Fractional Reserve Banking Refuted (2012)

From the October 2012 issue of the Socialist Standard

Since the financial crisis first erupted in the summer of 2007, there has been a renewed interest in what is now commonly called ‘fractional reserve banking’. This is mainly from those who contend that it is the root cause of the problems besetting the world economy. But is this idea really plausible? Both logic and the available evidence would indicate not.

Fractional reserve banking (the idea that the banking system can lend out vast multiples of what has been deposited with it) is not a new theory. It is also – and perhaps more accurately – sometimes called ‘credit creationism’ as it assumes banks can create almost endless amounts of credit from what has been deposited with them by savers. Ever since the MacMillan Report into Finance and Industry in the UK in 1931 gave it credence, variants of this theory have been taught to students in universities and colleges across much of the world.

In truth, there are two versions of the theory –the initial crude one, and a more sophisticated version which on some readings isn’t really credit creationism at all, even if it uses some of the same terminology. We will examine both versions, starting with the original, crude one.

Magic money?
This version of the theory was the one put forward in the MacMillan Report itself and is based on a simplified ‘one bank’ model of the banking system. The MacMillan Committee assumed that this bank would hold a cash reserve of 10 per cent of their deposits to meet any likely withdrawals from customers (today the cash reserve held by banks is a lot less, usually 2-3 per cent). Into this bank a customer places a deposit of £1,000 in cash. Operating with the 10 per cent cash reserve, the bank would then be able to lend out £900 to another customer which is withdrawn by cheque before being returned to the bank as a new deposit. So in this way the initial £1,000 had grown to £1,900 (the initial £1,000 cash plus the cheque that had been deposited for £900 from the loan granted). This is a process the MacMillan Committee argued could then be repeated nine more times assuming the 10 per cent cash reserve, with the bank therefore lending out £900 to each of ten customers in total. It would lead to a situation after all these transactions had been completed whereby £10,000 in deposits was balanced by £1,000 in cash plus £9,000 in loans owed by borrowers. So, as if by magic, an initial £1,000 deposit had become £10,000.

This type of credit creation theory has been put forward by many modern critics of capitalism (including Zeitgeist and some in and around the Occupy movement) who claim society is being enslaved by bankers and the ‘debt-money’they create. It is used to illustrate the view that banks have special powers to create wealth and that the banking system is inherently fraudulent and corrupt. This outlook also has its echoes on the political right, such as in the views of Representative Ron Paul in the US. Shorn of its overtly political implications, it gets an airing in some standard economics textbooks too. For instance, a typical textbook aimed at undergraduate university students like An Introduction to Modern Economics by Hardwick, Langmead and Khan describes a similar, crude credit creation process as if it were fact. Imagining a one-bank economy where the bank operates a 10 per cent cash reserve, with £10,000 in deposits and £1,000 of this in cash, they say:

  ‘suppose now a customer deposits an extra £2,000 in cash . . . Notice now that the ratio of cash to deposits is no longer 10%, but is now as high as 25% [i.e. £3,000 out of £12,000]. Given that the bank’s desired cash ratio is 10% and that the bank wishes to maximize its profits [by making  loans at interest], it will increase its total deposits to £30,000 so as to restore the desired ratio. The bank does this by granting new loans amounting to £18,000 . . . the cash deposit of £2,000 has led to an increase in loans and investments of £18,000 so that total deposits have risen by £20,000 –that is, by ten times the amount of the cash deposit’. (5th edition, pp.439-440).

In this way banks are allegedly able to magic up money they don’t really have, by either the stroke of a pen or push of a button.

Logic deficit

There are a number of reasons why this one-bank model of credit creation is flawed, both theoretically and empirically. The main ones are these:

• Just because a theory is explained or advocated in some economics textbook doesn’t mean it carries any weight. Economists famously cannot agree amongst themselves and economics isn’t called ‘the dismal science’ without reason. Conventional economics has consistently failed to explain all sorts of contemporary phenomena within the market economy (unemployment, recessions, inflation, etc) and there is no reason to suppose it has it right about banks and credit. Furthermore, as we shall see, most modern economics textbooks have moved away from the crude credit creationist views outlined above as they know they are intellectually indefensible. Why might this be so . . . ?
• The model assumes a certain cash reserve (10 per cent in the examples quoted, though a lower cash reserve makes the potential for banks to ‘create credit’ even greater). But is also assumes something else. It assumes that this cash reserve is never actually accessed by anyone in the entire series of transactions, and so is totally unrealistic. In other words, taking the example used by the MacMillan Committee, the initial £1,000 cash is completely untouched throughout. This is interesting, because if credit creation can multiply £1,000 into £10,000 at a stroke of a pen, the equal but opposite effect would come into play if anyone actually withdrew any cash! It would only need one of the borrowers to access their new deposit by demanding cash rather than a cheque to blow the model apart. So the model is not only unrealistic but logically flawed.
•  The model also confuses the apparent ‘creation’ of credit or money with what is merely standard double-entry book-keeping. If someone withdrew £10,000 from their bank and lent it to a business associate with an account at the same bank, the total amount of deposits held by the bank would be unaffected –£10,000 would merely go out of one account and into another. However, if the bank, when acting as an intermediary, did the same thing (i.e. the person concerned left the £10,000 on deposit and then the bank took £10,000 from its deposits to lend to the businessman) then in this instance the bank deposits and loans recorded by the bank would have increased by £10,000. Yet the only difference is that the bank has lent the same amount of money itself. Nothing else has materially altered and the bank hasn’t ‘created’ anything –the apparent difference is merely the product of the way balance-sheet records are kept.
• If banks really could create multiples of credit from a given deposit base then no bank would ever go bust. If a borrower failed to repay a loan, they could merely write this off and create more credit from their deposit base to make another one. Or, more directly still, the credit ‘created’ in this way could be used to buy additional assets. Lehman Brothers, Bear Stearns, Northern Rock, HBOS, Landsbanki and all the other banking disasters testify in a very practical way that this just doesn’t happen in the real world.
•  If banks could create vast multiples of credit from their deposit base in the way supposed, they would never have any financing issues and a need to seek any other sources of capital aside from the deposits they have from savers. Yet this is not the case. When Northern Rock imploded it had £113 billion of loans outstanding, but only £24 billion of this was backed by deposits i.e. less than a quarter. Did this mean the difference in these two figures was due to their ability to create credit over and above the £24 billion of deposits? No. The rest was financed from the money markets, where banks, building societies, companies, governments, local authorities and other organisations buy and sell short-term loans to finance their economic activities. When interest rates rose this put Northern Rock under pressure because the interest payments it was receiving on the loans and mortgages it had granted was barely covering what it had to pay in interest on the money markets to get the capital to lend out in the first place. And when the money markets started to seize up in late 2007, Northern Rock was doomed, having no more access to capital. Similarly, HBOS’s deposits covered only 44 per cent of the loans on its books before the crisis, the rest being financed from the money markets –and with most of this being short-term finance, it had a similarly disastrous result. Indeed, until the financial crisis broke the tendency within the banking sector had been for an ever greater proportion of banking capital to come from the money markets rather than deposits. This was because of a competitive drive to expand their capital so they could lend more and hence increase their revenue and profit. Until recent decades this was only ever done at the periphery of banking practice as to ‘borrow short’(via short-term loans on the money markets) while ‘lending long’(granting long-term loans and mortgages) was considered too risky.
• If banks really were able to increase purchasing power in the economy at the stroke of a pen or push of a button, there would be clear and observable consequences of this. For instance, many credit creation theorists have expected prices to rise alongside the expansion of bank credit, yet there is no observable correlation between the two. Prime Minister Margaret Thatcher gave up on this view in the mid 1980s when she realized the theory didn’t match the facts. Furthermore, while so-called ‘credit creationism’ is as old as banking itself, persistently rising prices (that have been left unchecked) have only been an economic phenomenon since the Second World War.
•  If banks were able to flood the markets with credit it would, other things being equal, drive interest rates down, and this is the opposite of what banks want to happen. If this phenomenon were a reality, banks would be caught in a ‘Catch 22’ situation where near endless credit creation would push interest rates down towards zero. But the rates banks charge have invariably been very healthy (for them), even during the crisis.
•  If banks can create vast multiples of credit from the savings that have been deposited with them, then so could other financial intermediaries. Building societies and even credit unions could do it, as the same principles would apply.  But nobody seriously suggests they can –if a credit union lent out more than had been deposited with it, it would go bankrupt (as, in reality, would a bank, the only difference being that a bank can also normally access the money markets for capital).
• The bankers themselves have explicitly stated that they cannot magically create credit in the way the theory supposes. For instance, Walter Leaf , Chairman of the Westminster Bank in the years leading up to the publication of the MacMillan Report was one of many who said so explicitly:    ‘The banks can lend no more than they can borrow –in fact not nearly so much. If anyone in the deposit banking system can be called a ‘creator of credit’ it is the depositors; for the banks are strictly limited in their lending operations by the amount which the depositors think fit to leave with them’. (Banking, 1926, p.102)

