Prof. Richard Werner explains how banking works. (money creation)

to answer that question we need to look at what what central banks are and how they operate and that allows us to explain how banking works and why we have the recurring banking crises let me do that in fact it goes back to the fundamental question how do banks operate and actually there have been three theories on banking for over a century three different explanations and I'm sure you will have encountered all three at one stage or another the currently dominant theory is that all banks are just financial intermediaries and this one is being reinforced a lot by the financial news reporting by statements from central banks and also there if you look into academic and research literature the leading journals say the Journal of Finance American Journal considered number one in the area it considers banks nowadays as financial intermediaries what does this mean that means the banks gather deposits on the one hand then they do their thing their analysis and their credit risk assessment all these things whatever it is good or bad and then they lend those deposits so they're just in the middle and middleman is the middleman theory of banking that one is currently dominant and also bank regulation how actually regulators look at banks and how they regulate them the entire approach to regulation which you know is this Basel approach we can come back to the specifics but this Basel approach is also based on the assumption the belief that banks are just the middlemen they gather deposits and they lend them out now if you go back in this journal of Finance to the 1960s you might get confused because it's the same journal but in the 60s they were talking very differently in this journal because then still just out the previous theory of banking was dominant which was dominant from the 1920s to the 1960s and that one you will also have heard maybe once or twice before the fractional reserve theory of banking this one is connected to another concept known as the money multiplier I think a lot of ears of those who haven't looked in into economics and finance should prick up now when I was a student and I heard this money multiplier whoo that sounds interesting I thought what is that the money multiplier the magic money tree so well just very briefly in fact there's a similarity if the money fractional reserve money multiplier Theory banking to the middleman intermedia intermediary theory of banking namely it says yes each individual Bank is an intermediary it's also this fractional reserve theory also says that but they say as you put many banks together you've got many banks now they interact and they do their things overlapping interacting then something happens somehow in this system as the banks interact and operate together money is being created there is money creation going on it's not the central bank we're not talking about central bank money creation okay now the actual technical details are a little bit complex students are always confused and there's actually reason it's meant to be confusing so don't worry if you think this this sounds a bit confusing you can look it up later fractional reserve theory of banking money multiply the main point is it says each bank isn't is a middleman an intermediary but in aggregate collectively and it's interesting that there's a recognition we have to look at something systemic which is different from each individual Bank something happens and money is being created of course you can imagine if that's true and if money's being created this will have an impact there will be some consequence this therefore means there should be a different approach to Bank regulation and the approach to Bank regulation going hand-in-hand with this fractional-reserve money multiplier theory of banking is the old reserve requirement approach to bank regulation which was dominant in fact during that era when fractional reserve theory itself was dominant which was until the early 80s 1980s even the Federal Reserve and the Bank of England were looking at reserve requirements it's a bit monetarist you know looking at money aggregates but then that was scrapped as from the 60s 70s onwards this financial intermediation theory of banking became dominant and then we have the Basel approach which is all about capital adequacy is all about capital not reserves we'll come back to this regulation but okay now there's one more theory of banking you need to hear the third one now now that we've come this far namely until roughly the 1920s this theory was dominant and this theory says that no banks are not financial intermediaries neither individually nor collectively so this is a different theory this theory says when a bank gives out a loan a bank loan which is talk about ordinary banks commercial banks when they give out a bank loan then money is being created money is being created essentially out of nothing economists tend to write ex nihilo because it's a bit embarrassing out of nothing it's too obvious it's it sounds too shocking so put it in latin it sounds more technical this theory was dominant until the 1920s now we've got this all these three theories if the the olders theory the banks create money is known as the credit creation theory of banking is correct then you need also bank regulation consistent with that theory and it's not the fractional reserve approach to the reserve requirement approach and it's not the Basel approach notice the Basel approach has not been very successful we've had so many banking crises since the Basel approach was introduced in the 1980s Basel 1 Basel - Basel 3 it's like these you know movie installments could you just briefly explain what that is I'm not sure everybody knows 1 2 3 yes this well they this is the currently dominant approach to bank regulation and the fundamental idea is that well we can