The meme that is destroying Western civilisation Part IV
Why economists aren't really interested in how money is created
In the last post in this series (Substack; Patreon), I claimed that economic textbooks get the impact of a deficit on private sector savings wrong: they claim a deficit reduces the savings of the private sector, and doesn't change the amount of money in the economy; I claimed that a deficit actually increases private sector savings by creating money.
That might appear bizarre to anyone who hasn’t studied economics. Economics is about money, right? Therefore, surely economists are experts on money? Surely they should know how money is created?
The truth is almost the opposite. Mainstream economists insist the economics isn’t really about money at all. In fact, they see money as a veil—a “veil over barter”—which obscures what’s actually happening in the economy. The granddaddy of economics textbooks—Samuelson’s Economics, now edited by William Nordhaus—is quite disparaging towards anyone who thinks in monetary terms:
You might calculate the cost in dollar terms. But in economics we always need to “pierce the veil” of money to examine the real impacts of alternative decisions. {Samuelson, 2010 #1480, p. 13}
This has been the attitude of mainstream economists for centuries: Jean-Baptiste Say, back in 1821, asserted that merchants aren’t interested in money, but in goods. Though they set prices in terms of money, they want money:
only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise. {Say, 1821 #6263, p. 112. Emphasis added}
I have read few more delusional paragraphs than that. Of course capitalists want to accumulate money! Of course they conceal how much they have! Yes they buy fancy goods with their profits, but their first motivation of any capitalist is the accumulation of wealth in the form of money. On this front, Marx was both more poetic and far more realistic:
Accumulate! Accumulate! That is Moses and the prophets! {Marx, 1867 #1083, p. 558}
Nonetheless, this silly attitude to money became ingrained in Neoclassical economics. Consequently, Neoclassical economists aren’t really interested in how banks actually work, and how money is actually created. They made up two models of money creation and bank operation—“Loanable Funds”, in which banks are just intermediaries between savers and borrowers, and the “Money Multiplier”, in which banks “multiply up” central bank money in a chain reaction process. They are superficially persuasive, so economists think they know how money is created.
But the results of these models meant that they could justify not including money and banks in their mathematical models of the economy. Having gotten rid of banks and money from macroeconomics, they never checked to see whether these models were consistent with what banks actually do, and how money is actually created.
And they are not consistent with what banks actually do, and how money is actually created. A century of non-mainstream economists tried to set them straight—contrarian economists like Joseph Schumpeter, Irving Fisher, Hyman Minsky, and Basil Moore—but the mainstream ignored them. Then the Bank of England (and even the Bundesbank!) sided with the contrarians:
banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. {McLeay, 2014 #5066, p. 14}
And the mainstream economists ignored these Central Banks too!
The reason for this deliberate ignorance about banks and debt and money is that, for mainstream economists, believing that money is unimportant is as critical to their view of the world as not believing in God is for an atheist. You can’t understand that banks create money and remain a Neoclassical economist—just as you can’t change your mind to believe in God and remain an atheist.
Therefore, to really understand money, you have to throw the textbook supply and demand curves away, and look at what banks actually do: they create money via double-entry bookkeeping.
Double-entry bookkeeping was invented in the 15th century to enable merchants to accurately record financial transactions, but it also enabled banks to create money.
In double-entry bookkeeping, as the name implies, every transaction is recorded twice—once as a Debit (DB) and once as a Credit (CR). Every account is classified as either an Asset—a claim you have on someone else—or a Liability—a claim someone else has on you. The difference is your net worth—your Equity.
Every company uses double-entry bookkeeping. What is special about how banks use it is that it’s how they create money. If a bank lends you say £1 million, they add that number £1 million to your Deposit account, and they record that you owe them £1 million at the same time—and on the same double-entry bookkeeping line:
Table 1: A bank creates money by double-entry bookkeeping
That action simultaneously creates debt and money: as the Bank of England says, “bank lending creates deposits” {McLeay, 2014 #5066, p. 14}.
The government uses a very similar mechanism to create money too. And just as mainstream economists don’t understand how banks create money, they don’t understand how the government creates money either.
I’ll cover how the government creates money in the next post in this series.
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