Malinvestment and the endogeneity of money

By Frances Coppola

So much has been written about the endogeneity of money that I thought it was now widely accepted. But recent exchanges have shown me that people STILL aren’t getting it. Most recently, there have been two themes doing the rounds that bother me:

malinvestment is caused by a growing money supply
– the presence of excess reserves in the system indicates a growing money supply (and therefore malinvestment)

Both are wrong. They are wrong for slightly different reasons, but they both boil down to the same thing – that money exists independently of the actions of banks. It does not. If there is malinvestment in the system, it is caused by an excess of bank lending, not by a growth in the money supply: very fast broad money growth is a consequence (or better, an indicator) of excessive bank lending. And if there are excess reserves in the system, they are caused by the desperate attempts of central banks to stop the money supply falling as banks deleverage. You could say they are caused by LACK of bank lending. 

Firstly, let me run through how bank lending works. The example I shall give is simple unsecured bank lending, but it applies equally to all forms of bank lending, including retail and wholesale secured lending (mortgages, repo).

Banks do not “lend out” existing money. They agree a loan, then obtain the funds to enable the borrower to pay the money. Let’s use a car loan as an example. The bank lends say £5,000 as an advance against a car that the borrower intends to purchase. The accounting entries are DR loan account (asset)*, CR customer current account (liability). At that point the bank’s balance sheet has expanded by £5,000 and sterling M2 has also increased by £5,000. But because the entries are balanced, there is no need for additional reserves at this point.

At this point also, no payment has been made. All the bank has done is put money in the borrower’s account. And it has not “moved” this money from anywhere. The bank’s cash balance does not change, and neither do the balances on any other customer deposit accounts. Banks DO NOT LEND OUT DEPOSITS.

The customer may leave that money in his account for several days or even weeks after the accounting entries have been made for the loan. The money supply therefore increases as an inevitable consequence of loan approval, not the consequent payment. Unfortunately traditional “money multiplier” explanations of lending fail to separate loan approval from its subsequent drawdown. Consequently we get absurdities such as “banks need reserves in order to lend”. No they don’t. They need reserves in order to make payments. And it doesn’t matter whether the money they are paying out is money they have lent to the customer, or money that the customer himself has deposited. The same reserves are used to make payments in both cases.

When the customer actually pays for the car, he withdraws £5,000 from his current account. The entries are DR customer current account (liability), CR reserve account (asset). At the central bank, the entries are DR reserve account (liability), CR receiving bank’s reserve account (liability). Note there is no impact on the asset side of the central bank’s balance sheet. The amount of reserves in the system does not change as a consequence of payments being made: only the distribution of those reserves changes. Or, putting it another way, banks don’t lend out reserves.

The sending bank has to obtain funds if funding that payment would take its central bank reserve account below the required reserve limit. It does so by borrowing from other banks, or as a last resort by borrowing from the central bank. In these days of instantaneous funds transfer, you could even say that the bank funds the payment by borrowing back the £5,000 it has created from the bank it has just paid it to, since it can run a daylight overdraft in its reserve account and clear it at the end of the day. Making payments has no effect on broad money, but if a bank has to obtain additional reserves from the central bank then it can result in the monetary base increasing. Monetary base expansion therefore tends to lag broad money expansion.

When the loan is repaid (let’s assume bullet repayment to keep it simple) the entries are DR customer current account (liability), CR loan account (asset), reducing the loan account to zero. The bank’s balance sheet has shrunk by £5,000 and so has M2 by the same amount. Repaying a loan actually destroys money. Yes, the bank may make another loan of £5,000 to someone else, in which case the money supply will be restored, but it doesn’t have to. It will only do so if the risk versus return profile at that point in time is in its favour. And that is not a constant factor.

