D Orrell The Money Bomb

David Orrell  Quantum Economics (excerpt) –  Ch5  The Money Bomb 

Fairy dust
As described theoretically in textbooks such as Mankiw’s , fractional reserve banking apportions most of the job of creating money from the sovereign to the private banking system , but the central bank is still firmly in control . However , Soddy’s warnings take on a new dimension when we consider that the practice today is rather different . In reality , private banks are free to create as much money as they like by issuing loans , subject only to things like regulatory or self – imposed capital requirements . The vast majority of money ( in the UK , for example , about 97 per cent ) is created by private banks lending money for things like mortgages on houses . 10

One person to point out the role of banks in money creation was the Austrian economist Joseph Schumpeter . In his 1934 Theory of Economic Development , he defined entrepreneurs as innovators who come up with ideas and realise them in high – growth companies ; a process which usually involves upfront expenses and the need to borrow money . He argued that the primary funding mechanism was money creation by banks : ‘ It is always a question , not of transforming purchasing power which already exists in someone’s possession , but of the creation of new purchasing power out of nothing . ’
11 In his final work , published after his death in 1950 , he complained that ‘ It proved extraordinarily difficult for economists to recognize that bank loans and bank investments do create deposits . ’ 12

Other commentators have made similar remarks over the years . Bizarrely , though , this fact was only formally acknowledged by central banks quite recently . Indeed , as economist Richard Werner remarks , ‘ The topic of bank credit creation has been a virtual taboo for the thousands of researchers of the world’s central banks during the past half century ’ .  In 2014 the Bank of England created a considerable stir in the financial press when it broke this taboo by noting that ‘ The reality of how money is created today differs from the description found in some economics textbooks … the central bank does not fix the amount of money in circulation , nor is central bank money “ multiplied up ” into more loans and deposits . ’ 14 Adair Turner similarly observed in 2014 that ‘ Economic textbooks and academic papers typically describe how banks take deposits from savers and lend the money on to borrowers . But as a description of what banks actually do this is severely inadequate . In fact they create credit money and purchasing power . ’ 15 Or as Werner drily concluded the same year , ‘ The money supply is created as “ fairy dust ” produced by the banks individually , “ out of thin air ” ’ . 16 ( See also the Bank of Norway quote from 2017 at the start of this chapter . )

The loan creation process helps explain why this freshly – created money tends to go into things like real estate – where loans are apparently backed by assets – rather than funding Schumpeter’s risky entrepreneurs , or new technologies where the ‘ asset ’ might seem to have little proven value . * It also explains why money seems to dry up in a recession . Since money is created by private banks when they issue debts , a flip side is that when the debts are repaid , the money just disappears back into the void , like a particle annihilating with its anti – particle . As noted by the Bank of England , ‘ Just as taking out a new loan creates money , the repayment of bank loans destroys money … Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy . ’ 17 So unless new loans are constantly created to replace these funds , the money supply will shrink , further exacerbating a downturn .

Of course one might ask why it took quite so long to clear up the misconceptions promoted by what the Bank of England called ‘ some economics textbooks ’ ( for ‘ some ’ read ‘ major ’ ) on the topic of money , or why the ability to create what Turner calls ‘ potentially infinite ’ funds in this way was largely ‘ written out of the script of modern macro – economics ’ .  As Werner notes , the fact that ‘ such important insights as bank credit creation could be made to disappear from the agenda and even knowledge of the majority of economists over the course of a century delivers a devastating verdict on the state of economics and finance today . As a result , the public understanding of money has deteriorated as well . Today , the vast majority of the public is not aware that the money supply is created by banks , that banks do not lend money , and that each bank creates new money when it extends a loan . ’ This is true even of policy – makers : according to one 2017 poll of UK Members of Parliament , ‘ Only 15 % of MPs were aware that new money is created when banks make loans , and existing money is destroyed when members of the public repay loans . ’

