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The veil of deception over money: how central
bankers and textbooks distort the nature of banking
and central banking
Norbert Häring1
In reality even central banks ostensibly adhering to the Reserve Position Doctrin, have not
been steering the monetary base, but have been occupied with setting an interest rate on the
money market, with which they try to influence and smooth short-term interest rates in the
economy in general. Goodhart (2001) claims that the Fed continued to use interest rates as
its fundamental modus operandi, even if it pretended to pursue monetary base control. He
talks of play-acting and even deception in this regard.
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The veil of deception over money: how central
bankers and textbooks distort the nature of banking
and central banking
Norbert Häring1
[Handelsblatt, Germany]
Copyright: Norbert Häring, 2013
You may post comments on this paper at
http://rwer.wordpress.com/2013/03/25/rwer-issue-63/
“The study of money, above all over fields in economics, is one in which
complexity is used to disguise truth or to evade truth, not to reveal it.” John K.
Galbraith
Introduction
This paper will argue that we are being intentionally and systematically mislead about the
nature of money and about the role of central banks and commercial banks in the monetary
system. We are led to believe by central bankers and by textbooks, like the ones of Krugman
and Wells (2009) and Mankiw and Taylor (2011), that central banks have always been
government institutions acting in the public interest. In reality, central banks’ historical origin
and role had more to do with the desire of private bankers to control and coordinate the
process of private sector money creation. That most money is created in the private sector is
something that central bankers like to gloss over and textbooks “explain” in a distorted and
unnecessarily convoluted way.
While governments have increased their influence over central banks over time, these still
fulfill functions which are mostly in the interest of the banking industry. They coordinate
private sector money creation and act as lenders of last resort for commercial banks. It is far
from clear, whether central banks will side with commercial banks or with the public at large, if
their roles as protector and coordinator of the former and their role of promoting the interest of
the latter are in conflict. The desire of central bankers to hide the lucrative role of commercial
banks in the process of money creation and their distorted account of central bank history
give reason to be suspicious in this regard.
This is particularly relevant today, as during the financial crisis central banks have emerged
as the most powerful agents in economic policy. An examination of the disclosed calendar of
US Treasury Secretary Tim Geithner by the research institute Bruegel revealed that the
President of the European Central Bank was the person Geithner called most often in Europe,
with a big margin to the runners up. Between January 2010 and June 2012, 58 out of 168
calls of Geithner to European officials went to the president of the ECB (Pisany-Ferry 2012)
2
.
In Europe, the ECB is involved as a member of the so called “Troika” (with the EUCommission
and International Monetary Fund) in drawing up and enforcing reform and
austerity programs for crisis countries like Greece, Portugal and Ireland. These Memoranda
of Understanding go into almost all areas of economic, labor market and social policy and are
1 The author is economics correspondent of Handelsblatt, the German business daily. He is co-director
of the World Economics Association and co-editor of the World Economic Review. The author has no
material conflicts of interest with regard to any of the subjects discussed in this paper.
2 http://www.bruegel.org/nc/blog/detail/article/934-tim-geithner-and-europes-phonenumber/#.UUsNr1ceWy0
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very detailed. The ECB is taking their decisions in complete independence from governments
and parliaments. Other major central banks are also independent from government, even
though not in such an extreme way. If there is an important element of central banks serving
the interests of the financial industry, this unchecked power should be regarded as highly
problematic.
I will examine the rhetoric of two central bankers, Jens Weidman and Otmar Issing, regarding
the process of money creation, inflation and the role of central banks. Weidmann is Präsident
of Deutsche Bundesbank and member of the Governing Council of the European Central
Bank (ECB). Otmar Issing was a former board member (Until 2006) of the European Central
Bank in charge of economics. I use the rhetoric of these two German central bankers,
because, due to the tradition of the Bundesbank to give prominence to monetary aggregates,
German central bankers are more inclined to explicitly talk about money than the average
European central banker.
I will also examine how two widely used economics textbooks by Krugman and Wells and by
Mankiw and Taylor treat the subject. Drawing on Häring and Douglas (2012) I will juxtapose
this rhetoric of central bankers and textbooks with the historical and current evidence. I will
argue that this rhetoric frames the minds of central bankers, other policy makers, academics
and - through economic journalists educated with the same textbooks - the general public, in
a very unfortunate way. This prevents them from understanding the current financial crisis
and from drawing the right policy conclusions from it.
The narrative of Jens Weidmann and Otmar Issing
According to the central bankers’ narrative, governments created central banks to use and
abuse fiat money creation for the financing of government expenditure, crating runaway
inflation in the process. In a widely reported speech in Frankfurt in September 2012 entitled
Money Creation and Responsibility,
3
Bundesbank-President Jens Weidmann (2012a) made
references to Goethe’s drama Faust II to take a swipe at government controlled fiat money.
In Faust II, Mephisto (the devil) talks the Emperor, who is in dire straits financially, into signing
an IOU, which Mephisto copies many times to issue it as paper money for the benefit of the
Emperor. Soon, however, money issuance gets out of hand. It ends with runaway inflation.
Weidmann interprets Goethe’s scene as an impressive rendering of the dangers of creating
fiat money for financing government expenditure. He argues that the government’s power to
create money from nothing brings with it the temptation to create too much money to get extra
financial leeway, and he asserts that governments have historically more often than not given
in to this temptation. “If we look back in history, we see that government-owned central banks
were often created with the purpose of giving those governing the country free access to
seemingly unlimited financial means.” He proceeds to say that governments control over the
central bank in combination with governments need for money often resulted in too much
money and runaway inflation.
