Democracies and central banks did not find what they were looking for
In 2012, I interviewed economist Russell Napier. In the four years since the start of the 2008 financial crisis, Western central banks had printed a lot of money in order to avoid an economic depression. Being younger and more naive, I had asked Napier if he saw the fiat money system as it exists surviving, to which he replied: “The story of the fiat money system is really history. of democracy. ” In the fiat money system, paper money is not backed by any commodity, as has historically largely been the case.
Before the start of World War I, the world largely operated on the classic gold standard, with paper money worth a certain amount of gold. This ensured that governments could not create money out of thin air by printing it, because once people found out about it they would exchange silver for gold and there was no that a limited amount of this metal for everyone.
During this war, many governments suspended the gold standard in order to print enough money to fund war efforts. But when they tried to go back to the gold standard, it created even more pain for people who were already suffering from the ravages of war.
As Raghuram Rajan and Luigi Zingales write in Save capitalism from the capitalists: âWorkers, many of whom had become politically aware in the trenches of World War I, organized themselves to demand some form of protection against economic adversity. But the gold standard limited the government’s options, forcing politicians to change course. standard, they could acquire the power to print an endless amount of money.
This power has survived to this day. When the 2008 financial crisis hit, Western central banks printed a huge amount of money. Something similar happened when the covid pandemic began to spread. Many governments have given printed money directly to people. In this sense, fiat money and democracy, where politicians and government-backed central banks are to be seen as doing things to alleviate people’s economic hardship, go hand in hand.
The idea is that with more money floating in the financial system, interest rates will drop, people will borrow and spend, businesses will borrow and grow, and jobs will be created. It will help the economy.
Such thinking stems from a poor understanding of how the bank works. Most of the writing in economics textbooks tells us that banks borrow deposits to make loans. This is not true. A 2014 Bank of England bulletin states that a bank providing a home loan “typically does not do so by giving the borrower” thousands of pounds of banknotes “. He credits the lessee’s bank account with a deposit equal to the amount of the mortgage.
David Orrell explains this in Quantum economy, where he says that when a bank lends money, “it doesn’t get the amount back by borrowing it from its clients’ savings accounts, it just catches it up by entering it into their computer system.”
Therefore, a bank creates a deposit of the same amount as the loan in the bank account of the person taking out the loan. In the process, it creates new money. While the loan is an asset for the bank, the deposit made is a liability. The money given in the form of a loan will eventually be spent and thus exit the account of the person who takes out the loan.
Now every asset needs a balancing liability. When the money taken out in the form of a loan comes out, the assets and liabilities do not match. To fill this gap, banks need deposits from savers.
As an article entitled The Truth About Banks published by the International Monetary Fund (IMF) points out: âOnce the purchases are made [using loans] and the sellers deposit the money, they become saversâ¦ but this saving is an accounting consequence. “
This dynamic ensures that banks do not grant loans just because interest rates are low. As Josh Ryan-Collins et al write in Where does the money come from?: “The main determinant of how much [banks] lending is not the interest rate, but the confidence that the loan will be repaid. In the United States, for example, commercial and industrial loans stood at $ 3.03 trillion in May 2020. By November, they had contracted by one-fifth to $ 2.4 trillion.
In addition, a lot of money has seeped into stocks and real estate, causing their prices to rise rapidly, or asset price inflation. From July to September, home prices in the United States rose almost 20% from last year’s figures, which had hardly been seen before.
It is clear that the policy of central banks to print money to stimulate growth is not going in the desired direction. As the IMF article puts it: âIf the funds are used to support relatively unproductive economic activity, it will lead toâ¦ asset price inflation and less additional output. This is precisely what is happening. activities such as real estate speculation.
How can central banks correct this phenomenon? To begin with, their primary focus on consumer price inflation as a target needs to be broadened and measures of asset price inflation need to be incorporated.
Vivek Kaul is the author of ‘Bad Money’.
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