Final Notes on Credit Creation
Introduction
Throughout history knowledge has not been a smooth progression from one better theory or idea to the next. In some areas of study knowledge is lost, regresses or dissolves into mysticism.
The study of economics is one area of knowledge, which has suffered an irreversible setback at the hands of its practitioners. Why this is so calls out for comment. The nearer the sciences impinge on social relationships within capitalism the shallower and apologetic they become.
The result is that economics has degenerated into a vulgar pseudo-science. To attack Marx's labour theory of value economists created, at the end of the nineteenth century, a subjective utility theory of value formed from psychological preferences of individuals, infinite demands, a scarcity postulate and a concept of human nature based on calculating greed and opportunism. In the process they not only blocked out Marx's useful and scientific insights about the anarchy of commodity production and exchange for profit but also the entire classical economic tradition from Petty through to Smith and Ricardo.
In the twentieth century the degeneration of economics continued unabated. Workers were erroneously blamed for inflation and unemployment. And banks were supposed to have the power to create credit at a stroke of a pen. Schools of economics came and went with the passing failure of each government economic policy. Economists could no more explain periodic trade depressions than to predict them. Today economists are ridiculed and treated as a joke.
Socialists have periodically written on banking and inflation to show that wealth is not created by banks but by the exploitation of wage labour in the productive process of commodity production. Surplus value is created in production but realised, as rent, interest and profit in circulation. Likewise we have shown that wealth is not created on the stock exchange where the gambling in shares is a zero-sum game, some winning others losing. And we have shown that inflation is the consequence of governments pushing out more currency into circulation than is needed for trade.
Capitalism has to be understood and rejected in its entirety. Consequently, the main battle of ideas in the class struggle is in the field of economics. The ideas of the capitalist class and their political agents cloud a clear understanding of capitalism since they present conflicting class interests as being harmonious and the economy as capable of being run in the interests of all society.
These ideas have to be dealt with however arduous and boring the study of economics happens to be. Capitalism benefits capitalists, not workers and capitalist economics is the employer's set of ideas to keep workers in their place. You will not hear Chancellors of the Exchequer lecturing the CBI not to make more profit but you will always hear Chancellors telling workers to be more productive and not to take increased pay rises.
The Historical Background to the Degeneration of Banking Theory
In the nineteenth century economists such as Jevons and Mrs Fawcett had no difficulty in explaining the banking operations of receiving deposits of notes and coins, and lending part of what is deposited to borrowers, for which the bank charges them interest.
Depositors are entitled to withdraw at any time all or part of what they have deposited, but experience has shown that, in return for the payment of interest by the bank, the total of deposits held by the bank accumulates and enables the bank to carry on business. Of course interest paid by the bank to depositors is smaller than the interest it charges to borrowers.
Let us suppose at 31st December 1999 a bank had received £1,000,000 deposits, had had £100,000 withdrawn by its depositors and that out of the balance of £900,000 the bank had lent £850,000 to borrowers. The bank's liabilities of £900,000 owed to depositors would be covered by £850,000 owed to the bank by borrowers, and £50,000 cash, total, £900,000.
Such a balance sheet presented no problem to the nineteenth century economists, Jevons, Fawcett and others, despite them holding to shallow economic ideas elsewhere, notably the utility theory of value. But some later economists, described by Professor Cannan as "the mystical school of banking theorists", (foremost among them being J.M.Keynes), have continued to create mystery where there is none in the real world. They argue that as a bank has lent £850,000 and only £50,000 in cash the bank must have "created" the other £800,000.
For example Professor F.W. Paish writes:
Bank deposits can originate in either of two ways. Customers and deposit cash with the bank, or the bank itself can create deposits by making loans or buying securities". (BENHAM'S ECONOMICS p. 428).
Banks and Railway Stations
Professor Edwin Cannan who taught at the London School of Economics in the 1920's, dealt extensively with the "mystical school of banking" in an article in "ECONOMICA" (January 1921), AN ECONOMIST'S PROTEST (pp 256-266 1927), and a book, "MONEY: ITS CONNECTION WITH RISING AND FALLING PRICES" (Fifth edition pages 79-83).
Cannan dealt with the classical theory of deposit banking, with the origin of the phrase "loans make deposits" (meaning that a banker who assists a capitalist by lending him money may expect to receive his firm's deposits as the business grows), and with the misuse of the phrase by Hartley Withers and others to support the "Creation" theory.
In his article in ECONOMICA, Cannan sought to restore sanity by comparing a bank to a Railway Station cloakroom, both of which accept "deposits". The bank accepts deposits of notes and coins, and the cloakroom accepts deposits of hats, coats, bicycles, and so on.
The customers of the bank, like the customers of the cloakroom, can demand at any time the return of all or part of what they have deposited. With, however, this difference: that while the customer of the cloakroom wants back the identical hat, coat or bicycle that he deposited and will have a legitimate grievance against the railway company if the individual hat, coat, bicycle etc. has been in the meantime been lent or sold, the customer of the bank is only concerned with getting back the total amount that he deposited and does not expect or want to receive back the identical notes and coins he deposited.