3
http://www.bundesbank.de/Redaktion/EN/Reden/2012/2012_09_20_weidmann_money_creaktion_
and_responsibility.html
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The goal is clear and explicit. Weidmann wants to drive home the lesson that you cannot
entrust government with managing the monetary system and that you therefore have to guard
the central banks’ independence from government.
In another speech, given a few days later (available here4 in German), Weidmann gives the
example of the first known paper money system of the Chinese-Mongolian Emperor Kublai
Khan and his successors. “Off course, the Chinese Emperors recognized the importance of
the invention and made much use of it. They produced more and more money bills –
unfortunately without taking the old ones out of circulation. The result is hardly surprising.
There was inflation. At the end of the 13th Century, one bill was worth 1000 copper coins,
almost 150 years later it was worth less than one.”
In his speeches on money and inflation, Jens Weidmann does not utter a single word about
money creation by commercial banks; he does not even mention commercial banks. Even
though he is not explicitly saying so, all his remarks give the impression that only the
Government via a government owned and controlled central bank issues money, and only for
the benefit of the government.
Otmar Issing, who talked at the same event in Frankfurt, made it even more obvious that
money creation by commercial banks is a taboo subject in public. The former Chief Economist
of the Bundesbank and later of the ECB talked about paper money, government finances and
inflation. A focus of his talk was the free-banking alternative favored by Friedrich August von
Hayek, which involves no central bank but has commercial banks issue their own banknotes
in competition with each other. Even while discussing this proposal, Issing manages to
entirely avoid the words bank and banknote, rather making it seem as if he was talking about
different (national) “currencies”, rather than about domestic money issued by commercial
banks.
While this speech is not publically available, Issing gave a very similar speech in 2003 upon
receiving the Hayek-Prize, which is available in German5 on the ECB’s website. The word
bank does not appear, other than as “central bank”.
Weidman and Issing are the rule rather than the exception. Western central bankers rarely, if
ever, make it explicit that commercial banks create money.
Historical evidence and current practice6
Before we look at the treatment of the subjects: central banks, banks and money creation by
leading textbooks, we will first take a look at the history of important central banks, to see if
Weidmann’s narrative is correct. We will see that it is not. Neither did or do governments have
a monopoly on money creation, nor did they routinely abuse any power they had in this
regard. The insinuation of Weidmann and Issing that it is only central banks who create
money will turn out as just as wrong.
4
http://www.bundesbank.de/Redaktion/DE/Reden/2012/2012_09_27_weidmann_markenverband.ht
ml
5 http://www.ecb.int/press/key/date/2003/html/sp031012.de.html
6 This section draws on Chapter 2 of Haering and Douglas (2012)
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Paper money in early China
It is no coincidence that Weidman goes back to 13th Century China to give us an historical
example of government-controlled money creation that went wrong. He has to do so because,
contrary to his claim, the important central banks in the west historically were created by
private bankers for private gain. It is true that bankers created them in cooperation with the
government as a new scheme to give credit to the government. This usually involved
privileges conferred on these commercial banks, notably the privilege that their notes would
be accepted for payment of taxes and duties. But still, central banks were not government
controlled entities, issuing money on behalf of the government. The bulk of the seignorage,
i.e. the direct monetary gain from printing money, usually went to private bankers. There was
a lot of political controversy, historically, about whether commercial banks or the government
should issue money, and for a long time, the commercial banks prevailed in this fight even as
far as banknotes are concerned. As far as deposit money is concerned, the largest part of the
money supply, banks have prevailed until today. So Weidmann is clearly giving a badly
distorted account.
Not even the Chinese example that Weidmann chooses is a good one to make his point.
Contemporary reports about the economy of Kublai Khan’s empire and of his successors
stress how wealthy and well organized it was. China was far ahead of Europe at that time.
The system of paper money might or might not have been instrumental, but it is far from
straightforward to argue that this monetary system was a failure. The devaluation of this
paper money over 150 years, that Weidmann alludes to, amounts to a hardly spectacular five
or six percent inflation annually. According to Werner (2007), this paper money system
worked well for decades, if not centuries, as all available research reports the Chinese
economy as flourishing during that time.
The Bank of England
The Bank of England was founded in 1694 as a private enterprise. A consortium led by the
Scottish businessman William Paterson had suggested the scheme. It would afford King
William and Queen Mary a large loan. The consortium was granted the right to found the
privately owned Bank of England and to create money by issuing banknotes. They lent those
“Notes of the Bank of England” and some gold to the crown against interest of 8%. (Rothbard,
2008). The Bank of England was awarded the monopoly of issuing banknotes in London by
the Bank Charter Act of 1844. Only in the 20th century did the Bank of England move away
from commercial endeavors. It was nationalized in 1946. Until then it was a private institution
working mostly for the financial benefit of its private shareholders.
No evidence here for the theory of central banks as creatures of governments over issuing
money for the benefit of the government.
The US Federal Reserve and its predecessors
The merchant banker Alexander Hamilton, the first United States Secretary of the Treasury,
successfully promoted the chartering by Congress of the privately owned First Bank of the
United States in 1791, a bank with special money creation privileges. He staunchly opposed
the idea that the government itself should issue the money needed to fund manufacturing and
the settling of the west. He wanted commercial banks to do it, but they should have the strong
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backing of the government. This backing consisted, among other privileges, in accepting the
notes of the First Bank in duties and taxes (Nettels, 1962).
