This is a fantastic page. I just have an issue with one of his points though:
> That banks do not have any special powers in relation to money creation
They most definitely do though: FDIC insured accounts have legal government backing—a random IOU from me can't achieve that, no matter how much anyone trusts me. Put another way, a bank deposit seems less like an "IOU" and more like a "WeOU"—"we (the bank or the government) owe you". That seems like quite a fundamental difference, no? It seems to distinguish "fake" and "real" money (or banks).
Hey, author here. Your criticism is correct. Deposit insurance is a fundamental difference between bank IOUs and non-bank IOUs. So it's incorrect for me to say that banks have _no_ special powers (still not even close to central bank's power though).
Hi author, excellent article. But I'm just not seeing the central premise that Werner is wrong in saying that banks are unique in their ability to create money. What Full Tilt Poker did was illegal, simply because they were not licensed as a bank. We do have a special class of institution in our society that is blessed with the ability to create money through fractional reserve that we call "banks". Do you mean regardless of law?
Yes, I suppose I mean regardless of law. Although I wasn't looking at it like that, I was just looking at it from a practical perspective: "he is claiming that only banks create money - well here is a counterexample where a non bank made money".
The reason I attacked Werner's article is that he mystifies money creation and perpetuates the misconception that banks' ability to create money is similar to central banks' ability to create money (he does not directly say so, but a non expert reader is likely to gain this misunderstanding when he uses terms like "fairy dust" etc.).
In the article I attacked 2 specific claims of Werner. One was patently false. The other was correct due to a technicality only.
Hi author. Excellent write-up and nice food for my brain!
Although "technically" I agree with your article, banks have a legal definition, legal power and legal responsibility. That makes them special and gives them the legal power to create money -- not without limits, though. Banks can -- subject to some rules -- borrow money from the central bank, which will create said money for them. With repo rates hovering zero and all processing happening electronically, "out of thin air" is not really that far from reality. :)
I would argue that if I issue you an IOU, that is not real money: I do not hold a banking license, I do not keep track of all IOUs, I have no audit to pass once-a-year. In fact, I might drink away your deposited cash next day. :) The Full Tilt Poker example is relevant, but I would argue that that is illegal banking: It happens, but it really shouldn't. Wirecard is the other extreme: They were a bank (legally) and created money against the rules (I'm a bit oversimplifying).
I guess the common person needs to be educated about legal powers: For example, what makes this house special that I own it? A large enough hammer can open the door, as easily as my keys. In fact, if I sublet it, I might not even have the keys! Ownership, as money, are legal constructs that only hold value if they are properly enforced. Of course, enforcement is easier the more society accepts the construct.
How confident are you on that point? I don't have a reference on me right at this moment but I expect it is illegal for a non-bank entity to hand out IOUs at scale. People would be arrested.
That's what corporate bonds are. In the extreme, every as-yet-unpaid invoice on 30 or 90 terms creates a debt and "creates money".
Full Tilt Poker created a small closed e-money system which was seemingly legally fine; it was the gambling that got them raided, because only mob bosses in politically connected US states are allowed to profit from gambling and the US will go after gambling providers in other countries.
Liberty reserve were facilitating money laundering. This is the difficult bit - if you provide an electronic facility for easy transference of ownership of debts or e-money, the authorities want access to the paper trail.
>That's what corporate bonds are. In the extreme, every as-yet-unpaid invoice on 30 or 90 terms creates a debt and "creates money".
No, there's a big difference, in that you don't have the right to redeem ("put") the corporate bond any time at face value.[1] You do have that right for the IOU that is your bank account. This allows two people to carry on as if they both are full owners of the dollar in the bank account (both the depositor and the business it was lent to), and that mechanism is what allows the money supply to increase.
When you don't have that right, you, as the corporate bond holder, know that you can only get the money out early by selling the bond at its current market rate, whatever that is, which may force you to take a discount. This expectation -- and the necessity to redeem it for someone else's dollars on the market -- prevents it from being money creation.