somehow contain and control and regulate banks if we give them a requirement to hold capital what's called as capital now what's this capital is just when you look at a balance sheet of any company or also a bank you've got equity from shareholders that's the capital there's some slightly different types that can exist but we don't need to go into this that's the capital and banks so before the 2008 crisis had not much capital the large internationally operating banks had capital around two or three percent of their balance sheet that by the way is already a quick explanation why we've had all these banking crises because you can have them very quickly particularly if the the oldest theory of bank of the bank behavior the credit creation theory is correct the banks create money this will have consequences and then the Basel approach imposes capital requirements you must hold 8% simplified and it's not quite true for the big banks as issues was much less than 8 percent off your balance sheet in capital then this is some kind of security to ensure stability what's the thinking but it's not true because in to answer this we we must now ask this fundable question I'm sure you you want to finally hear Lee so which of these three here is is true and then I can answer your question properly about Basel which of the three theories is true because is linked to the currently dominant theory that banks are just intermediaries and if that was true that Basel has a chance to work now we have famous economists supporting all of these theories and the credit creation theory is supported by Schumpeter for instance Austrian economist and we've had the and also the young Keynes supported that one then the fractional reserve theory is supported by alfred marshall famous new classical economists and also by the slightly older Keynes and by many other economists and then we've had the financial intermediation theory which is supported by essentially all economists nowadays but which one is true well we need to test this empirically is what I thought over a century of debates but no empirical test what is the scientific way of doing this empirically test this well all the three theories differ when it comes to the question of where does money come from actually written the book with that title where his money come from because when you when you take out a loan from a bank the question is where is the money for the loan come from that's where the three theories differ the financial intermediation theory says or the bank's take deposits and then these deposits are lent out so and alone the money comes from deposit the fractional reserve theory says that banks need to hold excess reserves in order to lend and so the money for the loan comes from excess reserves and the credit creation theory you may guess this one says the money comes from nowhere the banks create the money out of nothing because that's the most shocking theory so I ran this experiment a few years ago I actually took out a loan from a bank and the bank was collaborating with me in this experiment this mirakl test because I told him look I I will take out the loan I will transfer the money away from you to my own old bank and I want you to show me exactly what you're doing which what transactions what bookings you're doing internally in your system I want to see where the money comes from that is booked into my account it's a reasonable approach it took a long while to get a bank to cooperate initially all said yes sure we'll do that the big banks and then when it comes to actually wanting to see their systems oh no no no this is far too sensitive and all sorts of reasons you cannot see this but I managed to find a bank in Germany that collaborated we actually had the BBC there filming this empirical test I took out a live loan 200 thousand euros and I was gonna transfer it away from the bank and we looked at the bookings and what they did and it turned out where did the money come from it was not transferred away from any other account inside the bank or outside the bank it did not come from deposits it did not come from reserves at the central bank in fact they didn't care about their reserves they didn't even look how much they had reserves were not affected it was newly created how does that work well the best way to understand is if you look at the law and this is of course one of the reasons why economists don't understand banking and they leave out banks in all their economic models because they never look at the law law is reality if you've got an issue well you can use the law to claim your rights and the court will decide and that is the result and you can challenge it to a higher court but ultimately you know the highest court will make a decision and that is it that's reality so what is the law say about banking economists consider banks as deposit-taking institutions that lend out money that's a standard definition by economists but when you study the law in the country that invented modern banking which is England in the 17th century and that's also when this legal system was created and it's still the same the law tells us it's a different story banks are not deposit-taking institutions and they don't lend money that's what the law says how does that work at law and we have we have Supreme Court judgments on this there is no such thing as a bank deposit it doesn't exist so what is it when you deposit your money with a bank we have the feeling and what you've given the impression that when you put your money with a bank it's my money in fact it did a survey and people respond no the money at the bank belongs to me that's my money and I'm holding it in deposit the bank they're taking care of it but it's my money I can ask it cause my money back anytime but at law that's not true at law there is no such thing as a bank deposit it's not held in custody it's