The bank faced stiff political opposition. The fight was not about fears of over-issuance,
though. It was about the constitutionality of outsourcing the regulation of money to a private
company and about the privileges conferred to private bankers at the expense of farmers and
other producers and the public at large.
Private bankers’ highly privileged role remained a source of political controversy for more than
a century. After its 20 year charter ran out in 1811, a bill to recharter the First Bank of America
failed. Five years later, the banker Alexander Dallas, in his other capacity as Secretary of the
Treasury, initiated the chartering of the Second Bank of the United States. He endowed the –
again – predominantly privately owned bank with the same privileges as the First Bank had
had (Rothbard 2008).
President Andrew Jackson eventually was successful in his campaign to take away the
privileges of the Second Bank in 1836. Jackson insisted that it was improper for Congress to
pass the important task of creating money and regulating its value to a private corporation.
Thus, the predecessors of the Federal Reserve offer nothing in evidence for the theory of
central banks as creatures of governments, over-issuing of money for the benefit of the
government.
For eight decades the US would not have a central bank. Banknotes were still printed and
circulated in the economy, though. They were printed by a multitude of competing commercial
banks. As Issing pointed out in this speech, such a system has the potential advantage that
competition of banks might prevent over-issuance in such a system and the palpable
disadvantage that transaction costs are very high, if notes of more than a thousand banks
with different discounts from their nominal value are circulating.
In 1862, Salmon Chase, who had been installed as Treasury Secretary by banker and
financier Jay Cooke and his newspaper owning brother, pushed through Congress a national
banking law that alleviated the competitive limit to money creation that banks had faced in the
absence of coordinating central bank (Rothbard 2008).
The new layered system had New York City based national banks at the top, designated as
central reserve city banks. They could give loans and thus create deposit money as a multiple
of the amount of Treasury bonds, gold and silver they held. Other nationally chartered banks
in big cities, the reserve city banks, could hold their reserves in the form of deposits at central
reserve city banks or in Treasury bonds. They could create a multiple of these reserves as
checking accounts. National banks in smaller places called country banks, could hold more
modest reserves also at reserve city banks to back up the loans they gave (Champ 2007;
Rothbard 2008).
One can see that money creation in the national banking system was driven mostly by the
interests of the banking community in the early United States. While it is true that the idea
behind the national banking laws was, besides creating a national currency, to help the
government finance the civil war. However, the money that the government created was only
a fraction of the money that commercial banks were allowed to create on top of the
government bonds that they were forced to hold. The result of the new system from which
initiator Cooke benefitted very handsomely, was a great expansion of the number of banks
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and of deposits and also a series of severe financial crises in fairly short order. There were
panics and bank runs in 1873, 1884, 1893 and 1907, because banks, notably those in New
York at the top of the money issuing pyramid, repeatedly had difficulty to meet demand for
redemption of their deposits (Champt 2007; Rothbard 2008).
As a reaction to these crises, the Federal Reserve System was created in 1913, again upon
private bankers’ initiative. At a secret meeting at Jekyll Island, Georgia in December 1910,
they hammered out the essential features of the new Federal Reserve System. Bankers
representing the interests of Rockefeller, JP Morgan and Kuhn, Loeb & company, the most
powerful institutions of the time, dominated the meeting. The continental European, notably
the German system served as a model for the basic structure. The idea was to make the
process of money creation more disciplined and orderly and to have a deep pocketed
institution to bail out the banks if the public lost confidence in the notes they had issued. The
bankers wanted the government only as paymaster, though. Otherwise, it was supposed to
have as little influence over the process as possible (Rothbard 2008).
To this day, the twelve regional Federal Reserve Banks, which are in charge of regulating
banks, are owned and governed by their member banks. Before the subprime crisis, this fact
was never advertised and often concealed by the pretense that the Federal Reserve System
was a public institution.
The Federal Reserve Bank of New York is the one in charge of regulating, overseeing and
bailing out Wall Street banks with public money. Wall Street banks chose the President of the
New York Fed and charged him with regulating and controlling them. A board chosen and
dominated by bankers makes sure he does it right. Only during the subprime crisis did the
Federal Reserve give up the pretence of being a public institution. The New York Fed,
managing US$1.7 trillion of emergency lending programs for banks and brokerages, was
called upon to inform the public of the whereabouts of the public funds going to Wall Street. At
this point, the Federal Reserve of New York insisted – ultimately in vain – that as a private
institution it is not bound by the Freedom of Information Act.
Central banking in Germany
In Prussia, the political powerhouse of mid-19th Century pre-unification Germany, a central
bank called Preussische Bank was created in 1846 as a hybrid institution, which was run by
government representatives but with a capital base which was mostly provided by wealthy
businessman and private bankers, who would have a right to a dividend as long as the bank
was profitable (Lichter 1999).
The reason for founding the central bank was a dearth of money in circulation in a period of
beginning industrialization. There were coins circulating and small denomination treasury
obligations, but not enough. In stark contrast to Weidman’s account, the Prussian
bureaucracy under-issued the debt certificates that served as small denomination paper
money rather than over-issuing them and the Royal Bank was stingier with credit than the
business community in the commercial centers wanted them to be.
