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