Commercial Banks, Foreign Exchange, Quantitative Easing

Why I don’t care what the ECB does today

People think that Central Banks ‘create money’ or ‘control the money supply’ but this is not true. Most money is deposit money, or commercial bank money, created by the loan making activities of private banks, and over the creation of/destruction of this kind of money they have no overt control. Rather, they seek to influence the quantity of money by acting on what they can control, namely, central bank money. Central bank money is a special kind of money that only banks use, and is the mechanism by which banks settle payments. Whilst all commercial bank money is a claim on central bank money, like paper money used to be a claim on gold, the amount of commercial bank money vastly exceeds the amount of central bank money just like paper claims on gold used to exceed the supply of physical gold.

So central banks actions for me and you are pretty 2nd degree. None of us use central bank money, we use commercial bank money. An increase in commercial bank money supply (by loan making) can have effects in the real economy, but supplies of cash to banks by a central bank only increases the money supply by effectively giving banks the confidence to lend more loans because they have more central bank reserves to back up any payments they will need to make. However, the link is not simple. If I am a bank treasurer sitting on a book of bad loans, I know that I will need a lot of central bank money in future to settle claims made on me by other banks. Any excess liquidity provided to me by the ECB will be used to shore up my balance sheet, not expand it. The duality of the two types of money makes central bank action ineffective in the kind of recession we have now, ie, a balance sheet recession where banks are not refusing to make loans because they don’t have cash, they have loads, but because they have a deadly combination of no confidence in the rest of the economy and uncertainty over future payments they will have to make. Thus, they hoard central bank money, whilst shrinking their balance sheets, the availability of credit and the money supply.

Apologies for any Econ/Finance professionals reading for whom this should all be well understood, but I think it’s worth ramming home just how little we should care what the ECB does today. Sure, their activities can and will excite financial markets, but that’s because financial firms and financial products are effected by Central Bank action in a way that the wider economy simply isn’t. The market cares a great deal whether the ECB lowers the interest rates paid on excess reserves, encouraging banks to lend more to each other. The world does not. The fundamental link that allows central banks to control prices and economic activity by changing the supply of central bank money is broken for the same reason that the economy is broken: Private banks are in charge of the supply of money. The only way to make policy effective and fix our macroeconomic woes is to solve this problem.

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11 thoughts on “Why I don’t care what the ECB does today

  1. I think you’re wrong in your assumption that the markets care but the world doesn’t when it comes to interbank lending and interest rates. Banks do lend but they tend to lend on assets, especially property, because this reduces their exposure to risk. An excess of commercially created money targeted at property inflates the market. They also lend wherever in the world is most financially advantageous to them, rather than where there is a need. They conversely don’t lend much to small and medium sized business as they are not asset rich, as a rule, and carry a higher risk. So banking mechanisms tend towards over inflating the cost of our homes whilst reducing our capacity to earn a living to pay for those homes. So the world does care! These same processes also tend to make the rich richer and the poor poorer. On the lending risk basis poor people score badly, so are charged much higher rates for their credit loans than rich people. The more you have, the less you pay, so the richer you become.

    • simplysellside says:

      My point is that banks do not lend reserves. The link between what central banks do and what banks do is broken because, and I cannot repeat this often enough, central banks do not control the money supply. Commercial banks do. All that stuff you said is absolutely true of commercial banks, and absolutely untrue of decisions made by the ECB.

  2. Pingback: Why I don’t care what the ECB does today » Positive Money

  3. Pingback: Why we weren't watching the ECB » Positive Money

  4. logo1 says:

    I thought that the central bank created the money and lent it to the commercial banks charging an interest rate set by the central bank. The commercial banks then repaid the loan and the interest charged by the central bank. Thus the central controls the money supply by deciding how much money to lend to the commercial banks.

    • simplysellside says:

      Well, that ain’t it at all. The central bank controls the supply of central bank money, commercial banks create a different kind of money, commercial bank money, when they make loans. Commercial banks do not lend central bank money to households and business, they simply create new deposit money.

  5. logo1 says:

    Presumably anything the commercial banks lend that they do not have in reserve has to be backed by money from the central bank.

    What is the difference between central bank money and commercial bank money? If it is the same denomination it has the same value and is basically an electronic funds transfer?

    • simplysellside says:

      Glad you asked as this is the main misconception people have about bank lending! Banks don’t take money that they have and lend it. Every time they make a loan they create new money. They click a button and that persons account is increased by the amount the loan is for. Whenever a loan is made, new money is created out of nothing. I have a few other posts on this, and check out the positive money website, they have some really good articles and videos that explain it better than I could!

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