Indifference Is Destabilizing
By Nicholas Murphy, Guest Columnist
After the 2008 financial crisis, confidence in the ruling orthodoxy of the economics profession, the neoclassical school, has waned. No matter how easy it would seem, now is not the time to point fingers, rather, it is time to change. Economics has always seemed to progress through crises, and now economists must prevent themselves from falling back into the mistakes of the past which would inevitably breed the same results. As many have said, the role of banks and private debt are a suitable place to start.
The neoclassical school of economics envisions banks as nothing more than intermediaries in the economy, passing the same money from one person to the next. This stems naturally from the idea that bank loans are taken from others savings. But, in actuality, banks are money originators and credit adds to aggregate demand. Neither can be ignored.
In the past, certain economists have tried to articulate the banks’ ability to create money to, what seems to be, no avail. Most notably the American Economist Hyman Minsky, who’s altered quote is the title of this article, believed banks could create money “out of thin air.”
The Australian Economist and very much Minsky’s intellectual successor, Steve Keen has spent his career trying to convince economists of this, as well as other truths. Even the famous economist Joseph Schumpeter in The Theory of Economic Development argued that banks can create money.
Irving Fischer, once arguably the world’s most famous neoclassical economist, in his Debt-Deflation Theory of Great Depressions, went so far as to say that the “two dominant factors” which cause depressions are “over-indebtedness to start and deflation following soon after.”
For a long time, these ideas seemed to have been widely ignored. The field of economics does well in hiding the inconvenient theories of the past. However, it seems, at last, they have found validity. In the 2014 Q1 Quarterly Report the Bank of England stated, “just as taking out new loans creates money, the repayment of bank loans destroys money.” The Bank of England goes on to say, “rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.” Other entities such as the Bundesbank and the Bank of Norway have come out stating the same.
The neoclassical intermediary view of banks can be understood quite simply. To quote the Bundesbank’s paper on the subject, “banks can only grant credit using funds placed with them previously as deposited by other customers.” This is a classic alternative fact.
The truth, however, even in this simplistic form, is a little more complicated. When a person goes to a bank for a loan, the bank, if they deem him eligible, will have him sign a loan contract stating he will repay the amount, let’s say $50,000, incrementally over a period of time. When the bank makes a loan, it credits the borrower’s bank account with a bank deposit the size of the loan, adding to the assets and the liabilities on the bank’s balance sheet. They do this, as some economists have said, with nothing more than a “stroke of a pen.” No money has been moved. No other accounts have fallen, the borrower has $50,000 of new spending power, new demand, and new money.
To understand repayment, picture the same bank balance sheet. There are $50,000 in both assets and liabilities. Now let’s assume our hypothetical person has spent the new money in full. Therefore, liabilities of the bank are now $0. Now let’s say our person just got his paycheck and his account has gone up to $10,000, his wage. He calls the bank and says he wants to pay down his loan by that amount. The bank will just type a couple of keys onto a computer, just as they did to add the money and reduce their assets to $40,000, and their liabilities will again fall to $0. Subsequently, our person’s debt is now $40,000 and is account is, again, $0. The money hasn’t returned to another place; it’s gone. Money has been, effectively, destroyed.
But why is this important? Simple, if we were an economy of one, it wouldn’t be. But we’re not. We must look at this in the aggregate. During the period now called The Great Moderation, a time of low inflation and low unemployment preceding the ’08 Crisis, central bankers and political economists, while they were patting themselves on the back, didn’t pay any attention to the exponential growth of US private debt. It should be easy for the reader to visualize this. If all that debt creates artificial demand in the economy what happens when credit dries up? What happens to confidence in the economy when all that demand disappears? I’ll leave the reader with those questions.
In this article, I tried to convey the very basics of this idea. Obviously, there are far more intricacies having to do with banks and private debt then I have room for here. I would only ask, now, that the reader to think about this. Think about what it means for the economy.
To any who are interested in the role of private debt in the economy I would enthusiastically recommend Steve Keen’s new book, “Can We Avoid Another Financial Crisis.”