not held for you you are not the owner of the money at the bank the money held in deposit at a bank is owned exclusively by the bank it was your money before you deposited it when it's deposited the bank the bank owns it and what rights do you have will you're a creditor so what that means the money at the bank is a loan that you've given to the bank and you just a general creditor so that's why banks don't take deposits they borrow money we lend it to them we are general creditors they own the money and they can do as they please they are the owners of this money at law very clear cut okay but it's surely they lend money what else would they do with this money no there is no bank that has ever lent money at law again very clear-cut how does that work very intriguing I thought that would be my question you go to a bank and you say I want to borrow money now an important thing is the loan contract and they will make you sign it now what happens at law is the moment you've signed the loan contract that you will borrow X amount of money and you will repay this money at this date with his interest whatever that moment once you've signed it you have issued a security a debt instrument that's what this loan contract is at law so what the bank does when it gives you a loan as we call it and lends you money as we call it at law they do no such thing they are the business of purchasing securities they will purchase the IOU the debt instrument that you've issued the bank will purchase this from you okay fine I don't care I just want the money when I get my loan ah you're right the bank now owes you money so the bank owes you money well that's what we call a deposit right a deposit is when the bank owes you money and the record of how much money the bank owes you we call a deposit and that's what you get you get a record of how much money the bank owes you and that's all you get because that's what the banks do so they purchase your debt instrument and then they record their debt to you and here's an accounting trick and actually in another paper published you find it online I could demonstrate that there is actually a slight well aspect of in correctness let's put it politely in in banking because technically from an accountants perspective they now have a an accounts payable liability to you right you've signed the long contract they should give you money accounts payable liability for the banks but the banks will book this now this liability called accounts pay my ability as another type of liability which sounds much more convenient for bankers namely customer deposit and that's how they'll show it to you and that's in your account in other words the bank will invent a fictitious deposit for the borrower and that is how the money supply is created I did a survey in Frankfurt of 1,000 people students helped me to do this and we asked in the streets around the University so probably slightly above average educational standard but doesn't matter bias may be in the right direction we asked him who do you think creates the money supply in the economy the majority of the money supply and of course the majority over 90% response well it's the central bank isn't it central bank or the government but that's not true the central bank only creates 3% of the money supply and the correct answer is the majority the vast majority 97% of the money supply is created by the banks when they lend money so this was the result of the empirical tests as well turns out the money supply is created by banks and where does the money come from for a bank loan it's created out of nothing by the banks and because of that so it's the credit creation theory the oldest theory which is correct it's now been empirically proven you can look up the paper if you Google can banks individually create money out of nothing you will get it it probably even shorter you will get it it's the most downloaded research paper of any Elsevier academic publication being a major scientific publishing and that means it's it's the oldest theory is correct and therefore for bank regulation to come back to your question on Basel we need a bank regulatory approach that recognizes this reality that banks create money the Basel approach uses the financial intermediation theory and thinks by having capital requirements we can contain the banks and avoid crises and it's not true because it's the credit creation approach which is career banks create money out of nothing and have you heard of have you heard of Christmas or Barclays in 2008 well how they got out of the crisis they were actually as bust as all the big banks remember in 2008 but did they go bust did they need public money neither they didn't what did they do they were clever they were aware of this and the decision makers in the crisis you know on the crisis you're under pressure they they remembered well what banks create money out of nothing why should we go bust they created their own capital out of nothing how do you do that well you need a borrower there was a borrower the sovereign of Qatar they had relations with them business relations and so they needed suddenly ten billion roughly let's say ten billion dollars worth of capital well let's create it out of nothing let's lend it to somebody like Qatar obviously needs to be a big player to borrow ten billion and be credible they will buy our newly issued shares of ten billion and we can create the money out of nothing for our capital and that's exactly what they did in a way we shouldn't do what what is now being done in the UK the Serious Fraud Office is going after them for fraud well they're just doing banking and they save the taxpayer billions and billions and money in fact this tells us that we can't get out of any crisis without using taxpayers money and without reducing public welfare spending as a result in austerity because we can just use the