Indeed, many of the signatories of the MacMillan Report in 1931 (mainly the bankers and economists) later repudiated the theory they helped popularize. These included Reginald McKenna, Chairman of the Midland Bank, and most significantly of all John Maynard Keynes, who was the main author of the Report. In his seminal General Theory in 1936 Keynes stated:

  ‘The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of others’(p.82)

In recent years the 2011 Vickers Report (the Independent Commission on Banking) has explicitly stated that banks are ‘financial intermediaries’that ‘bring together savers and borrowers’, without giving any indication that banks can create vast quantities of credit out of what is deposited with them.

• Many who are critical of capitalism as an economic system take inspiration from Marx’s ideas and his analysis of the market economy, but Marx took the view that banks are financial intermediaries between savers and borrowers who don’t create purchasing power: ‘A bank represents on the one hand the centralization of money capital, of the lenders, and on the other hand the centralization of the borrowers. It makes its profit in general by borrowing at lower rates than those at which it lends’(Capital, Volume 3, p. 528). For Marx, wealth and purchasing power arise through production, not the sphere of circulation and exchange. Banking profit does not, in Marx’s view, arise mystically out of financial conjuring, but as a portion of the surplus value created when the working class of wage and salary earners is exploited. This surplus value is then turned into industrial profit, ground rent, and banking interest.

In the light of all these arguments and the empirical evidence, it seems reasonable to conclude that the crude credit creationist viewpoint has little if anything going for it.

Second theory
A recognition of this has led to the popularization of the second, and more sophisticated, version of the theory. This is the version that argues that even if the one-bank model of credit creation isn’t plausible, the banking system when considered as a whole can effectively do the same thing. This was the view for years elaborated in standard economics textbooks by the well-known American academic Paul Samuelson and is perhaps the version that is most common today.

Samuelson dismissed the argument that an individual bank could lend more than had been deposited with it as ‘false’ and went on:

  ‘According to these false explanations, the managers of an ordinary bank are able, by some use of their fountain pens, to lend several dollars for each dollar deposited with them. No wonder practical bankers see red when such power is attributed to them. They only wish they could do so. As every banker knows, he cannot invest money that he does not have; and money that he invests in buying a security or making a loan soon leaves his bank.’ (Economics, 5th edition, 1961, p.331)

The argument he put forward is that when someone deposits £1,000 into a bank when there is a 10 per cent cash reserve ratio, the bank keeps £100 cash and lends out the other £900. This will then be spent by the borrower and will find its way back into the banking system more widely, which will then keep £90 of the £900 as a cash reserve and lend out the remaining £810, and so on.  Eventually, after these deposit and loan circuits have been completed, this leads to a situation whereby the initial £1,000 deposit in a particular bank has multiplied to £10,000 across the banking system as a whole.

Although it is an obvious oversimplification, in some respects this theory is sound. The key issue though is that it is not an example of ‘credit creation’at all. All this theory demonstrates is that money circulates and that for every loan that has been created, a deposit (that is greater than the subsequent loan) has also been made. In some ways it is little different to the concept underpinning the circulation of a bank note, whereby a £20 note can be used many times over a given period to facilitate transactions that, when aggregated, are many times the face value of the individual note.

No special powers
Given this, socialists say that ‘fractional reserve banking’ or ‘credit creation’ are myths. The crude version of the theory is illogical and at variance with any serious knowledge of banking practice, while the watered-down version most commonly found in modern economics textbooks isn’t really a credit-creation theory at all and proves nothing beyond the accepted fact that accepted means of payment circulate within the economy. In reality, banks can only lend out what they have received in deposits (or borrowed on the money markets), making their profits by levying higher interest rates on the loans they grant than they pay depositors (or pay to the money markets).

There really is no mystery to this, and the idea that banks have special powers and can hold the rest of society to ransom is consequently unfounded and movements for banking reform misplaced. The real problem in society stems not from what banks do specifically, but from the way society is organized as a whole. In particular, from the fact that the vast majority of people do not own and control the planet’s resources and have to work at the behest of those who do –some of whom are indeed bankers . . . but most of whom are not.

Dave Perrin

The Guardian: Haven for Cranks (2012)

From the October 2012 issue of the Socialist Standard

One way in which the notion that banks can create credit out of thin air has got into circulation has been through the Guardian.