So I suppose I put it to you that there is something special about the IOUs created by banks - they are legally allowed to used.
Even if everyone agreed to use your IOU from the article the tax office is going to have quite a bit to say on the subject and probably start launching audits. And if the IOU start getting traction they are likely to trigger police raids and maybe a legislative response (look at how Facebook dropped their Libra for example). That seems substantially different from the IOUs the banks can create.
I wouldn't use bank-issued IOUs if I thought I had a choice. I'm pretty sure I'm forced to by government policy.
> So I suppose I put it to you that there is something special about the IOUs created by banks - they are legally allowed to used.
IANAL, but the IOUs created by Full Tilt Poker were also legal to use. When the government eventually pressed charges in the debacle, no charges were pressed against regular players of the poker site, including those who used these IOUs for small economic activity. If using these IOUs would have been illegal, then surely the government would have pressed at least some charges after spending years investigating the case?
But anyway, even if _using_ the IOUs was not illegal, creating them like a fractional reserve bank surely was illegal. So you definitely have a point that the regulatory environment creates a special status for the legal tender of the country.
This article is misleading. Banks do ultimately create money. Even if you ignore the details and complexity of how this works, the empirical evidence is clear:
- How do you explain that the M2 money supply is always going up? Where is all that new money entering into the system? Government contracts funded by government bonds? If that was the case, government contractors would be getting very wealthy and everyone would be working for them (directly or indirectly)...
- How do you explain the recent, significant, almost instantaneous jump in stock prices of major tech companies after the Fed printed and injected trillions of new dollars into the economy? Did these corporations all suddenly score huge government contracts from the bonds which the government created? Seems more like investors and company insiders used loan money from banks to do stock buybacks or increase their positions.
- Under the model suggested by the article, how does one explain why there are so many millionaires are in the real estate industry? If you assume the opposite argument that banks are able to print money (directly or indirectly), the number of millionaires makes perfect sense since everyone buys houses using 'loans' from banks; so it's natural that all this free money from banks would constantly inflate real estate prices; each new generation of citizens would inflate the prices of the properties which were bought by the previous generation with increasingly larger loans from newly printed credit from their banks.
What is claimed by the article does not match the evidence, even the people have wised up to this scheme which is why Bitcoin and cryptocurrencies have been able to hold their value.
People and other non-bank entities do not create money, they create and attempt to sell contracts to the bank which are supposedly backed by the value of future goods and/or services. The bank is the one which decides if a contract is worth what the seller is claiming. The seller could claim that they own a lot of user data and that this data is a valuable intangible asset and if the bank agrees with this valuation, then that person can get access to a lot of credit.
Nonetheless, this is all irrelevant, people cannot legally create money (that would be counterfeiting), they can only create assets; only banks can create money and they can cherry-pick who is allowed to get credit and who isn't using whatever rules or metrics they see fit. All the new money enters the economy through loans and government bonds. Companies and individuals who are close to the money printers get most value out of the new money since they get it first (Cantillon effect). By the time inflation kicks in, these people who are close to the money printer will be able to take another bigger loan in the future using their existing collateral which will undoubtedly be worth more due to inflation in the nominal monetary 'value' of that collateral.
I agree with you, but as a non-expert in the matter, I have to add that banks are heavily regulated in that regard and have to deposits certain reserves to central banks (depending on the country) for that privilege. It's not that they operate differently than LLCs while having the privilege of insurance. They pay a price for that privilege, and we can argue whether that price is too low or not.
> Deposit insurance is a fundamental difference between bank IOUs and non-bank IOUs.
Deposit insurance is a fundamental difference but it's not the main difference. Individuals and most non-banks don't have access to Federal Reserve accounts and therefore access to reserves. The main distinction between a bank and a non-bank is the ability to create IOUs ultimately backed by reserves (whether they have sufficient amounts or not) which can only be created by the FR (and in this context) to back a bad IOU. Whether the new reserves go directly to backing up the IOU or indirectly via added liquidity is irrelevant. A bank can create a misguided IOU that defaults, which if too big to fail, is a liability that the FR and thus all holders of the IOUs, cash, and reserves must bear.