Prior to 2008, banks were lending exorbitantly, and borrowers were lapping it up. Money supply consequently grew very fast. Then came the subprime crisis, followed by the collapse of Lehman and the financial crisis. The swathe of mortgage and other loan defaults at that time not only caused bank failures, it caused a sudden catastrophic fall in the rate of growth of the broad money supply. As an example, this chart from the ECB clearly shows the overheating growth of M3 followed by sudden fall back when the crisis hit:

Click here to see the full series

Post-2008, banks are more risk-averse than they were, partly because of regulatory changes that force them to include more equity in their funding mix, and partly because – as the Large report noted – bank staff responsible for lending decisions have had their fingers very badly burned and are terrified of getting it wrong again. (Sometimes I think we forget that lending decisions are made by people.) And banks are still cleaning up their balance sheets. Therefore they are not lending as much as they were prior to 2008. They discourage demand in two ways – firstly by charging higher interest rates on loans, particularly to poorer risks (that’s why interest rates to SMEs have gone up considerably since 2008), and secondly by refusing to lend at all. Furthermore, households and corporates are not borrowing to the extent that they were before the crisis. They are paying off debt and not taking out new loans.

The problem prior to 2008 was that banks mispriced risk and therefore lent far more than they should have done at too low a price. The result was malinvestment (sub-prime loans and their derivatives, dodgy corporate lending and so forth). And the result was also a sharply rising money supply AS A CONSEQUENCE of that malinvestment. In Austrian economics, this is inflation – but it showed itself as rising prices in certain asset classes, not a general rise in the price level. I’m not going to discuss the reasons for this here: inflation-targeting central banks claim credit for it, but in my view it might also have something to do with the imbalances in international trade and the general stagnation in wage levels in developed countries.

We now have the opposite problem: banks don’t want to lend, and households and corporates don’t want to borrow. The result is a broad money supply that stubbornly refuses to grow. Central banks are attempting to counter that by increasing the monetary base – with some success, though mainly through portfolio effects as bank lending, particularly in Europe, is still very low. Except for the ECB, that is, which has been happily allowing broad money supply to stagnate for the whole of 2013, mainly due to banks paying off the LTROs early and not lending to periphery businesses.

This is not to say, however, that there is no malinvestment at the moment. There is, and it comes in two forms: residual malinvestments from prior to the crisis that banks, households and businesses are still trying to unload, and new malinvestments. But the new malinvestments are not caused by central banks increasing the supply of the monetary base. They are caused, just like the older malinvestments, by the mispricing of risk.

Good investment requires accurate pricing of risk. Too cautious a view is as damaging as too reckless a view. So when banks and investors take too cautious a view, they stuff their balance sheets with safe assets while denying viable businesses the investment they need. When businesses take too cautious a view, instead of investing in risky projects for the future they hoard cash on their balance sheets and buy back their own stock. When households take too cautious a view, the result is a stagnant housing market and depressed consumer demand. And when governments take too cautious a view, the result is lack of public sector investment.

Prior to the crisis, malinvestment was caused by too optimistic a view of risk: post-crisis, it is caused by too pessimistic a view. Malinvestment doesn’t end when there is a crash: a crisis does not necessarily clear out all malinvestment. Denying finance to viable businesses because of too-tight credit criteria, or killing off developing businesses by raising interest rates to “clear out zombies”, is just as much malinvestment as providing credit to businesses whose business plans have serious weaknesses or whose market is in terminal decline.

We can reasonably ask what is being done with all the money that central banks are producing. I have no doubt that there are all manner of stupid investments being made. But I am not convinced that investment would be any better directed without central bank support. Unless we become much, much better at pricing risk, malinvestment is an inevitable consequence of doing business.

Related reading:
Understanding the Modern Monetary System – Cullen Roche
Malinvestment, not overinvestment, causes booms – Ludwig von Mises (excerpt)
The Trading Dead – Tom Papworth, Adam Smith Institute
Reply to Pedro al Sombrero Negro – Smiling Dave’s Blog

* Footnote for non-accountants. DR to an asset increases it, CR decreases it. DR to a liability decreases it, CR increases it. So a DR to an asset is balanced by a CR to a liability, and together they increase the size of the balance sheet. Conversely, a CR to an asset is balanced by a DR to a liability, and together they decrease the size of the balance sheet. I hope that is clear. 

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