The Prussian bureaucrats were loath to give commercial banks the freedom to emit currency,
because they feared that too much money would be issued. Their mistrust was fuelled by the
fact that none of the bankers’ proposals for the licensing of private note-issuing central banks
had a provision of unlimited liability of the banks’ owners as prevailed in the Scottish free
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banking system. The contemporary US-system with private note issuing banks and
correspondingly many different notes trading at varying discounts was regarded as a bad
example to be avoided (Lichter 1999).
The fight in Prussia over the right to issue notes had an important political dimension. The fact
that private shareholders were invited to provide the capital for the Preussische Bank was a
compromise between the preference of Prussian bureaucrats like Minister Christian von
Rother, who wanted to keep note emission in public hands and mistrusted profit oriented
private bankers in this respect, and the King’s perceived need in pre-revolutionary times to
appease a dissatisfied moneyed citizenry, which was pressing for the right to issue banknotes
(Lichter 1999, p. 89f).
From 1871 to 1876 the Prussian Bank would serve as the central bank of the newly unified
German Reich and eventually would become the Reichsbank, which was also run by the
government and owned by private shareholders.
The German model of giving a (near-)monopoly of note issuance to a government run central
bank was considered highly successful and would later, together with the Bank of England,
become the blueprint for the Federal Reserve System.
Money creation by commercial banks today
We have seen that for much of history, government was only indirectly involved in issuing
banknotes, and had nothing like a monopoly on it. Over time, most governments took over the
responsibility for central banks and the issuance of banknotes, which functioned as means of
payment. (Some of that control they have relinquished again recently by deciding to let
independent technocrats, often with commercial banking backgrounds make the relevant
decisions.) However, even where the government had or has this monopoly to issue notes,
this is far from being a monopoly to issue money. Today, only a fraction of the money which
circulates in the economy consists in cash issued by the central banks. M3, the preferred
definition of money of the European Central bank is 11 times larger than the sum of currency
in circulation and reserves of commercial banks at the central bank, i.e. base money. We
make by far the largest part of our payments without using any government issued banknotes.
We pay by transferring deposits at commercial banks to someone else and we receive our
paychecks in the form of deposits in the bank, i.e. in electronic money, created by commercial
banks.
This money is created any time a commercial bank gives credit to a non-bank or buys an
asset from a non-bank. If I take a mortgage loan from a bank of €100,000, the bank will credit
my account with a deposit of €100,000 in exchange for my obligation to pay back, say
€150,000 over time. €100,000 in new deposits has been created by a few keystrokes and
signatures. It might soon leave my bank account, as I pay my house with it, but it will remain
in the banking system, as I will transfer the money to somebody else’s account at another
bank. (The money market, on which commercial banks exchange liquidity, will in normal times
make sure that my bank will be able to obtain the central bank deposit needed to make the
transfer.)
This deposit money created by commercial banks is equivalent to legal tender for all practical
purposes. The government accepts a transfer of this deposit money as taxes and everybody
is obliged to accept it for payment in normal business. That these deposits created by
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commercial banks are “money” is also recognized by the fact that all major central banks, like
the Federal Reserve, the European Central Bank and the Bank of England count them as
money in the monetary statistics they compile.
Even when commercial banks were refused the privilege to issue banknotes in 19th Century
Prussia, they were able to create money by issuing fungible deposit slips on current account
balances of their customers. Whoever presented these deposit slips had the right to have the
balance paid out in cash. This enabled commercial banks to lend out much more money than
they had in deposits, since most customers would leave the deposits in the bank and transfer
the deposit slips to pay their bills (Lichter 1999).
The Reserve Position Doctrine (RPD), also called Monetarism, which was first propagated by
the Federal Reserve (Bindseil 2004) and later also by the Deutsche Bundesbank and, for a
few years, by the ECB, rests on the assumption that central banks control the process of
money creation. They issue so-called base money in the form of currency and bank deposits
at the central bank, i.e. reserves. Banks use this base money to give credit and thus create a
more or less fixed multiple of the monetary base in deposits, according to the money
multiplier (see next section).
In reality even central banks ostensibly adhering to the Reserve Position Doctrin, have not
been steering the monetary base, but have been occupied with setting an interest rate on the
money market, with which they try to influence and smooth short-term interest rates in the
economy in general. Goodhart (2001) claims that the Fed continued to use interest rates as
its fundamental modus operandi, even if it pretended to pursue monetary base control. He
talks of play-acting and even deception in this regard.
Ulrich Binseil (2004) who used to be head of liquidity operations of the ECB and currently is
Deputy Director General of financial market operations, makes it clear that interest rate
targeting, which has long been the norm for all major central banks, and control over base
money are incompatible: “Today, there is little debate, at least among central bankers, about
what a central bank decision on monetary policy means: it means to set the level of short term
money market interest rate that the central bank aims at in its day-to-day operations.” And he
quotes Goodhart (1989, p. 293) a renowned academic economist with central banking
experience, saying “Central bank practitioners, almost always, view themselves as unable to
deny setting the level of interest rates, at which such reserve requirements are met, with the
quantity of money then simultaneously determined by the portfolio preferences of private
sector banks and non-banks.” In other words: the central bank will normally feel obliged to
provide whatever demand for monetary base is created by the interaction of private borrowers
and banks, because otherwise, short term interest rates would gyrate wildly.
Thus, according to this view prevailing among central banking practitioners, central banks
fulfill the task of supporting money creation by commercial banks by providing reserves as
needed and disciplining the process in such a way that runaway inflation does not erode the
public’s trust in the money thus created.