“Money from thin air” was the heading of an article by James Robertson published in 20 March 2008 in which he claimed that

  “commercial banks are allowed to create almost all the money we use. They create it out of thin air and put it into circulation in the form of profit-making loans. They credit those to their customers’ accounts by a simple accounting procedure, and their customers spend the money into circulation.”

That banks give loans cannot be denied –that’s one of their functions –nor that those given a loan spend the money. That’s not the point at issue, which is: Do the banks create this money out of thin air by a simple accounting procedure? Or are they transferring previously existing purchasing power? In other words, are they creating purchasing power that did not exist before? In asserting that they do, Robertson has some other questions to answer. Why do banks compete with each other to attract people’s savings (i.e., money people don’t want to spend for the time being)? What is the difference between a bank and a moneylender? Do moneylenders, pawnbrokers and loan sharks also create money out of thin air when they make a loan? If not, why not?

In an article by Richard Werner and Green Party MP (and then Party Leader) Caroline Lucas on 12 February this year the two asserted that:

  “banks simply pretend that borrowers have deposited the money they lend them, and thus create it out of nothing, when they credit their deposit accounts, adding to the money supply.”

When they make a loan, banks generally do open an account for the borrower to which the amount of the loan is credited, but it does not follow that this has been created “out of nothing”. In fact, it has to come from what the bank has, either from outside depositors or from what they themselves borrow. Banks are essentially financial intermediaries which borrow money (depositing money in a bank is in effect lending it the money) from savers and lend it to investors (those who want money for some project). Their income comes from the rate of interest (if any) they pay those who lend them the money and the higher rate they charge those who borrow it from them. Bank profits are what is left after their expenses (buildings, computers, staff costs, etc) have been paid out of this income.

In the build-up to the present crisis, according to an article to an article by Deborah Orr (14 July):

  “The big international banks manufactured money, using very simple raw materials. All they needed were computers and borrowers. Every time they made a loan, the banks simply typed the amount they were lending into their computer system, transferred it to their victim’s account, and charged interest for the privilege.”

The fact that she herself described this as “the closest thing to alchemy that humanity ever contrived” ought to have alerted her that there was something wrong with this account.

If the banks she referred to only needed computers and borrowers, how come some of them got into serious difficulty when the rate of interest at which they had been borrowing money on a short-term basis rose, squeezing their income since they were unable to raise the rate they charged borrowers? Clearly, they did need the money to lend as well as their computers.

Orr went on to give her support to a bank reform under which banks would be “lending from their capital, not ‘lending’ money they had conjured up from thin air of cyberspace.” She didn’t seem to realise that this is what banks already do today.

Only a woolly-minded reader of the Guardian would believe the tosh that banks can conjure up the money they lend from “the thin air of cyberspace."

Adam Buick

The Banking System (2012)

From the October 2012 issue of the Socialist Standard

The origin of the banking system was the practice of depositing money for safe keeping with the goldsmiths and paying them for this service. The goldsmiths subsequently adopted the practice of paying interest to the depositor, and they re-lent the money at a higher rate of interest to a borrower. This was only an indirect way of the depositor himself lending his money at interest to the borrower. Whether the goldsmith acted as intermediary or whether the lending was done directly the general effect was the same, i.e., the owner of the money (representing a command over goods) was lending it to a borrower, who would thus, for a specified time, have at his disposal the means of buying goods. It was not an act of “creating” goods or values, but only of lending them, the banks being intermediaries between lenders and borrowers.

Fundamentally, the same process underlies the modern banking and credit system. People who deposit cash and cheques in the banks are, in effect, placing at the disposal of the banks a command over goods, expressed as a certain sum of money. The banks pay to the depositor a fluctuating rate of interest on most of the deposits, and place the deposits at the disposal of other persons and companies who wish to borrow. Again, it is, in effect, a process of transferring the command over goods from the saving section to the borrowing section. As the banks need security for their loans to industry the borrower in fact (or in effect) pledges his factory, his stock-in-trade, etc. The bank is just like a pawnbroker, except that the bank largely works on borrowed money. The banks are intermediaries between one set of property owners and another set. The borrowers pay interest to the banks, who pay a smaller or no interest to the lenders. The whole of the interest comes ultimately out of the productive process.

(Socialist Standard, May 1933)

Monopoly money (2019)

The Cooking the Books column from the August 2019 issue of the Socialist Standard

In June Mark Zuckerberg announced that in 2020 Facebook would launch its own ‘digital currency’. Since Facebook is the F in the GAFA group of US technology corporations that are widely criticised for harvesting private information for profit and/or not paying enough tax (the others are Google, Apple and Amazon), suspicions, not to say conspiracy theories, immediately arose that there must be some ulterior motive, one beyond making more money that is. Even Ed Conway, Sky News Economics Editor, had an article in the Times (21 June) headlined ‘Facebook currency will help it rule the world. Mark Zuckerberg’s new move is designed to make his company more powerful than any country’.

Is there anything in this? Or is it just sensationalism or the usual left-wing practice of selecting particular capitalist corporations or groups of capitalists to blame for things rather than the capitalist system as such or even the far-right delusion that the Jews are out to rule the world?

What is being proposed is an international payments system based on blockchain technology. This is a technology that allows any transaction to be both uniquely digitalised and unable to be tampered with. It was the basis of the Bitcoin scheme devised by the so-called crypto-anarchists. But the Libra, as the Facebook money is to be called (the same as the l in the old l.s.d.), will be different from Bitcoin in several key respects.

First, it will not be that decentralised but run by a central board on which other corporations, such as Paypal, Visa and Mastercard, participating in it will be represented alongside Facebook.

Second, it will be linked to a bundle of state currencies (dollar, euro, yen, sterling, etc) so that, unlike Bitcoin, its value can be stabilised so it can be used as a means of payment.

Third, it won’t be secret. Secrecy is not built-in to blockchain technology but was something added by the crypto-anarchists for Bitcoin to avoid states knowing who the payers and payees were.

Fourth, it will be profit-making. The corporations participating in it are aiming to make a profit out of the fees charged to users.

Those using the service – in theory all of the 2.3 billion Facebook users – will be able to open an account in Libra by converting their state currency into it and using this to pay for goods and services in any part of the world (except China where Facebook is banned). It is rather surprising that the banks themselves have not come forward with such a system. They may well be forced to now. Even the state central banks might have to,

That this is a bid by Zuckerberg to become the ruler of the world is complete nonsense of course. For that, he would have to control armed force, which he doesn’t. And his scheme will be subject to the control of states. They are bound to introduce regulations to stop Facebook money being used for currency speculation, money laundering and other dodgy dealings, just as they have done with Paypal and the others and would love to do with Bitcoin.

