1 00:00:00,000 --> 00:00:04,680 To understand how central banks work it is essential that we understand how 2 00:00:04,680 --> 00:00:10,740 banks work and in particular how they create money. However, many popular 3 00:00:10,740 --> 00:00:16,160 textbooks and YouTube videos teach this using the money multiplier theory. There 4 00:00:16,160 --> 00:00:20,800 is just one tiny little problem with this and that is that this money 5 00:00:20,800 --> 00:00:25,800 multiplier is a myth. In this video I will tell you why and I will also 6 00:00:25,800 --> 00:00:39,300 explain how banks do in fact create money so the mythical money multiplier 7 00:00:39,300 --> 00:00:44,520 theory goes like this. Banks create money through something called fractional 8 00:00:44,520 --> 00:00:50,480 reserve banking. Fractional reserve banking means that every bank is 9 00:00:50,480 --> 00:00:55,320 required to hold a fraction of the money they receive from people in reserve at 10 00:00:55,320 --> 00:01:00,240 the central bank. The rest of the money banks are free to lend out to other 11 00:01:00,240 --> 00:01:06,180 people. Then these other people will deposit that money at another bank and 12 00:01:06,180 --> 00:01:12,600 this bank also has to hold a fraction of the money at the central bank and it can 13 00:01:12,600 --> 00:01:18,180 lend out the rest. And so this process repeats itself until there's no more 14 00:01:18,180 --> 00:01:24,180 money left to be lent out. Following the logic of this story banks can only create 15 00:01:24,180 --> 00:01:30,900 a multiple of the original cash created by the central bank. I do understand that 16 00:01:30,900 --> 00:01:36,360 this story sounds compelling. It's a bit abstract but it has a certain logic to it. 17 00:01:36,360 --> 00:01:40,620 The problem with this story is that researchers that work with banks and money 18 00:01:40,620 --> 00:01:44,460 directly have produced compelling evidence that contradicts the money 19 00:01:44,460 --> 00:01:49,420 multiplier. As a consequence top economists and central bankers have long 20 00:01:49,420 --> 00:01:55,860 moved on and are no longer using the money multiplier story. Sadly educational 21 00:01:55,860 --> 00:02:01,880 textbooks and videos often lag a bit behind developments in economic research. Hence this 22 00:02:01,880 --> 00:02:06,740 story is still being told in multiple prominent textbooks and even in some very 23 00:02:06,740 --> 00:02:12,220 popular YouTube videos. So what is the real story that is being rolled out by 24 00:02:12,220 --> 00:02:18,100 state-of-the-art textbooks such as the new and free core economics book that was 25 00:02:18,100 --> 00:02:23,380 produced by leading economists in the UK. This is also the story that has been 26 00:02:23,380 --> 00:02:28,900 largely adopted by the central banking world. This story starts out just as the 27 00:02:28,900 --> 00:02:34,220 money multiplier myth. Banks do indeed create money when they give out loans but 28 00:02:34,220 --> 00:02:41,800 the factual story is much more simple than a money multiplier story. So how does that 29 00:02:41,800 --> 00:02:48,040 work? Well a customer goes to the bank to request a loan. When the bank approves 30 00:02:48,040 --> 00:02:53,880 it two things will be recorded. The first is that the customer owes the bank a 31 00:02:53,880 --> 00:02:58,760 certain amount of money due to be paid back at a certain time and at a certain 32 00:02:58,760 --> 00:03:04,360 interest rate. Second is that the bank owes its customers the same exact amount of 33 00:03:04,360 --> 00:03:10,120 money but the customer can retrieve this money on demand. Did you hear something 34 00:03:10,120 --> 00:03:16,200 strange in what I just said? A bank borrows from a customer and a customer borrows from a bank. 35 00:03:16,200 --> 00:03:23,320 This happens at the same time. Just think about that for a moment. So when lending to a customer 36 00:03:23,320 --> 00:03:29,000 a bank will simultaneously record that the customer owes it money and that it owes the 37 00:03:29,000 --> 00:03:34,600 customer money. Simple but also a bit complicated. Why would both parties agree to this? 38 00:03:34,600 --> 00:03:40,520 Well let's try to put yourself into the mind of the customer. Why would you agree to this deal? 39 00:03:40,520 --> 00:03:46,680 You have