One reason , suggested by Werner , is ‘ the predominance of the hypothetico – deductive research methodology in economics , which begins by posing axioms and assumptions ’ . 20 In other words , economists are not letting empirical facts get in the way of a good theory . Another explanation is that the mechanistic worldview is fundamentally hierarchical , because it views systems as being built up in an ordered fashion from individual parts . With this analogy , it makes sense to see the central bank as a central control unit for the financial system , from which power radiates out to the parts , just as a general submits orders to the troops . From a quantum viewpoint , however , the parts are better viewed as making up a coherent whole , whose function is characterised by feedback loops , so there is no single central node .

The most obvious reason for omitting the pivotal role of banks , though , was because economists wanted to keep money out of the equation . Only by doing so could they maintain the pretence that the economy is some kind of barter system based on rational exchange . Just as subjectivity is considered taboo in sociology , so the emotion – laden topic of money creation is taboo in economics .
More troubling , perhaps , are ‘ indications that attempts were made to obfuscate , as if authors were at times wilfully trying to confuse their audience and lead them away from the important insight that each individual bank creates new money when it extends credit . ’ 21 We return to this later .

The levitation trick
To see how this magical money creation works in practice , let’s return again to the example of purchasing a house – an entity which in many ways exemplifies the real / virtual split , since it combines the psychological properties of owning a ‘ real ’ home with the financial properties of an estate ( hence real estate ) . We’ll suppose that the market is hot so you are willing to pay a high price on the expectation that prices will soon rise further still . In fact , we’ll suppose you are in Toronto in March 2017 , when house prices – which at least in the detached market mostly reflect the price of land – have surged by 33 per cent in the past year alone . The only thing holding you back is that in order to qualify for the best mortgage , you have to make a significant down – payment of 20 per cent , which you can’t possibly afford . Fortunately a secondary lender has agreed to loan you that amount , though at a somewhat punishing interest rate .

Your realtor informs you that the house is going to auction , so you have to show up on the appointed day with the best offer you can make – with a certified cheque for the suitably impressive deposit stapled to it . You therefore call up your bank to arrange a slightly higher loan , which they agree to . In a rising market , the question how much often seems to be less about how much is it worth , than how much can you borrow .

To your delight , you win the auction against seven other would – be buyers ! Of course that means you paid well over the average of what a good sample of potential buyers thought the house was worth , but that doesn’t matter because everyone knows houses will be at least 20 per cent higher next year anyway . Your bank sends the vendor the funds , and you are the proud owner of a new house / asset .

So what actually happened in monetary terms ? When the bank sends the vendor the money , it doesn’t scrape together the amount by borrowing it from its clients ’ savings accounts – it just makes it up by entering it in their computer system . It is like creating a brand – new tally stick . You get the foil – the short end of the stick – meaning you have to pay up over time . Meanwhile the stock – in return for title over the house – is transferred to the vendor , who is now free to go out and spend it . So when you analyse it in these terms , you see that the purchase is far more than some tit – for – tat exchange .An entirely new money object , equal in value to the price of the loan , has been created by the bank . This money then goes out into the economy , and much of it is used for bidding up the prices of homes . The higher prices go , the more money is created , and so on in a positive feedback loop . Eventually the loan is repaid , but that might take 25 years or more , by which time many more new loans will have been created .

According to the quantity theory of money , if too much money is in circulation , the result is inflation . However , because the virtual economy is largely decoupled from the real economy , inflation can occur in the former but not the latter . And because traditional inflation metrics focus only on the real economy , it appears that inflation remains low . This is illustrated by the figure below , which compares the Teranet house price index with a broad measure of money supply in Canada from 1999 ( when the index began ) until 2017 . During this time period , both the house price index and the money supply tripled , while inflation remained negligible and gross domestic product was also relatively stagnant . The most striking – but least remarked – empirical fact about the housing boom is that it was matched by a money boom . †
The story was similar in a number of other countries , but Canada’s build – up was unusually smooth and extended in that it was almost unaffected by the financial crisis of 2007 – 08 .

