Investing,  Markets and economy,  Modern Monetary Theory

How MMT looks at banking

Banks create new money whenever they make a loan. In fact, banks are responsible for creating most of the new money in the economy. But MMT has a particular way of distinguishing money created within the banking system compared to money created by a government.

If a bank approves me for a $1 million loan to buy a house, the moment the bank presses a button on a computer and transfers the money to the vendor’s account, the vendor can use that money to buy stuff. Money that wasn’t there a moment ago can now be used to buy a car, or a holiday, or another house.

However, the tricky part is that MMT says that loan has not changed the ‘stock’ of money, because the credit balance in the vendor’s bank account is exactly offset by an equal and offsetting balance in my loan account. The banking system creates new money countless times per day, but every single transaction that creates a credit balance in one account, has an exactly equal offsetting transaction creating a debit balance in another account. And every day, the banking system makes sure all those transactions net out to zero.

In that sense, the banking system is kind of a closed loop, creating money within itself, which is why MMT refers to it as ‘endogenous money’.

For the actual stock of money to increase it has to come from outside that loop, and the only way for that to happen is by the government creating it.

Conventional economics by and large gets banking wrong

Some mainstream economists talk about banks having to get funding via deposits before they can lend money out, but it’s far more complex than that. While banks are indeed required to retain a small amount of capital behind every loan they make, the vast majority of every loan is simply newly created money.

Conventional economics has also taught the ‘money multiplier’ model of banking for decades, which says for every dollar that gets deposited, the bank retains a small portion and lends out the rest, which then gets deposited into a bank, which again retains a small portion and lends out the rest, and so on. However, it’s wrong.

As usual, MMT’s explanation of how banks generate money is based on a strict understanding of bank accounting, and it makes the observation that the loan creates the deposit. That might sound a bit whacky, but when my home purchase settles, the bank will have created a deposit account and a loan account which will simultaneously show a balance of $1 million (double entry bookkeeping requires two entries). The deposit account then gets cleared out and the money is sent to the vendor, who now has a credit balance of $1 million and my loan account is reflected as the equal and offsetting balance. My loan has created the vendor’s deposit.

That deposit will get passed around the banking system and will only disappear if it is either used to repay a loan, or to pay taxes.

The upshot from this is that bank lending is only limited by the approval process – finding a credit worthy borrower who will repay the loan – it is never limited by having to find funding. Banks have ‘reserve accounts’ with the central bank that are used solely to balance transactions, the reserves are a kind of special, central bank money that never finds its way into the real economy. When banks make loans and expand their balance sheets, the central bank will always provide reserves because that’s how it retains control of the cash rate, which is simply the interest rate charged to banks for overnight lending.

When the economy is strong and there’s lots of borrowing going on, the banks are able to dedicate some of their profits to increasing the capital they’re required to put behind their loans, which then enables more lending. But strong credit growth raises the risk of a private sector debt bubble.

Where bank lending and MMT meet

We’ve learned in the past that MMT shows us that government spending is essential to maintain economic activity. If a government runs a budget surplus, it is sucking money out of the economy and the only way to offset that and so maintain economic activity, is for the private sector to either run down its savings or increase debt.

That’s exactly what happened when the Howard government ran a budget surplus: economic growth stayed positive because household debt increased from $200 million to $900 million. Credit growth was running as high as 20% per annum, compared to the recent pre-COVID levels of about 3%. This is how MMT foresaw not only the GFC, but also the anaemic recovery afterwards as governments adopted austerity policies and households were no longer in a position to borrow heavily.

MMT observes that increasing household debt as a source of growth can only go so far, and once households reach debt saturation, the only source of growth available then is for governments to increase spending, that is, exogenous money creation.

This is a very broad-brush summary of MMT’s take on the banking process. For more detailed discussions, see:

Modern Monetary Theory Part 2, and why you’re still hearing a lot more about it, by Chris Bedingfield

The role of bank deposits in Modern Monetary Theory, by Bill Mitchell

How banks create deposits and reserves, (video) by Warren Mosler

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

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