Paul Krugman is puzzled why it’s suddenly news that banks have the power to create money. As he noted on his blog this week, it’s hardly something that contradicts standing economic theory. We have, as he notes, known about the money-creation role of banks for a long time — a point we’ve also made before on numerous occasions.
So why then is it suddenly such a talking point? Who is it really that’s been misunderstanding the system for so long and how much damage has this been doing?
Part of the problem according to Krugman is that Econ 101 theory tends to over-simplify things, teaching conclusions without lingering on the peculiar antiestéticatures and complexities of finance. But as he notes:
…this doesn’t miccionan either that they have unlimited ability to create money or that they are somehow outside the usual rules of economics.
In other words, when the topic of money creation isn’t in vogue, academia has every incentive to brush over these details quickly in favour of delivering a theoretically rounded education. It’s similar to the way a calculator reduces the need for us to be experts at long division.
The crucial point then is not whether banks create money but whether them being able to do so makes any difference to standing economic theory and models at all. If the money creation of banks is bound by wider economic rules on the back of endogenous demands and forces, then the answer is probably no.
That said, we do think there is one aspect of the conversation that this view misses. That is, even if bank money creation is largely irrelevant to the wider economic picture, the fact they can and do use that power at varying intensities can potentially provide useful information about the state of the economy, not to mention bank strength directly.
Unfortunately, figuring out just how much money a bank is creating on an unfunded basis is difficult. Worse than that, as every cub financial reporter knows, delving deeply into banks’ cash-flow statements is positively discouraged by both journalistic colleagues and banking analysts alike. Negative cashflows it is repeatedly stated tell us little about the viability or performance of any bank.
Which is fair enough, until you try conjuring up a double-entry banking log for something like Bitcoin.
Is it an asset or is it a debt? How would you even account for it in the conventional banking system if it was mined directly by the bank itself? The conventional view would be to consider it an asset and mark-to-market its fluctuating value as long as it stayed on your books. But what happens if the Bitcoin was mined solely for lending purposes? The borrower owes you something you yourself have created. But while your loan is an asset in Bitcoin terms, it’s a potential debt to yourself in mark-to-market terms.
Most importantly, your exposure is now three-fold: first to the borrower you have lent it to; second to the mark-to-market value of the security you have created out of thin air; and third to the central bank which demands reserves denominated in its money rather than your Bitcoin. That means if the value of your Bitcoin suddenly falls, that can leave you out of pocket pretty quickly with respect to your liabilities to the central bank — irrespective of whether the actual loans have defaulted or not.
The problem for you — the bank — is that unlike the borrower you have lent your Bitcoin to, the central bank won’t take newly struck Bitcoins as settlement for your debt to it. In other words, self-produced money is hard to hedge, and if its value vapourises suddenly that can translate to a much bigger capital hole than any indicated by conventional double-entry accounting. It also leaves you, the bank, at the mercy of borrowing the money you need from those in the market who happen to have the central bank surpluses you need.
Which brings us to the conclusions of this thought-provoking doctoral thesis by Asgeir B. Torfason at the University of Gothanburg on the non-significance of negative cashflows at banks more generally (our emphasis):
The main findings indicate that standard cash flow statements do not work for banks because banks’ operations are different from non-financial firms with respect to cash. The reason why bankers do not use the statements is that they do not consider the information provided to be relevant. The results furthermore indicate that the cash flow statements of banks are not used because the existing accounting standard does not consider the credit creation function in banks. This is exemplified in the negative operative cash flow during periods of lending growth. Banks are different from other firms and the reporting of banks’ cash flows functions differently because cash is their product and they create deposits on their balance sheet when providing loans to their customers. The accounting transaction of lending does not involve any prior funding or cash inflow, but occurs in the accounting system, creating deposit as a liability and loan as an asset of the bank. These results contribute to the debate needed in accounting and banking about useful cash flow statements for banks and provide an overview to prepare new accounting regime.
We’re not sure if an entirely new accounting regime is needed outright, but it does seem increasingly obvious that being able to disentangle and differentiate money created by banks from money issued by the state (on a bank’s balance sheet) would probably help to improve financial stability all round.