Ellen Brown, the US anti-banker theorist, has suggested (‘Facebook May Pose A Greater Danger Than Wall Street,’ Truthdig, 25 June) that what should happen is that the international payments system be run as a public service by ‘democratised’ central banks. That’s to miss the problem. It, too, would be a colossal waste of information technology that could be more usefully employed, in a needs-oriented world, in organising the logistics of ensuring that everyone on Earth had access to what they needed when they needed it – without payment.

Marx and Banks (2013)

The Cooking the Books column from the May 2013 issue of the Socialist Standard

The Morning Star (23-24 March) carried a cartoon which has Marx holding a piece of paper on which is written ‘Cyprus banks grab’. He is writing on a blackboard:  ‘Banks in Capitalist society are institutions created for the systematic robbery of the people’ and asking, ‘Now will you believe me?’

The only problem is that this is not a quote from Marx, nor does it correspond with Marx’s expressed views on banks. Marx was well aware of the opportunities for swindlers opened up by the coming of limited liability companies and their promotion, and by stock exchange manipulations in which some financiers and banks already were involved in his day, and wrote about this.

However, Marx’s whole analysis of the nature of exploitation under capitalism was that this took place in the course of production in the places where real wealth was actually produced when capitalist employers extracted surplus-value from wage-workers, not in the sphere of money and finance.

In Volume 1 of Capital he specifically repudiated such views:

  ‘The great part that the public debt and fiscal system corresponding to it have played in the capitalization of wealth and the expropriation of the masses, has led many writers, like Cobbett, Doubleday and others, to seek here, incorrectly, the fundamental cause of the misery of the people in modern times’ (Chapter 31).

A large part of Volume 3 of Capital is devoted to a discussion of banking and finance. Here Marx analysed banks as being essentially institutions for collecting the savings of people who did not want to spend their money for the time being and channelling these as money capital for productive industry. As he put it:

  ‘A bank represents on the one hand the centralization of money capital, of the lenders, and on the other hand the centralization of the borrowers. It makes its profit in general by borrowing at lower rates than those at which it lends.’

In other words, banks were not a scam to systematically rob people but institutions which played an essential role in the operation of the capitalist system.

There is another problem with the cartoon’s supposed quote. When it says ‘banks in capitalist society’ this could imply that banks in a non-capitalist society would have a different role. But it was Marx’s view that banks would have no place in a socialist society (or as he preferred to call it, a communist society, meaning the same thing).

In Volume 2 of Capital he wrote: ‘if we were to consider a communist society in place of a capitalist one, then money capital would immediately be done away with’  (chapter 14, section 3) and that ‘with collective production, money capital is completely dispensed with’ (Chapter 18).

This is clear enough. Banks channel savings as money capital. Money capital won’t exist in socialism. Therefore banks won’t exist in socialism.

Ironically, since the paper normally gives free range to currency cranks, Richard Seymour writing in the Guardian (27 March) got it better when he concluded an article: ‘Cyprus crisis: why do we need banks at all?’

‘To paraphrase Karl Marx on religion, the demand to abolish banking is a demand to abolish the state of affairs that needs banking.’

That’s what Marx is more likely to have written on the Morning Star’s blackboard.

Pamphlet Review: ‘The Magic Money Myth – A Guide to Banking’ (2019)

Pamphlet Review from the April 2019 issue of the Socialist Standard

‘The Magic Money Myth. A Guide to Banking’. The Socialist Party. 30 pages.

Since the Crash of 2008, blamed rightly or wrongly on the banks, there has been a renewed interest in how the banking system works, and not just among regulators. At the Occupy Camps that sprung up in 2011 this was a major topic of discussion as those there looked for an alternative to capitalism, at least in its present form. Leaflets circulated reviving money theories of yesteryear and criticising ‘fractional reserve banking’. The Green Party too discussed the matter and committed itself on paper to the theory that banks can create money out of thin air. Money theories and denunciations of ‘banksters’ are all over the internet and get a hearing from those trying to understand why the present economic system doesn’t work in the interest of the majority.

Some of these theories are just plain wrong, factually mistaken about what banks do and can do. All assume that banking or monetary reform can improve the position of the majority class of wage and salary workers. But it can’t as these problems arise from the capitalist system of minority ownership of the means of life and production for the market and profit rather than to meet people’s needs. Monetary reform is a red herring sending in the wrong direction people who are looking for a way out of capitalism. If implemented it would not solve the problems that the majority face as it leaves their cause unchanged.

In this pamphlet we set out, as part of explaining how the capitalist economic system works, to expose factual errors about what banking is and how banks work. There is nothing especially bad about banks compared with other profit-seeking capitalist enterprises. They are merely in a different line of business. Banks are not the cause of the problems that the majority class face. It’s capitalism and its production for profit. The way-out is not to reform banks or the monetary system but to abolish capitalism and replace it with a socialist society based on the common ownership and democratic control of the means of production. There would then be production directly to meet people’s needs and distribution in accordance with the principle “from each according to their ability, to each according to their needs,” and banks and money would be redundant.

Price £4 including postage. Send cheque, made out to “The Socialist Party of Great Britain”, to 52 Clapham High St, London SW4 7UN. Or order and pay online at: Magic Money Myth

The Bank Charter Act (2012)

The Cooking the Books column from the October 2012 issue of the Socialist Standard

The Bank Charter Act of 1844 is back in the news. An article in the Guardian (13 July) by Deborah Orr discussed its terms and stated that it “removed from banks their licence to print money.” It did remove the right of banks other than the Bank of England to issue their own bank notes, but gradually rather than immediately. Banks which had been issuing notes until 1844 were allowed to continue until they merged or were taken over, but not to increase the amount they had been issuing. Some banks continued to issue notes for the rest of the 19th century, the last continuing till 1921.

According to the wikipedia entry, “The Act exempted demand deposits from the legal requirement of a 100-percent reserve which it did demand with respect to the issuance of paper money.” The source for this claim is given as the Ludwig von Mises Institute, as if this could be regarded as a source of reliable information.

This claim is wrong on two counts. The Act does not mention “demand deposits” at all, let alone exempt them from anything. Nor did it require banks to hold an amount of cash (gold or Bank of England notes) in their vaults equal to the face-value of the notes they were allowed to continue to issue.

The basic aim of the Act was to regulate the issue of paper currency which its promoters thought would lead to inflation if too much were issued. This was based on the theories of the Currency School, but was challenged by the Banking School who argued that, as long as bank notes were convertible on demand into a fixed amount of gold, this would not happen. Marx agreed and a whole chapter of Volume 3 of Capital is devoted, with contributions from Engels, to “The Currency Principle and the English Bank Legislation of 1844.”

