There is a particular scene in the film “It’s a wonderful life” in which the hero of the story is trying to prevent a run on the Bailey Savings and Loan. In an effort to calm the anxious savers wanting to withdraw their money George Bailey cries out “you’ve got it all wrong, the money’s not here, well your money’s in Joe’s house, that’s right next to yours, and the Kennedy house and Mrs Maitland’s house and a hundred others”.

As films go it is a genuine classic. But unfortunately it has perhaps unwittingly perpetuated a whopping misrepresentation of how banks actually work; a little white lie that the IMF have recently just driven a sledgehammer right through.

Their working paper, titled “The Chicago Plan revisited”, seems to have slipped under the mainstream media attention (and most of ours!) during the summer lull. That is until Ambrose Evans-Pritchard of the Telegraph picked it up a few weeks ago. At the core of the IMF paper is a deep seated analysis of how banks actually function in the economy and their role in the money supply. It is nothing short of revolutionary in that the paper gives full acknowledgement of, and support for, an intellectual movement that has doggedly criticised the very nature of money. Criticism that has so far been completely ignored and dismissed by mainstream economics.

We all think we know what money is (although reality gets a bit complicated when we start to lift the lid) but the more contentious issue is “where does money come from?”. How is the supply of money controlled? We know that the supply can go up and down over time, but who indeed has the power to expand or contract the money supply; the power of monetary creation and destruction?

But before we get into this we first need to clarify our terms. What is money?

As Wikipedia and all good textbooks will tell you; money is a medium of exchange and a store of value. There are other additional characteristics, but broadly these are the two most important. Indeed the history of monetary systems is riddled with tensions between these two key functions as they can work against each other [1].

Being a numerate person (and belligerent statistician by trade) it seems only fitting to start with the figures. When we look at the UK money supply, we find there isn’t one measure of money in the economy, there is a whole spectrum of measures! So, first off, money isn’t quite a singular construct. It can mean different things under different circumstances.

However, in the UK there are two main types of money that are officially recognised:

1) Narrow money (M0) – Cash (coins, notes etc.) or near cash equivalents, what we conceive of as tangible money that we can put in our wallet, and;

2) Broad money (M4) – all Narrow money, plus bank and building society deposits, wholesale deposits and certificates of deposit etc. – the additional subset is often referred to as “credit money” and is deemed to be less liquid (i.e. not as quickly, easily or widely accepted for transactions)

Here is a chart of the Narrow money (red) and the additional credit money that makes up the gap to Broad Money (in green):

Just by looking at these figures (which incidentally are industry generated and not in any way disputed by the banking profession or economists at large) we can clearly see some glaringly obvious issues. First is the sheer size of Broad Money versus Narrow Money. The second is the rising share driven by credit money expansion since the 1980s. Of the Broad money supply, only 3% or so is reckoned to be Narrow Money. The remaining 97% is the bank generated “credit money”. This only exists as accounting entries within the banking sector.

This is nothing less than expanding leverage that on face value alone is occurring within the banking system!

So where did this expansion come from? How was it created?

This is the crux of the IMF paper, and once and for all it should put to bed some long simmering arguments on the subject. A recent high profile example is the blog spat between Steve Keen and Paul Krugman [2]. Krugman opens the debate with some blatant Ad Hominen rhetoric, then claims that he was struggling to understand what on earth Keen was saying, and finally bowing out by saying that he was getting tired of the debate.

In the “standard” (i.e. Krugman) interpretation creditors are forfeiting purchasing power now (the money they loan out), in exchange for purchasing power in the future (repayment of interest and principal). Debtors obtain purchasing power now, in return for handing over future income (i.e. forfeiting future spending power). Krugman is channelling our dear friend Jimmy Stewart by characterising the operation as per the small town Bailey Savings and Loan description we opened with.

In this “standard” description of the system, money (cash) comes into the bank, and then gets recycled out again. It leaves one gaping problem to explain though. Where did the depositors’ money come from in the first place to put into the bank? The residents of Bedford Falls (being decent and upright people) haven’t got printing presses in their homesteads, so it can’t have been them. Maybe it was their employers who raised their wages, but again, where did their employer get the increased money from?

To answer this we just need to describe how the lending process within a bank actually works in practice. For by describing this, we can then understand how banks can spontaneously expand their balance sheet. And this is where the IMF paper [3] comes into its own. I’ve not fully read the paper yet, as much of it uses standard economic models and maths to demonstrate that which others have explained in more simple terms. However, the crunch passages from the paper are as follows:

“The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.” (page 9)

“Putting this differently, the bank does not lend out reserves (money) that it already owns, rather it creates new deposit money ex nihilo.” (My emphasis)

Hopefully that is clear enough language that even a disorientated and narcoleptic Mr Krugman shouldn’t have any difficulty with it. A crystal clear message from an IMF economist, that banks are not “irrelevant” to the macro management of the economy. Quite the reverse. They are the ultimate speed governors of the economy. The buck starts and stops with them, so to speak.