Even if one should be of the opinion that the central bank is able in our current monetary
system, to control the amount of money that commercial banks create, it is certainly not
justified to give the impression, as Mr Weidmann and Mr Issing do, that only (government
owned) central banks create money and that all money creation is for the benefit of the
government. Even if the central bank were to control commercial banks’ money creation, it
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would still be done by commercial banks for the benefit of commercial banks (and at the risk
of taxpayers who have to bail them out, if it goes wrong). Central bankers never, ever talk
about the hugely profitable privilege that the ability to create legal tender means for
commercial banks.
The textbooks’ narrative
“The essence of the contemporary money system is creation of money, out of
nothing, by banks often foolish lending.” Martin Wolf, Financial Times,
November 9, 2010
“It proved extraordinarily difficult for economists to recognize that bank loans
and bank investments do create deposits.” Joseph Schumpeter (1954,
p.1114)
There is very little on the history of central banks in the textbooks of Krugman and Wells and
of Mankiw and Taylor, and what there is, is distorted. Thus, students who happen to find out
about private ownership and control of central banks must regard it as an oddity, given that
they have been led to believe that it is part of the nature of a central bank to be a public
institution serving only the interest of the general public.
Mankiw and Taylor report that the Bank of England was created in 1694, but without giving
any background. Then they proceed to claiming that “(a)rguably the most significant event in
the Bank of England’s 300-year history was when the UK government granted it
independence in the setting of interest rates in 1997” (p.625-6). This wrongly implies that until
then the Bank was taking its orders from government and could not set interest rates
independently. However, this was only the situation for a few decades in this 300-year history.
It is noticeable that for Mankiw and Taylor the granting of the monopoly to issue banknotes for
Greater London in 1844 or the nationalization in 1846 are less important than the decision to
partially reverse the nationalization by granting the Bank partial independence from the
government.
Of the Federal Reserve, Mankiw and Taylor note the year of creation and that the president
appoints the seven governors. They mention that the decision making body Federal Open
Market Committee includes the Presidents of the regional Feds, but fail to mention that these
are private institutions owned and controlled by the banks in the respective region.
Krugman and Wells are silent about the Bank of England, but are a little more explicit on the
Fed. They let us know (p. 812) that “… the legal status of the Fed is unusual: It is not exactly
part of the U.S. government, but it is not really a private institution either.” What do they mean
by “not exactly” part of the government, and “not really” a private institution, a description
taken from the websites of the Federal Reserve System? Students are left in the dark. They
mention that the Board of Governors is appointed by the President and approved by the
Senate, but remain silent on who appoints the Presidents and boards of the twelve regional
Federal Reserve banks. While earlier versions of the textbook only stated that the regional
Federal Reserves have a board of directors, the 2009 version is at least hinting at the truth by
adding that the board of directors is “chosen from the local banking and business community”
(my italics). This is somewhat misleading. Two thirds are chosen by the local banking
community, one third by the Board of Governors in Washington. Most members indeed come
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from the local financial community, but they don’t have to. The point is: banks control the
regional Federal Reserve Banks that are supposed to control them. You would not know from
reading Krugman and Wells?
Without explaining the “unusual legal status”, Krugman and Wells (p. 813) arrive at the
surprising conclusion that “the effect of this complex structure is to create an institution that is
ultimately accountable to the voting public, because the Board of Governors is chosen by the
president and confirmed by the Senate.” Had they given the complete picture they would risk
being laughed at for this apologetic conclusion.
The equally apologetic treatment of commercial banks’ money creation by the textbooks is
also highly misleading. Mankiw and Taylor only start talking about where money comes from
after page 600 under the unlikely headline “Money and Prices in the Long Run”. That is:
explaining our monetary system is relegated to near the end of the book and reduced to its
impact on prices in the long run.
Krugman and Wells introduce the “hypothetical market for loanable funds” on page 678 to
explain how savings are used to finance investment. Banks as intermediaries channel money
from savers to investors. The interest rate is the price that equates saving and investment,
just like it does in the market for potatoes. No money creation by banks at this point, actually
no money at all. It might as well be a generic good like grain that is being saved and passed
on to investors who need grain to pay workers until they can sell their product. Money in the
modern sense appears only on page 804 under the equally unlikely header “Stabilization
Policy”. Again, money is relegated to the near-end of the book and does not deserve its own
chapter.
In wording, Krugman and Wells continue to follow the loanable funds doctrine in the section
on money. They pretend that banks are mere financial intermediaries, collecting deposits,
from a multitude of savers and passing them on as loans to companies, households and
government. This is very odd in a chapter in which they explain how banks create deposits. It
is a clear contradiction. A banking system that creates deposits in the process of lending does
not have to wait for deposits to come in, in order to intermediate them.
In order to hide the contradiction, both textbooks stubbornly insist that the process of money
creation starts with cash being deposited in a bank. Deposits are created in the textbook
examples, but they remain in the background. The textbooks rather focus on cash that is
deposited in the bank and then is being lent out again as cash (with a small fraction retained
in reserve), redeposited and lent out again. Thus, the rhetoric of loanable funds can in a
superficial way still be used. Rather than individual banks creating money they only
intermediate the cash that has been deposited. It just so happens that the banking system
overall intermediates the same cash many times.