The Act was not concerned whether or not banks backed up their notes with an equivalent amount of cash in their vaults. How much cash to hold was left to banks’ judgement. Knowing that only a small percentage of the notes were likely to be presented at any one time for payment in cash, the banks would normally only keep that amount in their vaults.

Giving someone a wad of notes was just one way in which banks could then make a loan. Another was to grant the borrower an overdraft, which is presumably what the Mises Institute mean by “demand deposits”. But these did not need to be backed by “a 100-percent reserve” either. The amount of deposits that a bank would need to retain as cash would depend, once again, on the bank’s experience of how much their clients were likely to withdraw in this form. That you don’t have to retain as cash all the money deposited is the basic principle of banking. To have required all loans to be covered by an equivalent amount of cash in the banks’ vaults would have turned banks into safety deposits and rendered all lending by them impossible. The promoters of the 1844 Act did base it on a fallacy but they weren’t that stupid.

The Act didn’t even require the Bank of England to cover all the notes it issued by an equivalent amount of gold in its vaults. It was authorised to issue £14 million, known as the “fiduciary issue”, without this. This proved not enough during financial panics and the Act had to be suspended in those of 1847, 1857 and 1866, as Marx chronicled in detail in Volume 3 of Capital. His conclusion is as valid today as it was then: “Ignorant and confused bank laws, such as those of 1844-5, may intensify the monetary crisis. But no bank legislation can abolish crises themselves” (chapter 30).

Swiss bankroll (1980)

Book Review from the February 1980 issue of the Socialist Standard

Switzerland Exposed by Jean Ziegler (Allison and Busby, £3.50)

Here's an easy one. Which European country does nearly everyone think of as the home of neutrality, winter sports and the cuckoo clock? Obviously, it is Switzerland but what is significant is its importance in the world’s banking system. Swiss banking operates as the leading fence for capitalism’s more dubious transactions and this is why hundreds of banks, finance companies and the like are located there.

Swiss banking’s code of secrecy and protection for customers is the big attraction. Vast sums of money are constantly being sent to Switzerland to avoid paying tax in the countries of origin. The money is changed into Swiss francs, placed in numbered accounts, and then reinvested by the banks. The owners of the funds, besides paying no tax, benefit by having their money in inflation-free currency while the banks, who pay little or no interest because of the service they provide, reap the profits from the investments they make.

Strictly speaking, all this is against Swiss law but the law is never enforced and even if it were numerous ways exist to get around it. Even the wealth stolen by “Third World” heads of state and politicians is safe. Ex-Presidents Thieu of South Vietnam and Lon Nol of Cambodia and ex-Emperor Haile Selassie of Ethiopia all sent immense fortunes in gold and money to Switzerland and none of the new governments can recover a penny of it. More recently the Swiss government refused a request from the Iranian authorities to freeze the ex-Shah’s assets in Swiss banks (The Guardian 11.12.79). The Mafia, too, sends some of its loot to Switzerland to be “laundered” and then returned for reinvestment in legitimate enterprises.

All this information, and more, is given in the book Switzerland Exposed by Jean Ziegler (Allison and Busby, £3.50). Ziegler is a Social Democrat member of the Swiss Parliament and although he uses the terminology of Marxism he understands that subject less well than he does Swiss banking. His thinking is thoroughly idealist. For example, he imagines that if Swiss banking stopped handling this “dirty money” from the “Third World” then this would somehow benefit the poor people who live there. Of course, all that would happen is that the money would simply be sent elsewhere, with Monaco and the Bahamas as possible alternatives.

This blinkered view is due to the fact that Ziegler is another of those who are obsessed by the exploitation of the Third World by the “imperialists”. By these he means the industrialised West only and thinks that China, Vietnam, Cambodia and Cuba have freed themselves from foreign domination. He apparently hasn’t noticed that China is itself now an imperialist power ever seeking to extend its frontiers and influence, while Vietnam and Cuba, although rid of American domination, are now colonised by Russia instead. At present China and Russia are involved in a bloody struggle over Cambodia.

So Ziegler thinks that the West’s domination of the Third World is the big problem and wants to reverse this by giving the Third World a bigger share of the world markets in agricultural produce and raw materials through “international agreements”. This is merely tinkering with capitalism and can only help perpetuate it by diverting working class attention away from the real task, which is to abolish the capitalist system altogether.

An important part of Marxist theory is an understanding of the role of the state. Historically, the state is the public power created by a ruling class to defend its interests. Engels described it as

the state of the most powerful, economically dominant class, which through the medium of the state, becomes also the politically dominant class, and thus acquires new means of holding down and exploiting the oppressed class. Thus, the state of antiquity was above all the state of the slave owner for the purpose of holding down the slaves, as the feudal state was the organ of the nobility for holding down the peasant serfs and bondsmen, and the modern representative state is an instrument of exploitation of wage labour by capital. (Origin of the Family, Private Property and the State.)

Ziegler claims that the Swiss state has only “become” like this, which implies that it had once been impartial. He actually says that the state should operate in the interest of all Swiss citizens! And although he describes the existence of the Swiss army as “social violence institutionalised” he is not opposed to it and merely wants to see workers “reaching the higher ranks”. Could idealism go further?

The author’s suggestions on how to fight capitalism are absolutely disastrous. He wants workers to have “temporary alliances with the class enemy . . .  to further the anti-imperialist struggle”. For example, Ziegler advocates unconditional support to OPEC in its oil price-war with the developed world customers, and Swiss trade unionists are advised to ally themselves with the “national bourgeoisie in their struggle against the growing control exercised by the multinational companies over the nation’s production system. . .”. Such taking of sides in the quarrels of our masters does not weaken capitalism: it gives it strength by causing further division and confusion within the working class and holding back the advance of socialist knowledge.

Vic Vanni

Economics: Banks and Credit (1975)

From the February 1975 issue of the Socialist Standard

The use-value of loan capital, which is made available through the banking system, consists of producing profit, and this type of profit is described as interest. The rate of interest is arrived at by competition between lenders and borrowers, or by supply and demand; the lender of loan capital striving to obtain the highest rate of interest for the use of his capital, and the borrower seeking the lowest rate. There is no "natural" rate of interest, nor is there any limit to the rate that can be charged.

