The Bank of England Quarterly Bulletin published in March carried two articles on money which were received with delight by currency cranks. They were further comforted by an article by David Graeber in the Guardian (18 March) headed ‘The truth is out: money is just an IOU, and the banks are rolling in it. The Bank of England’s dose of honesty throws the theoretical basis for austerity out of the window.’
He interpreted the main article as saying that ‘there’s really no limit on how much banks could create, provided they can find someone willing to borrow it’ and that the money a bank lends mortgage holders ‘is not, really, the life savings of some thrifty pensioner, but something the bank just whisked into existence through its possession of a magic wand.’
The Bank of England article does repeat the old but ambiguous bankers’ saying that ‘loans create deposits’ (which could mean merely that a loan made by one bank will, when spent, become a deposit in some other bank or even that, by facilitating an expansion of production, a loan will lead to more deposits). It does indeed say that bank loans are essentially circulating IOUs. It does not, however, say that banks can issue these in unlimited quantities. Quite the contrary. Much of the article is devoted to describing in detail what the limits to banks’ lending are.
The section headed ‘The limits on what banks can lend’ begins:.
Figure 1 showed how, for the aggregate banking sector, loans are initially created with matching deposits. But that does not mean that any given individual bank can freely lend and create money without limit. That is because banks have to be able to lend profitably in a competitive market, and ensure that they adequately manage the risks associated with making loans. Banks receive interest payments on their assets, such as loans, but they also generally have to pay interest on their liabilities, such as savings accounts. A bank’s business model relies on receiving a higher interest rate on the loans (or other assets) than the rate it pays out on its deposits (or other liabilities). (…) The commercial bank uses the difference, or spread, between the expected return on their assets and liabilities to cover its operating costs and to make profits’ (emphasis added).It goes on:
In order to make extra loans, an individual bank will typically have to lower its loan rates relative to its competitors to induce households and companies to borrow more. And once it has made the loan it may well ‘lose’ the deposits it has created to those competing banks. Both of these factors affect the profitability of making a loan for an individual bank and influence how much borrowing takes place. (…) Banks therefore try to attract or retain additional liabilities to accompany their new loans. In practice other banks would also be making new loans and creating new deposits, so one way they can do this is to try and attract some of those newly created deposits. In a competitive banking sector, that may involve increasing the rate they offer to households on their savings accounts. (…) Alternatively, a bank can borrow from other banks or attract other forms of liabilities, at least temporarily. But whether through deposits or other liabilities, the bank would need to make sure it was attracting and retaining some kind of funds in order to keep expanding lending.This is a good enough description of how modern banks work. Graeber, however, is the victim of his own delusion that banks can lend whatever people want to borrow when he claims that this ‘throws the theoretical case for austerity out of the window.’ This would seem to imply that the Bank of England and the banks could, if they wanted to, create substantially more money for investment and spending than they currently do. But if they tried, the result would be roaring inflation and/or widespread bank failures.
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