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How the money system works, part 3 – summary and consequences

This has been a dry and technical discussion so far. But everyone should take the time to understand it,  because the political and economic consequence are immense.   Before explaining why, let’s recap. When a bank creates a loan it creates both an asset (a claim for payment on the borrower) and a liability (the borrower’s deposit). This liability amounts to a promise to deliver bank notes up to the amount of the deposit, or alternatively to use its bank reserves to settle payments made by the deposit, also up to the amount of the deposit. Bank reserves are amounts held by commercial banks in accounts at the central bank. Like commercial bank deposits, they are a promise to provide bank notes on demand. The key difference is that the central bank can create bank notes (or reserves) at will, whereas a commercial bank cannot. When a depositor instructs a bank to move money to an account at another bank, the first bank transfers reserves to the second bank, and the second bank then creat
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How the monetary system works, part 2 – taxation, inflation, bank notes and gold

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We saw in the last post that – contrary to the opinion of some commentators – QE does involve meaningful creation of money in the form of bank deposits. But we also saw that it puts that money in the hands of people who simply reinvest it in financial assets. What the economy needs, if it is to recover from the pandemic and grow, is not reinvestment but spending – real economic activity by actors in the real economy.   So what should policymakers do? How can spending in the real economy be encouraged? Well, the obvious answer is that money must be provided to participants in the real economy, not simply to investors. How can this be done?   This is where we come up against another false picture that influences our understanding of money and the economy, namely, the picture we have of taxation and government spending. In this picture, the government takes money from people and businesses in the form of tax and then spends it. Just as in the case of loans and deposits, experts and layme
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How the monetary system works, part 1 – deposits, reserves and bank notes

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What is happening in the economy and the markets? [1]  How can financial markets – or certain important parts of them, including most notably US markets for large-market-cap equities and corporate credit – be booming when businesses are shut, millions of people are out of work and a huge wave of personal and corporate insolvencies seems inevitable?   Most answers point to the actions of the Federal Reserve and other central banks, who have been carrying out something called quantitative easing, or ‘QE’.   Through QE central banks increase their balance sheets by creating the means to buy financial assets. Many describe this as printing money and worry that doing so on this massive scale must result in inflation. After all, didn’t Milton Friedman once say that “Inflation is always and everywhere a monetary phenomenon”? Haven’t we learned from Zimbabwe and Weimar Germany?   Others say that isn’t right: when central banks buy assets, they buy them from banks and pay for those assets with
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