But the "mystical school" of modern economists have claimed to discover another remarkable difference. They claim that while the cloakroom can only hand back to depositors exactly the number of hats, coats, and bicycles etc. that they have deposited, when it comes to depositing notes and coins in a bank the bank can, in some mysterious way, multiply the number of notes and coins, and can lend the multiplied total to borrowers.
Banks as Mere Intermediaries
The non-mystical theory of banking was and is that banks are simply intermediaries between lenders and borrowers.
Reginald McKenna, Chairman of the Midland Bank, put it in the phrase: "the bank merely stands as an intermediary between the depositor and the borrower" (POST-WAR BANKING POLICY Heinemann 1926 p.93).
Marx would have agreed with this view. He wrote:/p>
They (the banks) step as middlemen between the actual lender and the borrower of capital…so that in place of the individual moneylender the bankers face the industrial and commercial capitalists in the capacity of representatives of all (CAPITAL vol. 111 page 472).
F.L. Bland, a director at Barclays Bank, in an address to the Institute of Bankers, said;
Money saved in smaller or larger sums tended to aggregate…the commercial banks were essentially not much more than the channels through which the aggregate funds moved to their final destination…Bankers could not create money in the sense of wealth; that popular illusion was widespread and needed definite contradiction (TIMES 15 November 1934).
Walter Leaf, who was Chairman of the Westminster Bank, answered the creationists in his BANKING (University Library 1926. Ch. 1V).
The
banks can lend no more than they can borrow-in fact not nearly so
much. If anyone in the deposit banking system can be called a "creator
of credit" it is the depositor; for the banks are strictly limited
in their lending operations by the amount which the depositor thinks
fit to leave to them.
H. J. Welch also disputed the "credit creation" theory
in his MONEY, FOREIGN TRADE AND EXCHANGE (Allen and Unwin 1935). The
book was favourably reviewed in the SOCIALIST STANDARDStandard of
April 1935. In that review several other opponents of the theory were
quoted.
The Macmillan Report (1931)
The Macmillan Committee on Finance and Industry, of which Keynes was a member, stated the creationist case as follows;
It is not unnatural to think of the deposits of a bank as being created by the public through the deposit of cash representing either savings or amounts which are not for the time being required to meet expenditure. But the bulk of the deposits arise out of the action of the banks themselves, for by granting loans, allowing money to be drawn on an overdraft or purchasing securities, a bank creates a credit in its books, which is the equivalent of a deposit. A simple illustration, in which it will be convenient to assume that all banking is concentrated in one bank, will make this clear (p. 34-5).
The Committee went on to argue that if a depositor deposited £1000 cash in a bank, the bank could make loans (or purchase investments) to the amount of £9,000; based of course on the assumption that all cheques drawn by borrowers (or cheques paid by the bank when purchasing investments) would come back to the bank because it was the one and only bank operating in this hypothetical and unreal situation.
The end position would be that the bank's books would show deposits of £10,000, loans and investments of £9,000, and cash of £1,000 (ratio of cash to deposits of 10%).
The Committee said that their assumption would not work if there were several banks, and if the cheques drawn on the first bank (or paid by the bank when purchasing investments) were paid to people who deposited them in other banks, because this would reduce or eliminate the first bank's balance of £1,000 cash.
If the theory stated by the Macmillan Committee conformed to the facts of the real world it would be applicable to a new bank as well as an existing bank. The Committee failed to notice that in a world containing several banks a new bank starting with a cash deposit and trying to lend nine times as much would certainly go bankrupt.
If it started with a deposit of £1,000 cash and made nine loans of £1,000, experience shows that, on average, several of the cheques drawn by the nine borrowers would be paid to persons with accounts in other banks. One such payment would eliminate the new bank's £1,000 cash entirely, and all further such cheques would be dishonoured.
The fact is that the assumption of an isolated cash deposit of £1,000 is unreal. In the real world deposits flow into banks in the approximate ratio of £1,000 cash and £9,000 cheques (i.e. claims on the cash of other depositors in the same or another bank), and the Committee's assumption of a £1,000 cash deposit, if it is to be representative, should be recognised accordingly as part of that normal flow.
It will be noticed on this basis that the newly formed bank would survive, as in the real world it could. Receiving deposits of £1,000 cash and £9,000 cheques the newly formed bank (like an established one) would be able to lend £9,000 out of its total deposits of £10,000, and still retain the 10% cash ratio.
The unreality of the Macmillan Committee's assumptions would have been exposed at once if they had looked at the matter from the standpoint of the depositor. From his standpoint it would have been absurd to say, as did the Committee, that it would have not have been unnatural "to think of the deposits of a bank as being created by…the deposit of cash"; no depositor thinks that when he deposits cash and cheques, only the cash counts and not the cheques.