In the German Weimar Republic during the period of great inflation after World War 1, the rate of interest was raised weekly in some cases to 200%. The "natural" rate theory has its basis in the repetitive form of dealings between merchants and industrialists in the negotiation of Bills of Exchange. A substantial part of the business of a bank consists in discounting (cashing) Bills of Exchange. They are, generally speaking, promises to pay between merchant and industrialist at 60-90 day intervals, or longer. These Bills usually represent goods in transit or in store, and for the facility of advancing cash immediately on the strength of the Bill, which guarantees the value of the goods nominated in the Bill, the banker will deduct or discount a fraction of the amount shown and buy the Bill. If, for example, a Bill of Exchange was valued at £10,000, and the annual rate of interest was 10%, and the Bill was due in 90 days, the banker would deduct the sum of £250, i.e. 90 days' interest, and advance the sum of £9,750. When the Bill was finally redeemed, the banker would then receive the sum of £10,000 - the full value of the Bill.

Rates of Interest

Naturally the merchant and the industrialist (incidentally banking transactions as described above are not just confined to these two) would seek out the most favourable discount rates, and over a period of years the rate would tend to become adjusted at a regular rate. For many years between World Wars I and II the bank rate remained almost stable, around 2½%-3%. The old bank rate was based on this practice of discounting Bills, and gave rise to the theory of the "natural" rate of interest. Regarding the possibility of the banker getting the better of the merchant, industrialist etc., by successfully charging high discount rates; this would only result in a transfer of wealth between them. Were the British banks to consistently charge usurious rates, capitalists would endeavor to have their Bills discounted elsewhere, say New York or Paris.

Since interest is part of industrial Profit, the maximum limit of interest is marked by profit itself. The leaves can never be greater than the tree, or the part can never be greater than the whole. The high rate of interest today, i.e. 15%-16%, is distorted by inflation. The Chairman of Barclays Bank, Mr. A. Favil Tuke said:

"It is worth recording that of the three parties who make up a bank, namely stockholders, staff and customers, none has gained much from these profits.  Customers do not need to be told how much interest rates have risen in the last year or two; the increases in the salaries of our staff have been limited to about 7% per annum, and that of the stockholders dividend to 5% per annum; all this at a time of inflation of some 10%, per annum." (Directors' Report to AGM, 1974).

Obviously the depreciation of money is taken into account when fixing a rate of interest, and this is basic to the preservation of the value of the loan capital. On the other hand any prolonged fall, resulting in a total loss of interest, as well as an erosion of the value of the money capital, would eventually remove loan capital from the money market. This would, sooner or later, have repercussions in the productive process, as industrialists and other capitalists would find difficulty in raising capital for certain projects. As capitalism's wealth develops there is a tendency for the owner of inherited wealth to live on the annual interest without actively participating in the productive process. The same attitude is adopted by retired capitalists who want to take things easy, instead presumably of just taking them - as in their youth. Loan capital arises mainly from these sources.

Were there no profit in loaning capital, that capital would be hoarded until such times as things improved. The owners of such capital would not retain it in the form of paper currency at the mercy of inflation, which has the effect of gradually reducing the wealth of the banker and the landlord, as well as literally confiscating such savings as are owned by workers. They would hold their hoard either in gold, works of art, land, buildings, or any other desirable commodity which retained its value. No profits would accrue from assets held in this way, but on the other hand, there would be no losses either. However, if this happened on any scale there would be industrial dislocation.

Lenders & Borrowers

The function of banks is firstly to make recurring payments on behalf of their customers; meeting mortgage payment rates, quarterly bills, and regular annual orders. These are payments which are entirely concerned with the circulation of commodities. But their second and most important function is to provide credit or capital for industry, commerce, property, etc. This is not provided out of the resources of the bank, as can be seen by the statement of the London Clearing Banks. Total advances were £16.7 thousand millions (Quarterly analysis of Bank advances; Bank of England, 20th November 1974), whereas the total capital of these banks was £658 millions as at December 1973 (Annual Reports, 1973).

Generally speaking, bank overdraft limits are reviewed every year, and bank borrowing is mainly short-term; up to 3 years in the main. Long-term loans are usually handled by the merchant banks who charge a higher rate of interest for this facility. The credit system which owes its development to the specialized function of the bank has proved to be a significant force in the centralization of capital. Gathering as they do all the disposable money which is spread throughout society, they channel it into the hands of groups of capitalists, who turn it into capital. The accumulation of capital is speeded up, and with it the productiveness of labour, as more and more machinery is introduced into the productive process.

Credit, and the credit system, have given rise to many misconceptions about the power of banks to create credit. Firstly, credit, whatever its form, whether in money or goods, consists in a transfer from one person to another.

Credit, in its simplest expression, is the well or ill founded confidence which induces one man to extend to another a certain amount of capital, in money or in commodities, estimated at a certain value, which amount is always payable after the lapse of a definite time. (Tooke. Capital, Vol. III. Kerr edn., p. 471).

Elements of social wealth, and the conditions under which the transfer takes place, or the trustworthiness of either of the parties to the transaction, need not concern us. An owner of goods may be separated by an interval of time from realizing the value of these goods in money. Certain articles take a longer time to produce than others, and others longer to market. The production of certain commodities, mainly agricultural products, depends on certain seasons of the year. Inevitably the owner of the commodities will borrow money on them, or sell his right to them for money on the spot, or the written promise of money. This is putting it at its simplest — the goods providing the security for the loan. In any case, goods are exchanged or secured against a sum of money which is due to be repaid at a given date in the future. Payment in advance of delivery, or delivery in advance of payment, represent the two sides of simple credit. It is to be assumed that the credit seeker has a reputation for solvency, and that fraud is not the purpose. Credit advances in this way merely facilitate the circulation of commodities by getting them to the market quicker.

Weakest to the Wall

The second and most important function of the banker is to provide money for industry, which is capital. This has a separate function from money as the medium of circulation. The function of capital is not merely the circulation of commodities but their production in the first instance. Therefore, money used as capital is withdrawn from circulation because the wealth which it represents has been locked up in the process of production. The credit system of advancing capital allows individuals to use capital which is not theirs, and has opened the door to all sorts of swindles and reckless speculation. Who would not gamble with other people's money?

If banks could create credit with the stroke of a pen, that would mean in effect they could create wealth, and consequently the Marxist Theory of Value would be shown to be wrong. However, as time passes the validity of the Labour Theory of Value, i.e. that wealth can only come into existence when men apply their energies to nature, is all too apparent. If banks could create credit, they would never be in financial difficulties, nor would they go bankrupt. As we have seen in recent years, a number of bank failures are taking place. The Ideal Savings Bank, and the Bank of the Lebanon, for example. More recently, the Herstatt Bank of Germany, and the Sindona group of Banks in Italy; the Israel British Bank (London) with deficits of over £40 millions. Many of the 40 or so fringe banks are in dire trouble, and some have gone into liquidation, including Mr. Jeremy Thorpe's London & Counties Bank. (His insight into the political future has not helped him in his banking adventures.) Many of these failed banks had the dubious benefit of advice from economic and political experts forecasting the future of capitalism. Once again they have come unstuck, and we can say with certainty that more banks will fail as the competition increases — the large fish will gobble up the little ones.