D Orrell Can house price money supply

Figure 3 . House prices and money supply in Canada both triple in less than twenty years ( Statistics Canada ) .

The point here is not that there is in general a perfect match between money supply growth and house price growth , only that the house price inflation seen in places like Canada can be largely attributed to the feedbacks between money supply and property prices . Real estate is acting like a kind of breeder reactor for money . To understand the dynamics of the process , computations based on the idea that supply and demand of houses drive the system to an optimal equilibrium won’t get you very far .
And to understand its fragility , you need to appreciate that it is based on a foundation of debt , rather than something more solid like bricks and mortar .

It is often said that some aspects of quantum physics seem magical , for example in the ability of particles to appear out of the void or disappear back into it . Quantum money has similarly magical properties which banks have learned to exploit , as they make houses levitate while convincing their audience that the effect they see is real
. An important part of any magic trick is the magician’s patter , his ability to distract the audience from what is going on by creating a different narrative . With house prices , the narrative is supplied by people like realtors , banks , and economists , many of whom are employed by banks . For example , according to a 2017 report from the Toronto Real Estate Board , ‘ Key drivers of record home sales included population growth , low mortgage rates , low unemployment , and above – inflation economic growth ’ . 22
The head wizard of the central bank , Stephen Poloz , agreed that the rise in house prices is due to ‘ fundamentals … The greater Toronto economy is creating five per cent per year more jobs . Population growth is continuing to be strong . The same thing with Vancouver . That automatically generates more demand for housing at a time when there are constraints around supply . ’ 23 In other words , it all comes down to supply and demand , like in the textbooks .
Yet census figures in 2017 showed Toronto growing at its slowest rate in 40 years , while wages were increasing at the slowest rate in twenty years . Mortgage rates were very low , but total consumer debt was also at an all – time high which more than compensated .

Another article in the Globe and Mail noted that : ‘ Mortgage rates are low . Ontario’s economy is superheated … and , to make matters worse , land is in short supply . ’ In addition , Toronto is becoming a ‘ world class ’ city , ‘ owning a house is now the investment of choice for most of the middle class ’ , and of course , ‘ Dark words are muttered about how foreign money is to blame ’ . 24 ( That was actually from a 1988 article on a previous housing boom , but not much has changed . ) Of course , the boom cycle eventually turns to bust . For any of a number of reasons – government action , buyer fatigue , a rise in interest rates , the collapse of a lending institution , all of which happened in mid – 2017 – sentiment can change on a dime.  And just as rising house prices lead to more money creation in a self – reinforcing feedback loop , so falling house prices lead to less money creation ( though the correlation will be less neat as disruptions work through the system and the central bank tries to compensate ) .

The dynamics are therefore much the same as with John Law’s System . One could argue that the loans are backed by ‘ real ’ houses , as opposed to the fictional gold of the Mississippi Company . Indeed , one reason why people prefer to invest in houses rather than assets such as stocks is because they are something physical that they can see and touch , and either live in themselves or rent out to others . But house prices in Toronto and other cities can easily levitate to a point where they far exceed any sensible valuation in terms of things like the ratio of house price to rent . Instead they are better viewed as a financial asset that is hoarded not because of its productive value , but in the hope that it will go up in price . Their value is more virtual than real .

Inflation
As with most forms of inflation , the causes of house price inflation therefore have more to do with the basic mechanics of money creation than any of the reasons typically given.
It is a simple banking trick : banks create new money that is used to bid up the price of assets which are then used as the collateral for new loans . It is one example of the credit cycle , whose dynamics are not particularly mysterious and have been clearly explained by a variety of people including , perhaps most famously , the American economist Hyman Minsky .