reality of bank accounting to get cleanly out of any banking crisis and this is also what central banks have done and put in the past when they didn't want a banking crisis to turn into a major recession they just solved the problem like this you can do it in one morning and you will not have a real banking crisis and you will not have a recession this is what Ben Bernanke did in 2008 and he was actually I proposed all these things that the 90s in Japan in these big debates we had Wales proposed quantitative easing and Bernanke was joining these debates and he was in 2008 the only central banker to implement my advice the true quantitative easing because the other slightly changed the definition step one you have a bust banking system the capital and the Basel approach is not enough you know is this tiny amount anyway and when the banks had create money use it for financial transactions push up a surprises by three four hundred percent which is due to banks creating this money for financial transactions at the peak if then a surprise is dropped by 10 percent you've used up all the equity for the non-performing loans already your bust so that's why we have the banking crises so how do you get out of this quickly at no cost to the taxpayer it's very simple the central bank steps in goes to the banks and says oh you've got non-performing assets larger than your equity your bust all of you must banking system always the same story no problem because we don't want a banking crisis now turning into big recession we will let you off this time we will put in place measures to prevent this in the future we'll talk about what those are but we'll get you out of this one now and you don't use tax money that's expensive that increases national debt Ireland was a fiscal poster boy but because the ECB forced it to fiscal eyes all the banking non-performing assets Ireland became bankrupt at the put/call in the IMF no we don't do that the central bank steps in goes to the banks and purchases the non-performing assets at face value and the problem is solved there's no cost and this is exactly what Bernanke did that's why in September October 2008 the balance sheet of the Federal Reserve Quatro bolt in one month this doesn't create inflation some people thought at the time wow we can I get hyperinflation now they're inflating their way out no no if you want to create inflation some countries try to do this allegedly like Japan for 20 years it's not gonna work with this method because it doesn't create money because you're just shifting assets between central bank and the banks in the right way away from the bank balance sheets where they are harmful to the central bank where they can't do any harm but you don't eject my into the non banking sector so you can't create inflation oh but how on the dollar is gonna collapse well no as I said at the time and it strengthened why because you're not creating money you're solving the problem in the banking system the banks are healthy again have strong balance sheets and can lend again and they did in America is the first country to get out of the crisis since then very strong bank ready growth unfortunally too much that's why we're back in the same spot they continue to create credit for financial transactions that's how you prevent getting into this situation the first place of banks being unstable because banks create money you have to split the stream of credit creation from banks into two for the real economy and for financial transactions because they are not part of the real economy and if banks create credit for financial transactions you are creating an asset bubble which is always unsustainable and will always lead to a banking crisis ultimately if it's large enough so in in the early 2000s I was warning that in Europe the ECB which is newly created was gonna create bank credit driven asset bubbles banking crises unemployment large recessions in the eurozone that's exactly what they did in Ireland Portugal Spain and Greece based on 30% credit growth for how many years three four years way ahead of GDP growth this is all credit creation by banks for asset transactions property real estate that's how you blow up these countries and that's what the ECB did you mention you mentioned the real economy where are the banks where is the banking sector where are the central banks in all this do they participate in as they you know create money do they create value are they part of the larger GDP what can you tell us about that first of all what is the link in you know between banks and GDP the banks have a crucial role they are in what we call our market economies the decision-making control center of the entire economy why because they create the money supply and they decide who gets money for what purpose is this an important decision you bet it is in fact that is the decision that completely reshapes the economic landscape in just a few months or years and at the decision of who gets purchasing power for what purpose newly created money so the banks are the control center and economy and that's why we need to distinguish between bank lending for transactions that boost GDP then you get high economic growth and no inflation job creation everything is stable you get also less inequality you get more equality but if banks create money for unproductive purposes either for consumption then you get only nominal GDP growth but low real GDP growth you get inflation that's not good that's well recognized but the biggest problem has been the last 30 years banks creating money for unproductive purposes that are asset transactions that's not part of GDP and when banks do this bank lending for property bank lending for asset stock market whatever financial instrument transactions lending to private equity funds to hedge funds investing in financial instruments which banks do a lot because all the