Saturday, 21 December 2013

What determines the money supply?

The third of our economics reading group occurred on 18 December. The starting point for our discussion was chapter 3: What determines the money supply? (Jackson and Dyson 2012). The previous chapter had shown how the banks create money. This chapter turns its focus to what limits money creation.

What drives the demand for credit? (pp. 82-85)

Our attention turned initially to what drives the demand for credit? Jackson and Dyson provide a number of key reasons. These include lending to invest (pp. 82-83), to expand the business (p. 83), to manage the cash flow gap (something that pay day loan companies rely upon) (p. 83), for property purchase (p. 84), for consumption (p. 84), and for speculation (pp. 84-85). Lending for speculation applies to traders and to those who borrow in order to gain from increasing property prices. The final category is legal incentives (p. 85). This is where the law such as limited liability means that the risk to a business developer is limited to the capital that they invest. Borrowing with the hope of future gains looks more attractive than risking one's own capital. Also the law often treats loans differently to equity financing thus encouraging risk taking through borrowing rather than by raising equity in the business.

The key issue is that the system that we have created places an emphasis on credit in order for the system to grow and for people to be able to purchase the goods and services that are on offer. Through the use of laws, added incentives are given to encourage borrowing. Although the current government in the UK talks of reducing debt, through incentive programmes, they are encouraging the private sector to borrow more for both speculative (house purchase incentives supposedly aimed at first home buyers) and productive growth (business borrowing incentives). The conclusion is that the system as encourages a demand for credit whether by design or simply the way that it has developed.

What influences the demand for money? (pp.85-88)

If credit wasn't available then there would be an increased demand for money. Money has become central to our trading systems but there is also a demand to put aside money because of the uncertainty for future expenditure and income (pp. 86-87). There is also a demand for money as a protection against the uncertainty in the value of other assets.

However, since the banks are the money source of money and credit, there is a structural demand for credit (pp. 87-88). For someone to have money, someone else has to be in debt. There is no source of money that is not associated with increasing debt. To add to the problem, if someone pays off their loan, the money supply reduces. Therefore to maintain a stable money supply, someone has to be picking up the debt that is being repaid as a new debt. All credit incurs interest charges meaning that the system by its very nature requires an increasing money supply and as a consequence increasing credit. Note: Economists prefer to use the term credit rather than debt because it is associated with a positive attitude while the term debt is regarded as a negative attitude. However, in the end credit and debit are the same and it is required in increasing amounts just to keep the system moving forward. Some would argue that this is the reason why the system requires economic growth in order to survive even if this means raping the planet of all its resources.

What influences bank lending? (pp. 88-95)

Since the system is based on increasing debt, what influences bank lending? A bank is motivated like any business to make a profit. Banks profit is obtained by receiving interest on loans. The more successful loans that they make the the greater the profit. There is very little incentive for banks to limit lending. Theoretically, they want to limit the number that will not be repaid. Through securitisation, the bank can sell on a batch of loans and gain an immediate profit. In the process, the risk of the loan not being repaid no longer rests with the bank. The bank also increases its equity potentially allowing it to lend more.

Without securitisation, the bank may limit some of its borrowing simply because the risk of a loan not being repaid would be too high. When a borrower defaults, the shareholder equity in the bank reduces but not the bank's liabilities. This can lead to bank insolvency. If the bank can find a way of ensuring that the liabilities are reduced while retaining the profit margin (i.e. through securitisation of the loans) then it can potentially lend more without risk of becoming insolvent.

The bank is also encouraged to take risks through government deposit guarantee schemes. The government guarantees the deposits but when a bank looks like failing, is it cheaper for the government to prop up the bank or to pay out to depositors? In many instances, it is cheaper to prop up the bank. Added to this is the increasing dependency between banks through interbank borrowing and the uncertainty of the flow on effect should one bank fail. The consequence is that banks can take more risks because they know that if they look like failing, the government will bail them out and take on their debt for them. In effect, the government buys private debt and then through taxes forces the general public to take on more debt in order to reduce government debt. A perpetual cycle of ever increasing debt.

Inflation in property prices caused by bank lending on the surface reduces the risk to the banks should a borrower default. There is no risk to the banks of this inflationary behaviour. Combined with the need to compete with other banks, there is increased incentive to lend.

The end result is that banks in their desire for greater profits cannot and should not be relied upon to “create the socially optimal level of currency” (p 95).

What limits the creation of money? (pp. 95-109)

It is in the interest of banks to create an endless supply of money yet they don't do so. So what places limits in them?

One restriction is the capital requirements set by the Basel Accords. These define the capital to asset ratio that a bank should maintain. However, interest payments retained increase shareholder equity and consequentially capital. So as loans are repaid, banks can increase lending. Capital is not a fixed quantity. Through new share issues, banks can increase capital and thus enable them to lend more. Securitisation also increases the capital. Under the Basel Accords, banks can be allowed to calculate their own capital requirements. In effect, the Basel Accords do little to limit money creation.

The reserve ratio has been seen as a limiting factor. However in the UK, the Bank of England endeavours to create more reserves to meet the requirements for settlement. The consequences is that reserves are an ineffective mechanism for controlling bank lending.

Another mechanism is the interest rate. In theory higher interest are argued to reduce borrowing while lower interest rates are seen as stimulating borrowing. However, higher interest rates put pressure on prices causing increased inflation. The consequence is that the Bank of England moves very slowly to change interest rates. There is also a time delay between the announcing of a change in the interest rate and its impact on the economy. As a mechanism for controlling credit creation it is an ineffective instrument even though it is the one that many central banks seem to rely upon.

The final possibility is regulation. The idea with regulation is that the government can regulate the level of lending and the sectors of the economy that are supported through lending activity. Such regulation impacts the way banks can operate and their ability to decide where to invest to maximise profits. Although many countries have used credit guidance in the past to direct money creation, it has now fallen out of fashion and is seldom used. Instead governments tend to use incentive packages to encourage investment in desired sectors of the economy.

So what determines the money supply? (pp. 109-113)

The major influence on limiting the money supply is the ability of the banks to make a profit from their loans. There is a point where increasing interest rates further reduces the profit that banks make simply because there is a reduction in those who will borrow money. Even though the bank may be making more profit on individual loans, they are lending less and profits begin to fall away.

However, there is another issue related to money creation. This is where the money has been spent into the economy. According to the 2010 figures, only 8% of newly created credit in the UK went into the productive economy. The bulk of the credit creation went into property purchases by individuals (45%) and commercial real estate (15%). This investment in property fuelled the real estate bubble and rapid property price inflation. A further large chunk went into financial markets (20%). The recent quantitative easing also shows this pattern with the Bank of England having to create more reserves than actually entered the productive economy (

In effect increasing the money supply did little to boost productivity or an improvement in the living standards of the community at large.


This chapter portrays a message that leaving it up to the banks to be the primary manager of the money supply almost totally transfers control of the money supply to banks both in terms of how much money is created and into what sectors of the economy this money is invested. Not specifically discussed is the consequence of this new money being created as credit / debt with a consequent interest charge. Some of these issues are dealt with in later chapters.

Although investment in property may enable some people to live in better houses, it also increases the entry level cost to first time home buyers as prices rise. For banks, this isn't necessarily a problem as this provides an opportunity for more and larger loans. The consequence on the economy of a greater portion of the family income going into the purchase of a home or rent is not taken into consideration by banks with their focus on profits.

The real message of this chapter is that managing the money supply should not be left to banks. An alternative strategy needs to be found and implemented.


Andrew Jackson and Ben Dyson (2012) Modernising Money: Why our monetary system is broken and how it can be fixed. London: Positive Money.