Credit Creation a Myth

In these circumstances, why did these banks not create a bit of credit for themselves and literally pull themselves up with their own shoelaces? The answer is all too obvious. The credit of the banker is provided only by his depositors. This is real money. It matters not whether the bank transfers depositors' credit to a bad risk or a dud enterprise — he is liable for its return. At the present time, the property market has turned out to be a bad financial risk, and the little fish are in trouble having lent long to property speculators, and borrowed short from their bigger brothers. The alleged "rescue" operations organized by the Bank of England are nothing other than the lambs being eaten up by the wolves. The smaller fry of the financial and banking world are no more immune from the centralization of capital than the small car firms, garages, shopkeepers, etc. In the last four years the Big Five Banks, Westminster, Barclay's, National Provincial, Lloyd's and Midland, have become the Bigger Four. A number of Scottish banks have been taken over by the Big Four — the Bank of Scotland for example is now under the control of Barclay's, whilst the Clydesdale Bank is controlled by Midland; National Westminster controls Coutts & Co., also the Ulster Bank Ltd. Lloyd's control the Bank of London and South America, the National Bank of New Zealand and many others.

If these small satellites wanted to remain independent all they need have done was to create credit by increasing their capital by a stroke of the pen. Such fictitious capital would no doubt pay a fictitious dividend, and create a series of fictitious deposits. Unfortunately, however, the original depositors who have loaned real money have no sense of fiction — even the science fiction of the economic experts — and would require repayment in very realistic banknotes.

The bank profits for 1973, the last accounting year of the London Clearing Banks and subsidiaries, do not bear out the miraculous power of credit creation. Although this was a bumper year the total profits, after tax, were £335.7 millions (Annual Statement for 1973). This is a large profit, but it is only a small portion of the total industrial profit.

Inflation Fraud

The one institution which appears to create credit is the State, operating through the Bank of England. This is an act of deliberate political policy, the reasons for which will be given in a separate article. The Government, in a variety of ways, instructs the Bank of England to print an excess of paper currency, which the Government uses to finance its own schemes, and without having to introduce tax legislation to deal with particular cases. This inflation of the currency does not, nor cannot, add to existing wealth. What is really happening is that, far from creating credit, the Government is confiscating other people's. This has the same effect as a general increase in taxation. The constant dilution of the purchasing power of money by inflation raises prices and dislocates production and distribution. This is public fraud posing as public credit.

Capitalism is a system of production and distribution with many contradictions, and inflation adds yet another. Whatever strategy is worked out by economic planners and monetary specialists will make no difference. Capitalism will run according to its own laws, and they can only run after it. After all — who ever heard of an expert on anarchy? 

Jim D'Arcy

Swizz Banking? (2016)

The Cooking the Books column from the March 2016 issue of the Socialist Standard

Swiss banking reformers have obtained the 100,000 signatures needed to initiate a referendum to restrict bank lending or, as they put it, to stop banks benefiting from being able to create electronic money out of nothing.

Explaining the apparent logic behind the proposal in the Financial Times (5/6 December), Martin Sandhu wrote:

‘The bank decides whether it wants to make you a loan. If it does, then it simply adds the loan to its balance sheet as an asset and increases the balance in your deposit account by the same amount (that’s a liability for them). Voilà; new electronic money has been created.’

This is indeed what happens from an accounting point of view. Double-entry book-keeping requires every new asset or liability to be balanced by a corresponding liability or asset. In this case, in making the loan, the bank acquires a liability. This has to be balanced, in the accounts, by a corresponding asset, recorded as an IOU from the borrower. That a new asset has been created out of nothing is only an illusion arising from an accounting convention.

Outside the accounts department all that has happened is that the bank has committed itself to making a loan to a customer. It ought to be obvious that, to be able to meet the obligation (liability) to pay this, the bank will have to be able to fund it, but currency cranks (and, surprisingly, some financial journalists) overlook this and believe that banks really can ‘simply’ create out of thin air what they lend. Sandhu even used the word ‘scam’.

This is not to say that loans have to be funded entirely from what people have deposited with the bank (a view sometimes attributed to critics of the thin air school of banking) since other sources of funding are available, from the money market (i.e. other financial institutions) or the central bank, some of which can even be done after a loan has been made.

The Swiss banking reformers subscribe to the mistaken, monetarist view that an over-expansion of bank lending causes (rather than merely reflects) booms and busts and they want to control and restrict it to try to prevent this. It won’t work but that’s the theory.

The proposal is that banks should not be able to re-lend money deposited in current accounts. When it receives such a deposit the bank will be required to re-deposit it with the state’s central bank in return for what Sandhu calls ‘State e-money’. All banks would be able to do with this is transfer it between current accounts.

This would certainly restrict bank lending but it wouldn’t (and is not intended to) stop it altogether. As the Swiss banking reformers explain (tinyurl.com/hnemzep), after the enactment of their reform:

 ‘The banks can only work with money they have from savers, other banks or (if necessary) funds the central bank has lent them, or else money that they own themselves.’

But this is already, now, the case! Money deposited in a current account is just as much a loan to the bank as is money deposited in a savings account. Banks can, and do, re-lend most of it too, except that, unlike with a savings account, it keeps all the interest.

But if money re-lent from a current account is money created from thin air, why is money re-lent from a savings account not? Don’t ask us. Ask the currency cranks.

Will Hutton: Back to the Future, part 1/3 (2015)

From the Socialism or Your Money Back blog

It was with a sense of irony that I read Will Hutton in the Comments and Debates section in a copy of Guardian Weekly (16.10.15).  It was the previous week’s edition and the irony was that I was reading it on Back to the Future day (21/10/15), which summed up the economic views that I was reading.  Hutton wants to go back not to 1985 but to any date before the rise of what Hutton calls the ‘Anglo-Saxon political right’  in the US and UK which put Keynesianism out in the cold (usually identified by the left with the bogeymen of Thatcher in Britain and Reagan in the US).  Now I thought that the political reach of Anglo-Saxons had ended a thousand years ago but I will leave that particular question mark to one side.  Hutton argues that the roots of the 2008 financial crisis and current crises in China and other ‘emerging market economies’ lie in a ‘world financial system that has gone rogue’.  At the heart of this argument is Hutton’s claim that the power of banking to ‘create money out of nothing has been taken to a whole new level.’ 