leverage of these funds comes from banks plain old bank lending bank credit creation so this money creation for asset transactions of course is pushing up asset prices creating these asset bubbles while it happens it looks stable because we're all making money we're all having returns but they're all based on the capital gains and the expectations of capital gains and that will continue only as long as banks continue to create new money for asset transactions it's a it's a game of musical chairs if we took out all the chairs where nobody's sitting and then only have all the chairs where you're sitting in the room and then we take one out and we ask you ever understand we take one chair outright this game of musical chairs and we have the music on and if the music stops everyone has to sit down but one chair is missing well this is the credit creation for financial transactions it's a game of musical chairs when the music stopped that's when the banks do not anymore expand credit creation for financial transactions but they stop it or slow it then there won't be enough chairs for the speculators those who borrowed money and invested in financial instruments to sit on they will be bankruptcies but the moment their bankruptcies banks will have non-performing loans the banks get more risk-averse to reduce lending then they they reduce lending as the prices come down further there's no there's fewer and fewer chairs there's more bankruptcies and of course you will end up with a massive banking crisis that is the mechanism so therefore the answer to question is one link is that actually banks at the heart of the allocation of resources and they can determine by their decision of who to lend to whether we'll get high and stable equitable economic growth without crisis without inflation which is possible that's the scenario that East Asian economies have implemented through in fact I haven't told you what is the regulatory bank regulation regime in line with a credit creation approach to bank to understanding banks which is the true approach it is credit guidance direct guidance of bank credit window guidance also known as credit controls sounds a bit harsher but it's got credit guidance is more in line and that's been the key tool used in Japan in Korea and Taiwan and then adopted by Deng Xiaoping in China to create the Chinese economic miracle of high growth and if you do that you'll get your high growth but if banks create credit for asset transactions you will just create these asset bubbles and banking crises and higher inequality and all these problems and that's of course what's happening in most other countries because the bank regulators have not asked the banks to create credit for productive purposes it's quite extraordinary you know the banks make these key decisions but nobody's told them oh be careful when you make this decision you should create credit and lend mainly for productive purposes for business investment for implementing new technologies for increasing productivity which creates jobs is non-inflationary even at full employment you can have more growth if you have productive credit creation there's almost no limit to growth because the limit is the technology the ideas coming from humans as long as we have humans and we can have more humans if we have quantitative easing for for having more babies QE baby boners created by credits to have more babies fertility shoots up you know all these things are possible once you understand credit creation all the problems that we have that have to do with the economy including demographics can be solved but the second answer to your question is how do banks fit into our standard statistics of GDP and that's a very profound question you're asking there because even the statistics doing you know making our GDP accounts national income accountants as they're known and every country has big agency calculating these with very smart people even they haven't really solved this problem the answer to the other answer to your question because when we calculate GDP you know we've got the expenditure measure we've got the income measure and the output measure three approaches and normally we talk about the expenditure method measure you know consumption government spending investment net exports where do banks fit into this how do we get banks into this actually it's really not clear why because the approach in national income accounting is that will you measure Value Added you measure value added and you add it up so we're the banks fit in what is their value-added good question they're supposed to be according to official theory there's supposed to be only an intermediary a middleman there's no stew not really meant to be a net value-added because if then the middleman margin that they charge if we call that the value-added will be tiny supposed to be tiny but of course that's that's not what what's happening the banks are essentially claiming a lot of resources that they're paying out to them themselves and that is somehow this they're actually not a value-added in reality in most countries to the economy they're like a net drain a cost a loss so the national income accounts if to say okay but it's it's too complicated to try to figure out what banks are adding value in the economy maybe we maybe there is not much visible going on so let's just create a theoretical value that we that they call it imputing and let's just assume a number and let's wait let's just plunk that there and add it on to GDP and that's what they're currently doing because the fact is with this sort of banking system we have currently in most countries is not clear what value the banks are adding to the economy

Channel: Huizenmarkt Zeepbel

Views: 31,945

Keywords: Richard Werner, how banking works, money creation

Id: CXCMifLZsjs

Length: 33min 31sec (2011 seconds)

Published: Tue Jul 23 2019