Banks Create Credit Out of Thin Air

From Washington’s Blog:

More Evidence that Banks Create Credit Out of Thin Air

I recently provided evidence that banks create credit out of thin air.

I’ve just found two more pieces of evidence:

(1) William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, said in a speech last July:

Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference.

(2) On February 10th, Ben Bernanke proposed the elimination of all reserve requirements:

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

Of course, Bernanke’s proposal is the exact opposite of the 100% reserve system proposed by Nobel prize winning economist Milton Friedman and Laurence Kotlikoff, former Senior Economist for the President’s Council of Economic Advisers.

More importantly, if banks don’t make loans based on available reserves, but can enter into loan agreements first and then borrow any reserves needed, that means:

(1) This was never a liquidity crisis, but rather a solvency crisis, as I and many others have repeatedly tried to explain. In other words, it was not a lack of available liquid funds which got the banks in trouble, it was the fact that they speculated and committed fraud, so that their liabilities far exceeded their assets. If you don’t understand what I’m saying, please read this.

(2) The giant banks are not needed, as the federal, state or local governments or small local banks and credit unions can create the credit instead, if the near-monopoly power the too big to fails are enjoying is taken away, and others are allowed to fill the vacuum.

Loans Create Reserves, not Vice Versa

From Washington’s Blog – 7 Questions About Public Banking

This is an open letter to the economics, finance and banking communities.

I don’t have any dog in the fight, other than to figure out and then publicize what is best for the greatest number of people. People I greatly respect advocate for federal-level public banking, state public banks or a return to the gold standard. I am simply attempting to start a high-level debate about what the best option is.

Please see responses posted by economists and others below. I will update the responses as I receive them.

How Is Credit Created?

I pointed out in September:

As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.
Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
– 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
– Economist John Kenneth Galbraith
“[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.
– Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.”
– Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

“Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.”
– Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

I’ve also noted:

In First National Bank v. Daly (often referred to as the “Credit River” case) the court found that the bank created money “out of thin air”:

[The president of the First National Bank of Montgomery] admitted that all of the money or credit which was used as a consideration [for the mortgage loan given to the defendant] was created upon their books, that this was standard banking practice exercised by their bank in combination with the Federal Reserve Bank of Minneaopolis, another private bank, further that he knew of no United States statute or law that gave the Plaintiff [bank] the authority to do this.

The court also held:

The money and credit first came into existence when they [the bank] created it.

(Here’s the case file).
Justice courts are just local courts, and not as powerful or prestigious as state supreme courts, for example. And it was not a judge, but a justice of the peace who made the decision.

But what is important is that the president of the First National Bank of Montgomery apparently admitted that his bank created money by simply making an entry in its book …

William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, said in a speech last July:

Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.

Continue reading

Class Warfare: The Rich are Winning

From Washington’s Blog:    The American Dream Has Moved Abroad

The American dream has always been that even those with humble roots can end up wealthy.

The American dream is what has motivated generations of Americans – natives and immigrants alike – to work hard and play by the rules.

And as Michael Moore wrote in 2003, the American dream is what has kept Americans from rebelling against corporate corruption:

After fleecing the American public and destroying the American dream for most working people, how is it that, instead of being drawn and quartered and hung at dawn at the city gates, the rich got a big wet kiss from Congress … and no one says a word? How can that be?

I think it’s because we’re still addicted to the Horatio Alger fantasy drug. Despite all the damage and all the evidence to the contrary, the average American still wants to hang on to this belief that maybe, just maybe, he or she (mostly he) just might make it big after all.

So don’t attack the rich man, because one day that rich man may be me!But as I have previously noted, things have gotten much worse recently:

  • Income inequality is worse than it has been since at least 1917
  • “The top 1 percent incomes captured half of the overall economic growth over the period 1993-2007”
  • “In the economic expansion of 2002-2007, the top 1 percent captured two thirds of income growth.”

[T]he average wage of Americans, adjusting for inflation, is lower than it was in the 1970s. The minimum wage, adjusting for inflation, is lower than it was in the 1950s.***

On the other hand, billionaires have never had it better …

***

As economics professor and former Secretary of Labor Robert Reich writes…:

Are we finally in a recovery? … Big global companies, Wall Street, and high-income Americans who hold their savings in financial instruments are clearly doing better. As to the rest of us — small businesses along Main Streets, and middle and lower-income Americans — forget it.

Warren Buffet said a couple of years ago:

There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.Now, the OECD has found that upward mobility is lower in the U.S. than most other developed countries. Dan Froomkin provides a must-read summary of the report:

A new report from the Organization for Economic Co-Operation and Development (OECD) finds that social mobility between generations is dramatically lower in the U.S. than in many other developed countries.

***

The report finds the U.S. ranking well below Denmark, Australia, Norway, Finland, Canada, Sweden, Germany and Spain in terms of how freely citizens move up or down the social ladder. Only in Italy and Great Britain is the intensity of the relationship between individual and parental earnings even greater.

For instance, according to the OECD, 47 percent of the economic advantage that high-earning fathers in the United States have over low-earning fathers is transmitted to their sons, compare to, say, 17 percent in Australia and 19 percent in Canada.

***

All in all, the OECD report is an ugly reality check for a country that has historically seen itself as uniquely rewarding of talent; as a place free of the sorts of rigid social structures that led so many generations of immigrants to leave Old Europe.

In other words, the American dream has moved abroad.

Anna Schwartz on Liquidity vs. Solvency Crises

From Wall Street Journal, Oct 18, 2008:

By BRIAN M. CARNEY

New York

On Aug. 9, 2007, central banks around the world first intervened to stanch what has become a massive credit crunch.