But why should banks limit themselves to creating money in this roundabout way? In reality,
the process typically will start with a bank giving credit to someone and in the process
crediting this person’s bank account with the respective sum of deposit money, thus creating
deposits, not intermediating them. If someone deposits €1000 in the bank, as in
Krugman/Wells example, the bank can just deposit the whole €1000 at the central bank as
reserves and – given a reserve requirement of 10% as in the US, or 1% in the euro area – be
entitled to lend out €10,000 or €100,000 respectively, without having to wait for any further
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deposits. They will routinely do just this, rather than lending out €90 or €99 (depending on the
reserve requirement) and then wait for new deposits to come in before lending more.
Mankiw and Taylor (p. 629) explicitly tackle the possible amazement of students that might
arise from the fact that banks can create money out of nothing: “At first, this creation of money
by fractional-reserve banking may seem too good to be true, because it appears that the bank
has created money out of thin air”, they concede. Then they try to appease their readers’
minds by alerting them to the fact that no wealth is created by this creation of deposits,
because “… as the bank creates the asset money, it also creates a corresponding liability for
its borrowers.”
Here the explanation ends, even though here it would only start to get interesting. The bank
creates “the asset money” for itself in the sense that the bank can demand interest on it. This
is real wealth that the banks derive from their money creation. In the process they create a
debt for someone else. For society, no wealth is created, that is true. But for themselves, their
shareholders and managers, banks have created wealth and the rest of society has the debt.
In the pre-crisis version of their textbook, Krugman and Wells (2005, p. 969) had a box, in
which they explicitly defended banks against the possible charge of being dishonest, because
they promise to pay back deposits in full upon demand, while they know they will not have the
liquid funds to do so, if many customers require it at the same time. Krugman/Well’s (2005)
answer was negative, and they offered a bizarrely out of place comparison to justify this. They
equated the expectation of the bank’s customers being able to take out their money in the
bank at any time they want to the expectation of (potential) customers of car rentals to be able
to rent a car any time they want. If too many (potential) customers want to do this at the same
time, not enough cars will be available, they remind us. Everybody accepts that, and equally,
everybody should accept the risk of losing their money in a bank run, is their conclusion. The
fact that banks have entered into a contractual obligation with somebody who entrusted their
money to them, while car rentals have not taken any money from potential customers and
have not legally promised anybody to give them a car at any time, plays no role in their
comparison.
The extensive space that most major textbooks afford to the money multiplier is a relic of the
monetaristic Reserve Position Doctrine, which claims that central banks control base money
and, through the money multiplier, overall money. ECB policy maker Ulrich Bindseil (2004) is
puzzled by the stubbornness with which influential textbook authors teach an outdated
doctrine. He blames it on the interest of central bankers to avoid responsibility about
unemployment:
Overall, the 20th century thus seemed to have witnessed in the domain of
monetary policy implementation a strange symbiosis between academic
economists stuck in reality-detached concepts, and central bankers who were
open to such concepts, partially since they allowed them to avoid explicit
responsibility. Masking responsibility seemed to be of particular interest
whenever the central bank’s policies were strongly dis-inflationary and thus
causing recession and unemployment.
This kind of deception is not the topic of this paper. Bindseil is quoted here to show that even
seasoned policy makers, intimately involved in the interaction of the central bank with
commercial banks, considers the money multiplier fetish of economic textbooks an aberration.
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Capture by financial interests
The interest of central banks in making their influence on the economy less clear cut might go
some way in explaining this aberration. However, there is also the interest of commercial
banks in having something hidden. And this interest could be even more influential. There is a
complete absence in all major textbooks of any mention of the pecuniary benefit, which banks
derive from their role in “the money multiplier”. This points to a taboo imposed by the interest
of a very powerful group. If you present the money multiplier in the distorted way textbooks
do, with banks appearing to be mere intermediaries, it is very hard to see this profitable
privilege. Money gets somehow multiplied, but you do not see anybody directly claiming the
value of this newly created money.
If you were to describe the process in the less convoluted, direct way, as it really happens, it
would be obvious who gets to claim the value of the new money. The borrower who takes a
loan of €1000 from the bank gets credited 1000 in deposit money in exchange for the promise
to pay back €1000 plus interest. The bank gets interest on deposit money, which it can create
out of nothing and which will disappear again from the banking system as the loan is paid
back. All it costs the bank is the (usually lower) interest rate it has to pay on the small fraction
of reserves required (or necessary) to give a loan of €1000.
The authors of the most influential textbooks are highly recognized economists with very
close ties to central banks and to the financial elite. There is no dearth of opportunity in which
members of these groups could tell them about perceived anti-finance biases or mistaken
thinking, if they had passages in their textbooks, which could be construed as anti-finance or
having some perceived bias.
Recently an intense discussion has started about the close ties of economists with the
financial industry and about undisclosed conflicts of interest of this sort – a discussion that
was almost completely absent until the latest financial crisis. Only in 2012 did the American
Economic Association approved a code of conduct for its members. Economist Devesh Kapur
(2009) was still a rarity when he spelled out these conflicts of interest in the Financial Times in
June 2009. He noted that “there would be little chances of being invited to a lucrative talk at
Citigroup if one were in favor of sovereign debt-forgiveness in the 1980s, against capital
account liberalization in the 1990s or against stock options in the 2000s.”
