The political season is upon us. And with Thanksgiving just around the corner, complete with turkey, stuffing and football, you might find yourself in the middle of a heated family conversation about politics and money.

One family member who is an Ayn Rand fan and watches Fox News faithfully might start squawking about how the government is printing all this money and sinking us into this big hole. He might end up arguing with another family member who happens to be a fan of New York Times columnist and Nobel Prize in Economics laureate Paul Krugman.

Paul Krugman on Money

Krugman has been adamant since the financial crisis started that the government should be spending more money. This view stems, in part, from a belief that the government, not commercial banks, can boost the amount of cash in the economy.

He is not alone. Many people view money and banking similarly to how the field is idyllically portrayed in the movie Its a Wonderful Life, in which Jimmy Stewart’s S&L takes in deposits and lends them out to individuals in the community.

In the real world, the opposite happens. Banks create money when they make loans. That is why lending is called credit creation. In fact, what separates capitalism from other economic systems is that private debts created by banks circulate as new money.

For example, say a person who owns a home takes out a $50,000 equity loan. Here a bank is creating a deposit of $50,000 and crediting that person with a loan for the same amount. The customer then spends the money, and a private agreement between the bank and the customer results in new money entering the economy.

The Bank of England on Money

The Bank of England, the UK’s version of the Federal Reserve, estimates that bank deposits produce 97% of the UK’s money. Moreover, the loan-generating function of private financial institutions described above provides most of those deposits.

So you’re telling me to tell my Paul Krugman-loving cousin, aunt or sister-in-law that banks make money out of thin air? Yes—and most money in the economy is created by the magic wand of banks, not the government.

And what if your Fox News-loving cousin, uncle or brother-in-law argues that “QE” is government money printing? The Federal Reserve is the government’s bank, so it can create money. But in the case of QE, it is a swap. The Fed exchanged its own produced money for bonds. However, when commercial banks make loans, they are not trading assets. They are forming new ones—deposits—out of thin air.

Capitalism and Money

In capitalism, the government’s role in creating new money is limited. It mostly moves around money that is already in the economy, funds itself by collecting taxes or selling government bonds, and then spends that money back into the economy. So most of the money the government touches is already in the economy.

Our government’s primary role in terms of money is to backstop the bank-produced money. That is what happened in 2008 during the financial crisis. After a five-year binge of money printing by banks in which total mortgage debt doubled from $4 trillion to $8 trillion, the banking system froze as healthier banks were unwilling to honor the payments made by customers of weaker banks. The government had to decide whether to allow the weaker banks to fail, which would have likely brought down the entire financial system, or to step in and guarantee the bank money.

So what does all this mean for this made-up Thanksgiving beef? Both combatants are wrong. Again, in modern capitalistic economies, the banks, not the government, produce most of the new money. Moreover, this ability for private banks to create public funds that go into new dynamic investment has led to many of the advances that make life more enjoyable for all of us today.

Sometimes, though, too much new money goes toward buying existing assets. In that case you get the debt without the dynamism. That happened in the last economic cycle with a housing bubble, and, unfortunately, that seems to have happened in this one with stocks, emerging market debt, and other higher risk investments.

Capitalism’s uniqueness of private banks increasing and steering the public’s money requires a counterbalance of a strong government (football and hockey fans, take note) to backstop, referee, and regulate this bank-created money supply.

Money Creation in a Modern Economy – 14 Page PDF from the Bank of England

The United States is Not Japan

Sources:

Keen, Steve. “Nobody Understands Debt — Including Paul Krugman.” Forbes / Investing, Feb. 10, 2015. http://www.forbes.com/sites/stevekeen/2015/02/10/nobody-understands-debt-including-paul-krugman/

McLeay, Michael, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate. “Money Creation in the Modern Economy.” Bank of England Quarterly Bulletin, 2014, Q1. http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf

WashingtonsBlog. “Bank of England Admits that Loans COME First … and Deposits FOLLOW.” Washington’s Blog, March 20, 2014. http://www.washingtonsblog.com/2014/03/bank-england-admits-loans-come-first-deposits-follow.html

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Tim has been a professional financial advisor for 26 years. He specializes in building custom portfolios for people that are saving their money for retirement or are already retired.

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