This is not entirely accurate. Suppose a fraudulent bank decided to credit my account with a trillion dollars. The federal reserve would not honor this IOU with actual dollars. This is in stark contrast to federal reserve's ability to create a trillion dollars. They could create an actual trillion dollars and give it to a corrupt politician. A regular bank does not possess this ability.
What does a fraudulent bank have to do with the fact that the FR is the ultimate backstop to loans (IOUs) created by a bank...a "power" you claim is the same as a non-bank created IOU or a an individual IOU? Further not sure how your example refutes my previous reply's accuracy, regardless, if a bank makes a bunch of fraudulent loans adding up to a Trillion dollars and it isn't discovered until those loans are cross-collateralized sufficiently to cause systemic risk, you can bet the FR will back those loans. Finally, given a bit of time a single Trillion dollar loan may not seem as large as it does now. :)
> What does a fraudulent bank have to do with the fact that the FR is the ultimate backstop to loans (IOUs) created by a bank...a "power" you claim is the same as a non-bank created IOU or a an individual IOU?
I'm not claiming it's the same. I'm saying these are differences of degree (my IOU vs bank's IOU), whereas the difference between central bank IOU and bank IOU is fundamental. We have several historic examples of central banks ruining entire economies by printing excessive amounts of money causing hyperinflation. Do you have a single example of a regular bank printing so much money that it causes hyperinflation? No. Why is that, if it's so easy for a regular bank to print a trillion dollars of fraudulent money without anyone noticing?
I love the IOU vs WeOU differentiation. Banks need to have licenses and adhere to strict regulations, which are checked at least yearly by auditors. (Joke: Unless you are a German bank, in which case you get checked only once-a-decade.) That is what makes banks special: They have legal backing, but also legal responsibility.
Side note regarding non-bank IOU: I found the idea of having a payment card from my grocery store very appealing. If they run out-of-cash, they can repay me in food, which I'm pretty happy to take at any time. However, that is not how it works in 2020. The grocery entity and the banking entity need to be separated, and have different licenses.
> The grocery entity and the banking entity need to be separated
Quite a few of the grocery chain cards here in Sweden have accounts backed by chain-owned banks. So at least here, the separation is not all that great.
They share branding and sometimes ownership, but the entities are separated. ICA Gruppen has ICA Banken as a bank subsidiary. COOP outsourced banking to EnterCard, etc.
Exactly... not all IOUs are created equal. Any bank that is part of the Federal Reserve System can create US Dollars, the most liquid and trusted form of money in the world presently.
It comes with the downside of being highly regulated. I have no idea if the weights and balances are correct, but it makes sense at the surface level that if you are risking the government’s money, you have to do it on their terms.
So heavilly regulates you can hand out mortgages to people who can't afferd them, then turn around and package those loans intonCDOs, and mislead investors as to their liquidity. Then suffer no consequences when global economy crashes.
Seems like a great scam. Create a bank, go through the many many steps to obtain FDIC backing, pay out enormous loans to insiders, have a run on the bank, then everyone is made whole again while the fraudster skips town.
I understand that this is basically insurance fraud, but the money is gone long before the fraud occurs and the government must pay out, unlike a single insurer.
Quite true. Its also why we should find it deeply concerning when a tech company starts taking on some of the powers of a bank without any of the responsibilities of a bank.
Facebook's digital currency system is one recent example. Paypal's behavior is a much longer-running example.
> That banks do not have any special powers in relation to money creation
They most definitely do though: FDIC insured accounts have legal government backing—a random IOU from me can't achieve that, no matter how much anyone trusts me. Put another way, a bank deposit seems less like an "IOU" and more like a "WeOU"—"we (the bank or the government) owe you". That seems like quite a fundamental difference, no? It seems to distinguish "fake" and "real" money (or banks).