problem here. The federal government simply refuses to assert proper control over commercial banks. In other words, it’s refusing to do its job.
Given these facts presented here in our discussion, we can easily understand that there isn’t a private banking conspiracy going on, but rather, there’s a bunch of inept, corrupt politicians paid by Wall Street to allow commercial banks to run rampant. Unlike Positive Money asserts, the entire banking system doesn’t need restructuring with some undemocratic “committee” overseeing the “money supply” in order to achieve proper management of the monetary system and the economy. And what of the Positive Money proposal by the way? In light of everything we’ve discussed, I’d say it should be thrown into serious question.
Again, the key aspect for a proper understanding of how banks create “money” is the denomination of the bank IOU in the unit of account. The unit of account being the exclusive property of the national government in question. That is the critical aspect that Richard Werner fails to acknowledge, and it is because of that failure, his position then deteriorates into pure nonsense. Sadly, there seems to be no convincing Werner of this simple realty.