What is still lacking is a serious discussion of the even closer ties of many central bankers
with the financial elite and about the undisclosed and unfettered conflicts of interest that arise
from them. It is standard for influential central bankers to obtain highly paid jobs in the
financial industry after they leave their public office. ECB-board member and chief economist
Otmar Issing caused a bit of an uproar, because he did not even obey the informal cool-off
period of one year ususally observed by top-ranking ECB officials before taking a job with
Goldman Sachs as an advisor after leaving office in 2006.
It would go beyond the scope of this paper to delve much further into this, but a look at a
microcosm called Group of Thirty (G30) can serve to illustrate the overly cozy relationship of
high finance, central banking and eminent economists.
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According to its own website7
, the G30 is a private, nonprofit, international body composed of
very senior representatives of the private and public sectors and academia, whose work
impacts the current and future structure of the global financial system by delivering actionable
recommendations directly to the private and public policymaking communities. One such set
of recommendations was delivered in February 2013 in the form of a report called: “Long
Term Finance and Economic Growth”.8 The report reads like a wish-list of the leading
internationally active banks. Recommendations include more public-private partnerships,
more capital market based (rather than pay-as-you-go) private pension saving, reviving loansecuritization,
promoting international capital movements, toning down bank regulation,
government guarantees to take away the risk of certain investments.
If you look at the membership of this lobby-group it turns out that it is packed with current and
former central bankers with strong ties to the financial industry. Textbook-author Paul
Krugman is also among the members, as is Mario Draghi (President of the ECB, formerly
Golman Sachs), Mark Carney (President of the Bank of Canada – from July 2013 of the Bank
of England – formerly Goldman Sachs), William Dudley (President of the New York Fed,
formerly Goldman Sachs), Gerald Carrigan (Goldman Sachs, formerly President of the New
York Fed), Axel Weber (UBS, formerly President of Deutsche Bundesbank), Jacob Frenkel
(JP Morgan Chase, formerly Governor of the Bank of Israel), Paul Volcker (former FedChairman),
Jean Claude Trichet (former President of the ECB), Leszek Balcerowicz (former
Governor of the National Bank of Poland), Jaime Caruana (General Manager of the Bank for
International Settlements and former Governor of the Bank of Spain), Guillermo de la Dehesa
Romero (Santander, formerly Deputy Director of the Bank of Spain), Roger Ferguson (TIAACREF,
formerly Swiss Re and formerly Vice-Chairman of the Fed), Stanley Fisher (Governor
of the Bank of Israel, formerly IMF and formerly Citigroup), Arminio Fraga Neto (Gavea
Investimentos, formerly Governor of the Central Bank of Brazil), Philipp Hildebrand
(Blackrock, formerly Chairman of the Swiss National Bank), Mervyn King (Governor of the
Bank of England until June 2013), Guillermo Ortiz (Grupo Financiero Banorte; formerly
Governor of the Bank of Mexico), Masaaki Shirakawa (Governor of the Bank of Japan),
Yutaka Yamaguchi (former Deputy Governor of Bank of Japan) and Zhou Xiaochuan
Governor of the People's Bank of China).
This makes twenty current or former top-level central bankers of the most important central
banks of the world, the majority of which are now holding or have held very senior positions in
commercial financial institutions. While this might look like a convenient venue for central
bankers to exchange views, it is important to note that active central bankers meet regularly
at the Bank of International Settlements in Basel for gatherings which are behind closed doors
but nonetheless official. The unofficial Group of Thirty is better characterized as a private
sector pressure group dominated by those central bankers who are particularly inclined to
straddle the narrow divide between public service and private gain in commercial financial
endeavors.
The conflicts of interest arising for this are very relevant for the subject of this paper and might
well explain, why leading central bankers and central banks seem to have tabooed talk and
research about money creation by commercial banks. As a (rare) economic journalist writing
about the workings of the monetary system occasionally, I have routinely been confronted
with two reactions in the general public: outrage or disbelief. Since the privilege of having your
debt declared legal tender is extremely unusual, this sector has a very big interest in avoiding
7 http://www.group30.org/
8 http://www.group30.org/rpt_65.shtml
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the first of these two reactions by the public. Pretending that central banks are the only ones
“printing” money is a probate strategy to achieve that. Central bankers seem to play along, for
reasons that are not too hard to fathom, if you consider the history of important central banks
and the typical career path of influential central bankers as evidenced by the membership of
the Group of Thirty.
A consequence of the taboo: policy failure
Given the long-standing taboo to talk about money creation/credit creation by commercial
banks in a reasonable way even in textbooks, it is no wonder that central bankers and other
policy makers did not have the frame of mind to understand what was going on in the credit
booms in the run ups to the Asian crisis and the dotcom bubble and the subprime crisis. In the
run-up to the most recent financial crisis, banks were pumping massive amounts of credit into
the real estate market in the US and in parts of Europe. In the Euro area as an aggregate, this
led to many years of double digit growth in credit volumes and in monetary aggregates,
including M3, to which the ECB long pretended to pay special attention. Real estate credit
increased with excessive rates of up to 30% for years in several countries like Ireland, Greece
and Spain. There was a similarity strong lending boom in the US which also was ignored.
The money flowing into real estate created a self-reinforcing bubble of rising prices, a
booming economy and even more credit, until the bubble finally burst. According to a large
empirical study of Schularick and Taylor (2012) on many historical financial crises, this
episode was typical. They characterize most financial crises of the last five decades as “credit
booms gone bust”.
Even after this failure to understand the role of finance in producing boom and bust cycles
was exposed, the intellectual situation has not improved much, if any.