This is an up to date version of a theory that has been doing the rounds since the early 1930s, that of fractional reserve banking; the argument that banks by holding on to a fraction of its deposits (to ensure that withdrawals can be met) can create multiples of credit, that they can essentially ‘create money out of nothing’.  The crude version of this theory assumes that multiples of credit can be created from an initial deposit of £1000 with a fractional reserve of, for example, 10%, £900 could be lent (paid out as a cheque or transfer and deposited with the bank) expanding the initial deposit in one act of lending to £1900 of bank deposits.  If a loan of £900 was carried out 10 times the end result of the initial £1000 deposit would be £9000 in loans and £1000 in reserve, in 10 quick steps an initial deposit of £1000 has been turned into £10,000 – money has apparently been ‘created’ as credit from the scribble of a pen or the tapping of a keyboard.  However, this view of banking does not hold theoretically or empirically. Two quick examples (there are more) will show why the theory doesn’t hold.  Firstly, this model assumes that there will not be a cash withdrawal on the initial deposit during the whole series of transactions, a false assumption but necessary to prevent the theory’s instant collapse.  Secondly, the appearance of the creation of credit is created by standard double-entry book-keeping where when a bank lends, for example, £1000 this is recorded initially as a deposit of £1000 and a loan of £1000, apparently ‘creating’ £1000 (until the loan is withdrawn). Empirically we can also demonstrate that banks in fact do not operate in the way described.  If they did they would be able to create immense amounts of credit from relatively small deposits (pushing interest rates to very low levels).  This does not happen and banks back their lending not just from deposits but from money they themselves have borrowed – something that had increased to risky levels before the 2008 crisis (and interest rates do not fall to very low levels).

Hutton appears to hold to a less crude version of ‘credit creationism’ as he says that ‘the system depends on the truth that not all depositors will want their money back simultaneously… some of the cash banks lend in one month [will] be redeposited by borrowers the following month: a part of this cash can be re-lent, again, in a third month’ and so on.  This is just saying that some of the money that is taken out as loans will find its way back into the banking system as deposits, which can then be used to make further loans.  Unlike the crude version of ‘credit creationism’ Hutton acknowledges that money is constantly being deposited and withdrawn but this still does not mean that banks create money in the way that Hutton suggests.  According to the economist Paul Samuelson (who developed a more sophisticated version of credit creationism): ‘As every banker knows, he cannot invest money that he does not have; and money that he invests in buying a security or making a loan soon leaves his bank.’  That is, loans can only be made from deposited or borrowed money that is currently held - a fractional reserve in an individual bank cannot create multiples of credit.  Samuelson’s theory (and Hutton’s) is that, while multiples of credit cannot be created from a fractional reserve held by an individual bank, an initial deposit of £1000 (again with a fractional reserve of 10%) will eventually be multiplied to £10,000 across the whole banking system by constituting in circulation the basis of deposits in banks.  This theory describes in a simplified way the actual process of circulation of money and how a loan will, in circulation, be the basis of further loans but it does not demonstrate that money is ‘created’ as credit. 

Rather than by ‘creating money’ a bank takes money from real deposits and pays an amount of interest on it.  It then lends this money at a higher rate of interest.  Hence banks compete for customers deposits.  Why bother if it is so easy to turn a deposit into multiples of money out of thin air?  Rather, banks provide credit, they advance money at interest.  Marx held to this view that a bank ‘makes its profit in general by borrowing at lower rates than those at which it lends.’  Banking has an intermediary function, it does not create money but takes it from savers (from cash deposited and from money lent between banks) to lend to borrowers at interest.  By facilitating the transfer of money from where it is accumulated to where it is required in the process of production banks take a cut of the profits of the productive economy as interest. 

Hutton is attributing to banking a power it does not have, holding it responsible for turbulence in global finance that results in economic dislocation – the financial tail appears to be wagging the dog of the productive economy.  The reality is the reverse, turbulence in global finance reflects dislocation in the productive economy…

                                                To be continued…

For more detailed articles on fractional reserve credit creationism see:

http://www.worldsocialism.org/spgb/socialist-standard/2010s/2012/no-1298-october-2012/fractional-reserve-banking-refuted

http://www.worldsocialism.org/spgb/socialist-standard/2010s/2012/no-1298-october-2012/editorial-crunch-time-credit-creationists

CSK

No One’s in Control (2012)

The Cooking the Books column from the September 2012 issue of the Socialist Standard

Since World War Two governments have adopted various policies to try to control bank lending. This, to try to make the economy work smoothly without booms and slumps or “stop-go” as it used to be called. They are still trying.

At first they tried fixing a limit on the total amount of bank loans. Then they required banks to hold a given percentage of their assets as cash and hoped to influence  bank lending by increasing or decreasing this (this was known as “fractional reserve banking”, though this term has since taken on a wider meaning). This in turn was eventually abandoned in favour of trying to influence bank lending by manipulating interest rates.

Over time the language changed too. Instead of talking of controlling bank lending, economists began to talk about controlling the “money supply”. This led to a redefinition of money, which had previously meant currency (notes and coins issued by the state), so as to include bank and other loans. There are now at least five official definitions of money (M0, M1, M2, M3 and M4). Even so, economists have still found it necessary to maintain a distinction between “base money” and “bank money”, the former being what is directly controlled by the central bank (notes and coins plus banks’ cash reserves with the central bank, which is what M0 measures).

The failure of all these policies has led to a controversy among economists which is still going on. Some have come to the conclusion that the level of bank lending is linked to the state of the economy and so cannot be controlled by the central bank. This is undoubtedly true.

Banks lend more to businesses (and individuals) when the economy is expanding and less when it is not. This is being confirmed today when, despite government exhortations and incentives, the banks are not keen to lend more; they have calculated that with a depressed economy the risk of them not getting their money back is higher. Nor are established businesses keen to borrow as they know that the market for their products is stagnating.

So, on this point, these economists are right. However, some of them don’t see the banks as merely reacting to the state of the economy but as contributing to it by their lending policies; they attribute to banks an autonomous power to influence the economy. This leads them to offer a purely monetary explanation of the present (and past) economic downturn, in, precisely, the irresponsible use by the banks of their ability to “create money” outside the control of the central bank.

It also leads them to offer a purely monetary solution. Here some of them have crossed the fringe to join the currency cranks in advocating a return to gold-based money (as if there weren’t economic downturns when this applied) or to require banks to lend only what they’ve got (as if this wasn’t the case anyway).

Since the economic cycle is built in to capitalism, and slumps occur when during a boom one sector overproduces in relation to its market, their reforms won’t stop this any more than anything the central bank can do. The capitalist economy can be controlled neither by monetary policy nor by banking reform.