There’s a great paper out from the Bank of England’s Monetary Analysis Directorate. It proposes that the standard model of money creation in economics textbooks is wrong.
(The standard, exogenous model suggests that central banks determine the amount of money in the economy. Endogenous money proponents suggest that market participants determine the amount. The implications for monetary policy, quantitative easing, financial regulation, and the government’s ability to end recessions are enormous.)
The key parts of the paper:
Money is created by commercial banks making loans, not central banks.
Acts of lending create deposits, not the reverse
The quantity of reserves does not constrain bank lending.
If taking out a new loan creates money, then the opposite is true. Repayment of loans is therefore destroying money.
Central banks don’t choose a quantity of reserves to bring about the short-term interest rate. They set the interest rate directly. (Most textbooks don’t articulate this view.)
The paper itself is fairly concise, and explains the creation of money fairly well. One major quibble is that the authors suggest that Quantitative Easing worked. On the contrary, QE was terrible. Philip Pilkington sums it up best:
Again we must stress though, the original idea behind QE was that it should increase real investment and employment. This simply has not happened and by this standard — which is the standard by which QE should be judged — the program has been an abysmal failure. A key lesson should be taken from this: business investment is first and foremost demand-led and does not simply respond to lower interest rates or increases in the base money supply. If the customers are not there to buy the goods and services, the companies will not invest and hire in the real economy.
Conclusion: central banks are significantly less powerful than they (and many market participants) believe they are. Also, from this endogenous money viewpoint, banking regulation becomes essential, because the folks that create the money need to be harshly sanctioned if they abuse their power.
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