According to Minsky’s Financial Instability Hypothesis , which dates to 1972 , the desire for credit tends to increase during an expansion . 25 More money is therefore created through loans , and invested in financial assets , which today usually refers to real estate rather than companies . This investment has the knock – on effect of raising asset prices , which in turn provides collateral for further loans , and so on . Confidence builds on itself as ‘ Success breeds a disregard of the possibility of failure ’ . More people are drawn in , with the last being what Minsky called the Ponzi borrower , who can’t afford to service interest payments but relies for their financial survival on the borrowed asset increasing in value .

On the surface , everything seems to be going well , but only if you ignore the mounting and destabilising levels of debt . However , at some point – now known as the Minsky moment – people lose faith and stop playing the game . Asset prices stop rising , so speculative borrowers who can’t make payments try to cash out . The inflating bubble suddenly collapses .

The role of the central bank is to control this process before it gets out of hand , but its power is limited by a number of factors . One is the fact that since most of the money supply is created by private institutions , it only has indirect control over events .
Another is that central banks are eager to step in during an emergency , but are understandably reluctant to spoil what seems like a good thing .The biggest problem , though , is that mainstream economics has left them unable to correctly diagnose the problem , for the simple reason that it ignores the power of money . As a result , rather than improve the situation , their actions can even make it worse .

Because their mandate to control inflation does not usually include asset prices , central banks focus instead on inflation in the real economy , a small amount of which they see as a good thing , if only to avoid its opposite – deflation – which encourages people to hoard money and slows economic activity . Since the 2007 – 08 crisis , a number of countries have therefore tried to boost inflation by reducing interest rates to near – zero levels , with little success . In 2014 , for example , the Governor of the Bank of Japan forecast that inflation should ‘ reach around the price stability target of 2 per cent toward the end of fiscal 2014 through fiscal 2015 ’ but it apparently didn’t get the memo , preferring to remain well under 1 per cent . 26 Similar policies in other countries have helped fuel , not the expected inflation , but only inequality – boosting asset bubbles and a destabilising global explosion in private sector debt .

Central bankers are increasingly admitting that they have no satisfactory model of inflation – as former Fed Governor Daniel Tarullo said in 2017 , ‘ We do not , at present , have a theory of inflation dynamics that works sufficiently well to be of use for the business of real – time monetary policymaking ’ – but again that is obvious , because they have no satisfactory model of money . 27 Economists look at the circulation of money in aggregate – for example , the quantity theory of money states that the average price level is proportional to the average amount of money in circulation , and assumes that the average velocity of money ( the rate at which it changes hands ) is stable . However , this is like a meteorologist presenting the average wind speed for a country instead of a chart showing the speed at each location . And because money is treated as little more than a convenient medium of exchange , the main impact of inflation is to introduce some ‘ friction ’ into their models , since firms have to constantly update their prices , which leads to loss of efficiency . 28 Models also tend to endow the economy as a whole with perfect rationality and essentially infinite foresight , so they assume that agents take a long view of inflation rather than reacting over more reasonable timescales .

Such drawbacks may explain why central bankers have struggled with too much inflation in things like houses , and not enough in things like wages ( and why , when faced with such puzzles , they can only come up with Victorian – sounding platitudes like ‘ What we do know is the laws of demand and supply have not been repealed ’ )
. 29 Inflation is better seen as the emergent property of a complex system , whose exact course is as hard to predict as that of something like climate change . The idea that central banks can fine – tune it seems a good example of what behavioural scientists call the ‘ illusion of control ’ – but a first step to understanding it is to adequately model the flow of money , including into things like real estate .

Dissidents such as Soddy and Minsky who have drawn attention to the dynamics of money have long been dismissed as ‘ monetary cranks ’ or ‘ banking mystics ’ .
30 It is no surprise then that most central bankers have long seemed remarkably complacent about the risks in things like real estate , even when , as Dirk Bezemer and Michael Hudson note , ‘ real estate assets have grown into the largest asset market in all western economies , and the one with the most widespread participation ’ . 31
An exception is the former Deputy Governor of the Bank of Canada , William White , who noted in 2014 : ‘ We’ve got the potential to do so much harm by not getting the creation of fiat credit and money right . We’ve got the capacity to do so much harm that we should be focusing much more on making sure that doesn’t happen . ’ 32 Central banks like to make sage announcements about ‘ risks to the economy ’ but one of the biggest risks is their own models .