Since then, the Federal Reserve and the Treasury have taken a series of increasingly drastic emergency actions to get lending flowing again. The central bank has lent out hundreds of billions of dollars, accepted collateral that in the past it would never have touched, and opened direct lending to institutions that have never had that privilege. The Treasury has deployed billions more. And yet, “Nothing,” Anna Schwartz says, “seems to have quieted the fears of either the investors in the securities markets or the lenders and would-be borrowers in the credit market.”

[The Weekend Interview] Randy Jones

The credit markets remain frozen, the stock market continues to get hammered, and deep recession now seems a certainty — if not a reality already.

Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old, is one of the exceptions. She’s not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, “A Monetary History of the United States” (1963). It’s the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.

Since 1941, Ms. Schwartz has reported for work at the National Bureau of Economic Research in New York, where we met Thursday morning for an interview. She is currently using a wheelchair after a recent fall and laments her “many infirmities,” but those are all physical; her mind is as sharp as ever. She speaks with passion and just a hint of resignation about the current financial situation. And looking at how the authorities have handled it so far, she doesn’t like what she sees.

Federal Reserve Chairman Ben Bernanke has called the 888-page “Monetary History” “the leading and most persuasive explanation of the worst economic disaster in American history.” Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again.

To understand why, one first has to understand the nature of the current “credit market disturbance,” as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads — the difference between what it costs the government to borrow and what private-sector borrowers must pay — are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. “The Fed,” she argues, “has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.”

So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is “the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue.”

In the 1930s, as Ms. Schwartz and Mr. Friedman argued in “A Monetary History,” the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they’d lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: “If the borrowers hadn’t withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress,” deepening the crisis and causing still more failures.

But “that’s not what’s going on in the market now,” Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”

“Why are they ‘toxic’?” Ms. Schwartz asks. “They’re toxic because you cannot sell them, you don’t know what they’re worth, your balance sheet is not credible and the whole market freezes up. We don’t know whom to lend to because we don’t know who is sound. So if you could get rid of them, that would be an improvement.” The only way to “get rid of them” is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson’s original proposal to buy these assets from the banks was “a step in the right direction.”

The problem with that idea was, and is, how to price “toxic” assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail.

Ms. Schwartz won’t say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. “They should not be recapitalizing firms that should be shut down.”

Rather, “firms that made wrong decisions should fail,” she says bluntly. “You shouldn’t rescue them. And once that’s established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich.” The trouble is, “that’s not the way the world has been going in recent years.”

Instead, we’ve been hearing for most of the past year about “systemic risk” — the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake.

Ms. Schwartz doesn’t buy it. “It’s very easy when you’re a market participant,” she notes with a smile, “to claim that you shouldn’t shut down a firm that’s in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that’s their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves. The [government] doesn’t have to save them, just as it didn’t save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what’s been going on.”

It takes real guts to let a large, powerful institution go down. But the alternative — the current credit freeze — is worse, Ms. Schwartz argues.

“I think if you have some principles and know what you’re doing, the market responds. They see that you have some structure to your actions, that it isn’t just ad hoc — you’ll do this today but you’ll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what’s going on. So I think if you’re tough about firms that have invested unwisely, the market won’t blame you. They’ll say, ‘Well, yeah, it’s your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you’re stuck with assets you can’t sell and liabilities you can’t pay off?'” But when the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn’t know how to react. Instead of looking principled, the authorities looked erratic and inconstant.

How did we get into this mess in the first place? As in the 1920s, the current “disturbance” started with a “mania.” But manias always have a cause. “If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

“The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it’s so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses.”

The house-price boom began with the very low interest rates in the early years of this decade under former Fed Chairman Alan Greenspan.

“Now, Alan Greenspan has issued an epilogue to his memoir, ‘Time of Turbulence,’ and it’s about what’s going on in the credit market,” Ms. Schwartz says. “And he says, ‘Well, it’s true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn’t just the boom in the assets that was being terminated.'” In other words, Mr. Greenspan “absolves himself. There was no way you could really terminate the boom because you’d be doing collateral damage to areas of the economy that you don’t really want to damage.”

Ms Schwartz adds, gently, “I don’t think that that’s an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom.” Policies based on such thinking only lead to a more damaging bust when the mania ends, as they all do. “In general, it’s easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well.”

Fed Chairman Ben Bernanke, of all people, should understand this, Ms. Schwartz says. In 2002, Mr. Bernanke, then a Federal Reserve Board governor, said in a speech in honor of Mr. Friedman’s 90th birthday, “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

“This was [his] claim to be worthy of running the Fed,” she says. He was “familiar with history. He knew what had been done.” But perhaps this is actually Mr. Bernanke’s biggest problem. Today’s crisis isn’t a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. “I don’t see that they’ve achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job.”

Mr. Carney is a member of The Wall Street Journal’s editorial board.

Banking Welfare Queens – part I

The banking and finance industry is broken. We need overhaul and need it badly.
Exhibit #1 from Yves Smith at Naked Capitalism:  Indefensible Men

Since inequalities of privilege are greater than could possibly be defended rationally, the intelligence of privileged groups is usually applied to the task of inventing specious proofs for the theory that universal values spring from, and that general interests are served by, the special privileges which they hold.

Reinhold Niebuhr, Moral Man and Immoral Society

A year on from its brush with Armageddon, the financial services industry has resumed its reckless, self-serving ways It isn’t hard to see why this has aroused simmering rage in normally complacent, pro-capitalist Main Street America. The budget commitments to salvaging the financial sector come to nearly $3 trillion, equivalent to more than $20,000 per federal income tax payer. To add insult to injury, the miscreants have also availed themselves of more welfare programs in the form of lending facilities and guarantees, totaling nearly $12 trillion, not all of which will prove to be money well spent.

Wall Street just looted the public on a massive scale. Having found this to be a wondrously lucrative exercise, it looks set to do it all over again.