US Secretary of the Treasury Tim Geithner, who had been President of the New York Fed in
the run-up to the crisis, said in written testimony to the Financial Services Committee of
Congress on September 23, 2009 (quoted from Petifor 2013): “The purpose of the financial
system is to let those who want to save, save. It is to let those who want to borrow, borrow.
And it is to use our banks and other financial institutions to bring savers’ funds and borrowers’
needs together and carefully manage the risks involved in transfers between them.” No
wonder the Fed could not see the credit bubble building that the banks were blowing up, if the
President of the most influential Federal Reserve Bank can see banks exclusively as
intermediator of pre-existing funds.
Vitor Gaspar, in his capacity as Portuguese Minister of Finance, came to Frankfurt in January
2013 to praise his country’s adjustment program. He diagnosed the excessive build-up of
debt by households, government and companies as the underlying cause of the Portuguese
crisis. This built-up of debt had happened partly while he had been working in Frankfurt for
the ECB as head of Economic Research. Commercial banks had provided that excessive
credit refinancing with funds from the ECB. It had showed up in double digit growth of the
money aggregate M3, which the ECB ignored. However, debt buildup or debt in general was
not part of the research program of the ECB. Asked if he would draw any lessons from the
diagnostic failure of the ECB and its failure to do anything about this debt buildup, he said: “I
am embarrassed, because this is an important question and I have to admit that I have not
thought about it. I cannot answer out of hand”, (Haering 2013).
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The situation in the ECB’s economic research department did not improve post Gaspar. A
paper in which one could have expected some lengthy and explicit analysis of money and
credit creation by commercial banks is the ECB’s October 2012 “Report on the first two years
of the macro-prudential research network” (European Central Bank 2012).9 It aims to answer
questions like: “How does widespread financial instability affect the real economy? How can
the leverage cycle be described theoretically and empirically? How can these models help
understand the causes and features of the recent financial crisis.
You would not easily infer from reading this 80 page review of the state of knowledge by the
ECB that this is about a crisis produced by a credit boom. The tabooed expressions credit
creation or money creation do not appear. The expression “credit boom” is used twice in a
rather cursory way, barely enough to include the paper by Schularick and Taylor (2012) in the
reference list. The work of Minsky on financial instability, which focuses on cycles in credit
creation is mentioned once, but not at all discussed. Neither is the work of scholars, who do
not obey the loanable funds doctrine but rather have included credit creation in their models
and were able to predict the latest crisis on that basis, like Robert Shiller, Nouriel Roubini,
Steve Keen, Michael Hudson, Dean Baker and Wynne Godley. The list is from Bezemer
(2009). None of these are included in the references.
In the rhetoric of this ECB report, banks do not create and destroy credit and money. All they
do is increase or decrease their leverage, which is defined in the report as the ratio of debt to
equity.
In its Monthly Report of October 2012 (European Central Bank 2012, p.56), the ECB’s
economics department makes the fallacious thinking behind this explicit: “The concept of
monetary liquidity attempts to capture the ability of economic agents to settle their
transactions using money, an asset the agents cannot create themselves.” As Knibbe, Mahé
and Schrijvers (2013) point out, this refusal of the ECB economics department to accept the
fact that private agents can create money is in direct contradiction to the very monetary
statistics that the ECB assembles and presents. These are based squarely upon the idea that
banks can create money and even legal tender.
Conclusion
This paper aimed to give substance to the claim that central bankers and prominent textbook
authors share a desire to let us think that the creation of the vast majority of our means of
payment by commercial banks for their own benefit is normal, harmless, without alternative
and under the control of the central banks. Central bankers do so by avoiding any mention of
private money creation or credit creation, and by pretending instead that central banks have a
monopoly to create money. Textbook authors do so by distorting the process of money
creation, using the rhetoric of the inappropriate loanable funds model. Their account of the
role and legal status of central banks is highly selective and biased. Alternative monetary
systems are hardly ever seriously discussed.
The result is that even five years into the financial crisis brought about by a long and
pronounced credit boom, economists working for central banks and most prominent
9 http://www.ecb.int/pub/pdf/other/macroprudentialresearchnetworkreport201210en.pdf
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economist outside central banks still seem to lack a frame of mind that would allow them to
understand credit cycles.
The look into the history of central banks and the mechanisms by which commercial banks
create money has revealed that there is indeed an important element in the nature of central
banks of serving the interests of the banking community. We have seen that leading textbook
authors and central bankers are actively trying to disguise this. This should be kept in mind
then assessing the appropriateness of letting independent central banks, which do not have
to answer to the electorate or their representatives, wield wide ranging powers in economic
policy and banking supervision.
A suggestion for further research is to examine, how the major scholarly journals, notably
finance journals, deal with these issues. Cursory observation suggests that credit creation or
money creation are taboo words in the leading journals. The strong role of economists very
closely related to the Federal Reserve System in the leading finance journals might go pretty
far in explaining any such finding.
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Author contact: n.haering@vhb.de
________________________________
SUGGESTED CITATION:
Norbert Häring, “The veil of deception over money: how central bankers and textbooks distort the nature of banking
and central banking”, real-world economics review, issue no. 62, 25 March 2013, pp. 2-18,
http://www.paecon.net/PAEReview/issue63/Haring63.pdf
You may post and read comments on this paper at http://rwer.wordpress.com/2013/03/25/rwer-issue-63/