Given that the actual mechanics of money creation and the credit cycle are rather obvious , it seems strange that they don’t get more critical attention . It is like a magic trick which has been explained over and over with slow – motion demonstrations on YouTube videos , but which people are still willing to pay with their life savings to take part in . So how do we bring the money bomb back under control ? Can we learn to predict or even prevent its explosions , before metaphorical mushroom clouds appear once again over the financial system ?

Stable versus unstable

One approach to modelling complex systems , known as systems dynamics or nonlinear dynamics , uses traditional equations similar to Newton’s equations of motion , but allows those equations to incorporate nonlinear effects , which greatly complicates their behaviour . A property of organic systems , from a cell to the human body to the Earth’s atmosphere , is that they are characterised by complicated networks of opposing nonlinear feedback loops , which act to amplify or dampen out signals . The same is true of the economy , where the credit cycle , for instance , is a highly nonlinear phenomenon with unstable boom – bust dynamics . An example of this systems dynamics approach is the ‘ Minsky ’ model developed by a team led by Steve Keen . His 2017 book Can We Avoid Another Financial Crisis ? described how this model , which featured only three variables and nine parameters to model key macroeconomic variables , picked out escalating levels of private debt as a risk factor for financial crises . An important feature of the model is that it pays attention to basic accounting principles , such as the flow of money and credit , and explicitly includes the financial sector .

Such a diminutive model might sound like little more than a toy description of the system , but its design reflects a basic reality , which is that as with any mathematical model , the parameters , and the form of the equations , often cannot be pinned down from the data . As the writer of a declassified CIA document – who was charged with an evaluation of systems dynamics – put it in 1975 , ‘ Depending on the functional forms and the parameters we assume , a systems dynamics model can yield vastly different predictions ’ . 33 It is therefore necessary to use a minimal set of equations that extracts the features of interest . ‡ Sometimes less is more – after all , it doesn’t require a complicated model incorporating the intricacies of quantum behaviour to estimate the yield of a nuclear device , and similarly one can build a model of the money creation process without writing out wave equations .

Another technique ( discussed also in the previous chapter ) is agent – based modelling . One study from a team led by Jean – Philippe Bouchaud found that simulations of a toy economy showed a surprisingly high variation of possible inflation scenarios , depending on factors such as inflation anticipations . 34 In other words , if people expect inflation , then they are likely to get it , in another feedback loop . One can imagine such models being used as a kind of flight – simulator for central bankers . Again their predictive ability is limited by sensitivity to the exact choice of parameters that govern the behaviour of individual agents – ‘ micro – rules do matter , as they can lead to very different macro – states ’ – but this just reflects the inherent uncertainty in the system , which itself is useful information for policy – makers . Agent – based models can also be used to motivate simpler models which capture their basic properties . 35

 

David  Orrell   2019  Icon Books Ltd Quantum Economics  The Money Bomb  p131-p141


relevant articles  9/2021


voxeu.org   13 9 2021   What drives house prices: Lessons from the literature  John Duca, John Muellbauer, Anthony Murphy

Research on house price cycles and their interactions with the economy has burgeoned since the Global Financial Crisis. This column draws five lessons from a recent comprehensive survey. It argues that conventional theories of house price dynamics are misleading. Shifts in credit conditions, together with differences in housing supply response across cities, regions and countries, account for much of the heterogeneity of house price outcomes. Finally, increased demand for space and unprecedented policy interventions together explain the very different house price experience in the pandemic compared with the Global Financial Crisis.