At this point defenders of the “standard” interpretation might well concede that money expansion does occur, but that it is central bank governed; either through control of Narrow Money reserves or via the interest rate mechanism. This is the “money multiplier” interpretation of Fractional Reserve Banking. In this interpretation, the expansion of money is accepted as having occurred within the bank, but as a passive consequence of other actors; namely savers or Government. I have witnessed over the years some people on blog comments argue that by making a deposit any saver has “forced” the bank to lend it out. This is both preposterous in that customers cannot surely force the bank to lend on money, and more importantly risks the misinterpretation that it is all the “saver’s fault”. This is similar in flawed logic to the line of thinking that suggests that Gvt money supply methods and bank interest rates governs the banks’ lending levels [4]. In this interpretation the banks are either the passive victims of Gvt policy or those pesky consumers moving their money in and out of savings accounts.

But again, on this front, the IMF paper delivers a clear conclusion:

“The deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth. And because of this private banks are almost fully in control of the money creation process.”

The paper references a study which itself was used by Steve Keen in his seminal paper “The roving cavaliers of credit” [5], to debunk the myth that banks are passive responders. The Kydland & Prescott study showed that central bank reserves lagged bank created broad money. Therefore, the real power base in the money system lies within the private banking system:

All Mervyn King’s horses and all the Bank’s men, can’t get the process of lending going again!!

So, again, crystal clear conclusion here; the banks are in control.

And how to they obtain this control? Quite simply:

“[The Banks’] function is to create the money supply through the mortgaging of private agents’ assets.”

They, through no genuine forfeiture of assets (no genuine “consideration” of substance) obtain the means to hold us in hock to them. The assets of the nation are willingly surrendered to banks on the presumption that the bank is lending out someone else’s savings to you. But this is a complete fairly tale!

This is the crux of the complaint most recently voiced by Positive Money (and can be traced back at least as far as many other monetary “cranks” such as Frederick Soddy) is that unlike a private two-way loan arrangement, when banks extend loans there is no real FORFEITURE of notional spending power. Nobody’s deposit is reduced when a bank makes a loan. Both depositors and borrowers believe that they have spending power at hand. It is only when all depositors start withdrawing their money (i.e. invoke the spending power potential of their savings) does the system start to crack.

This is what happens with a bank run. It is not just a liquidity issue for a bank, but it exposes the accounting “trickery” behind the very basis of the money. In the words of JK Galbraith “The process by which banks create money is so simple that the mind is repelled.”

It is one of economics’ most carefully coveted omerta topics, which is why the IMF paper is so revolutionary [6]. No longer can the views of “heretics” be dismissed out of hand as cranks or wonks. In one fell swoop, the IMF has ripped up the Index Librorum Prohibitorum and legitimised such previously fringe people as: Steve Keen, Frederick Soddy, Richard Werner, David Graeber and Michael Hudson [7].

Not only that, but the paper does also provide a chilling reminder of how flimsy this pyramid of credit and money really is. Money is after all, just a social convention. An accounting entry of who owes whom. But equally, debts are not real either. They are just a claim on someone else. However, the chilling thing is, if the debts don’t get honoured then neither do the savings.

That’s the thing with money. It feels totally real. Right up to the moment it isn’t!

[1] This is a topic best left for another day, however Phillip Coggan’s “Paper Promises” is a good primer on this aspect, and I thoroughly recommend his LSE podcast:

http://richmedia.lse.ac.uk/publicLecturesAndEvents/20120119_1830_paperPromises.mp3

[2] There are various articles that cover the debate between Krugman and Keen, however this is a good overview:

http://www.cnbc.com/id/46944145/Paul_Krugman_vs_MMT_The_Great_Debate

[3] “The Chicago Plan Revisted” Jaromir Benes & Michael Kumhof

http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

[4] Richard Werner’s 2005 book “A new paradigm in Macroeconomics” argued / demonstrated that it was merely the supply of credit – a willingness to lend – that governed credit expansion, not interest rate levels themselves. Further debunking the money multiplier theory.

[5] http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

[6] This is not the first time this year that the IMF has offered some startling revelations – there have been two working papers on Peak Oil, and the latest World Economic Outlook report contained a section criticising the adverse effects of Austerity measures (which seems to have caught Madame Lagarde, off guard!

[7] This Bezemer article is also worth reading on the nature and origin of money:

http://mpra.ub.uni-muenchen.de/15766/