The starting point of the creationist theory is the fact that a well-conducted bank can count on the depositors collectively leaving deposits in the bank and not requiring more than about 10% at any time in cash. The bank can therefore meet normal demands if it retains about 10% of total deposits in cash and invests or lends the remainder.
But this kind of relationship between cash and debts is not due to some peculiarity of banks. If A lends £1,000 to B on the understanding that he will not call for repayment of more than £10% in cash, and if B similarly lends to C, and C to D and so on, the final situation is that two dozen people are involved, the first being owed £1,000 and the last only £100, while all the others both owe and are owed; the total of all the debts being £9,000. Nothing has been created; the collective net assets of the whole group being the £1,000 cash with which the operation started.
Alternatively,
if A lends £1,000 to B, who lends it to C and so on a group
of 9 would collectively owe and be owed £9,000 with the £1,000
cash being held by the ninth.
Early Views about Credit.
As
early as 1848 John Stuart Mill in his PRINCIPLES OF POLITICAL ECONOMY
was familiar with the belief in the magical power of credit.
In chapter XI in which he dealt with banks, cheques, the clearinghouse,
etc., he wrote:
Credit has a great but not, as many people seem to suppose, a magical
power; it cannot make something out of nothing…It seems strange
that there is any need to point out that credit being only permission
to use the capital of another person, the means of production cannot
be increased by it, but only transferred…The same sum cannot
be used as capital both by the owner, and also by the person to whom
it is lent; it cannot supply its full value in wages, tools and materials,
to two sets of labourers at once.
The French economist, Charles Gide answered the economist Professor MacLeod, who maintained that credit instruments are real wealth:
If every credit instrument really constituted wealth it would be possible to double the wealth of a community simply by each citizen lending his estate to his neighbour in exchange for a note (DIGESTED GIDE'S POLITICAL ECONOMY edited by H.M. Desai Harrap 1916, Page 118).
Credit Creation and Marx's Labour Theory of Value
The creationist theory can be shown to be groundless if stated in terms of the Marxian theory of value.
At a given moment total wealth represents a mass of value: it can be increased only by further application of human labour-power to nature-given material.
Suppose an individual holds £1,000 of that mass of value. If he uses that £1,000 to buy new shares by ICI it will not alter the total mass of value but will simply transfer £1,000 to ICI.
But we are asked to believe by the Macmillan Committee, and the later generations of economists who uncritically bought this mystical nonsense, that if a capitalist deposits his £1,000 to a bank, the bank can then lend £9,000 to ICI, thus increasing ICI's resources by £9,000 instead of £1,000 and without reducing anyone else's holding of value.
Note also Marx's observation in CAPITAL VOL. 1 (Kerr, Page 695);
The superficiality of political economy shows itself in the fact that it looks upon the expansion and contraction of credit which is a mere symptom of the periodic changes of the industrial cycles, as their cause.
It therefore comes as a surprise to learn that Milton Friedman wrote that "…among my fellow monetarists [was] Karl Marx…" (OBSERVER, 26 September 1983). In the book FREE TO CHOOSE written jointly with his wife, dealing with inflation, they considered who are and who are not "the culprits" of inflation.
None of the alleged culprits possess a printing press on which it can turn out those pieces of paper we carry in our pockets; none can legally authorise a bookkeeper to make entries that are equivalent of those pieces of paper.
Here we have Milton Friedman supporting the creationist doctrine of Keynes and the Macmillan Committee, which Marx's Labour Theory of Value repudiates yet in the same breath Friedman says that Marx is a "monetarist". We pity his students in Chicago University.
Conclusion
With the continued development of the banking system a noteworthy change has taken place in the size of the cash reserve the banks find it necessary to cover themselves against most depositors' potential demands for withdrawals.
Writing in 1967, the economist F.W. Paish said that a bank "Keeps in cash a reserve of much less than 100 per cent-say 20 per cent or 10 per cent" (BENHAM'S ECONOMICS, page 428).
At one time there was a Treasury policy (not enforced by law) that banks should keep a reserve of 10% of the amount owed to depositors. In practice the big banks found ways of satisfying the inspectors that they had reserves of 10% without actually keeping that amount.
The actual amounts of cash reserve have fallen drastically and there are specialised banks which because they do not need to provide cash withdrawals on demand have no permanent cash reserve.
The official journal FINANCIAL STATISTICS (October 1993) publishes what is called a Bank Balance Sheet, which presents in one account a picture of the total liability of banks to depositors and the total amount of cash reserve of all the banks combined.
The figure is £3,000 million of notes and cash, which together with the combined holding of securities, balances the combined banks total liability to depositors of £1,375,100 million.
It will be seen that this cash reserve of £3,000 million represents only a tiny part of the total liabilities of £1,375,100 million; little more than 1/500th part or 0.02%.
Finally, most credit is not of the small scale nature of personal credit and debts, but is for capital investment, via merchant banks, through bond and share issues - big money oiling the wheels of the capitalist system