to repay the bank far into the future and the bank has to repay you on demand. That means 40 00:03:46,680 --> 00:03:52,440 whenever you want. All you need to do is to go to an ATM and exchange what is recorded in your bank 41 00:03:52,440 --> 00:03:59,880 account to cold hard cash. What's more the debt the bank has to you can be used as money. So you can use 42 00:03:59,880 --> 00:04:05,960 your bank account to pay other people. This is why economists say that banks have the power to create 43 00:04:05,960 --> 00:04:13,080 money because you can use their debt to buy anything you want. Now if you put it like that it actually 44 00:04:13,080 --> 00:04:18,120 sounds like a bad deal for the bank and a good deal for you. Probably not what you expected when you 45 00:04:18,120 --> 00:04:24,120 learned that banks have the power to create money. So what is the catch? The catch is that you have to 46 00:04:24,120 --> 00:04:30,360 pay for the privilege. You pay the bank more than it pays you. The interest rate on loans is higher than 47 00:04:30,360 --> 00:04:36,680 the interest rate on bank accounts. As long as enough customers will repay their loans it is 48 00:04:36,680 --> 00:04:43,400 profitable for the bank to create loans like this. So it is in the bank's interest to create money 49 00:04:43,400 --> 00:04:49,480 by lending to customers. And that is exactly what banks love to do. In fact commercial banks have 50 00:04:49,480 --> 00:04:56,200 created so much debt and money that in most modern economies money created by commercial banks is by far 51 00:04:56,200 --> 00:05:02,600 the biggest share of all the money in the economy. This wasn't always the case. Just after the second 52 00:05:02,600 --> 00:05:07,160 world war cash and money only accounted for about half of the money supply. 53 00:05:13,640 --> 00:05:21,720 So let's go over the two most important differences with the money multiplier story. The first is about the 54 00:05:21,720 --> 00:05:28,840 order of events and the second is about what constraints money creation. The first difference 55 00:05:28,840 --> 00:05:36,680 is all about timing. If we believe the money multiplier myth the timing is as follows. Step one the central bank 56 00:05:36,680 --> 00:05:45,000 creates cash which then ends up in the economy. Step two people bring cash to the bank. Step three banks 57 00:05:45,000 --> 00:05:51,560 keep a fraction of that cash at the central bank and lend out the rest. This is the money creation part. 58 00:05:52,440 --> 00:05:57,160 Step four this will happen again and again till it is no longer possible. 59 00:05:57,960 --> 00:06:06,200 Now contrast this to the timing of the actual money creation story. Step one a customer goes to the bank for a loan. 60 00:06:07,240 --> 00:06:15,240 Step two the customer and bank both issue a debt. The debt the bank has issued is newly created money. 61 00:06:15,240 --> 00:06:23,160 Step three the customer will use this to make payments. Alternatively the customer can go to the 62 00:06:23,160 --> 00:06:30,760 ATM to convert bank money into cash. This is facilitated by the central bank which will lend 63 00:06:30,760 --> 00:06:38,360 money out to the bank provided that the bank has made prudent loans. The money multiplier story starts 64 00:06:38,360 --> 00:06:44,040 with the central bank creating cash and someone bringing that to a bank. In real life no initial 65 00:06:44,040 --> 00:06:51,000 central bank money is needed for loans to be created. That is a clear difference. So does that 66 00:06:51,000 --> 00:06:58,120 mean that central bank money or reserves don't matter at all? Well that brings us to the second difference. 67 00:06:58,120 --> 00:07:03,240 The second difference is all about what keeps banks from creating unlimited money. The money multiplier 68 00:07:03,240 --> 00:07:09,400 The money multiplier story is very clear on this. The total amount of money is constricted by the reserve 69 00:07:09,400 --> 00:07:15,960 requirement which is set by the central bank. There is just one tiny problem with this. Reserve 70 00:07:15,960 --> 00:07:22,280 requirements do not constrain money creation. The most important reason why reserve requirements do not 71 00:07:22,280 --> 00:07:30,120 matter is because almost all central banks have a policy in place that facilitates reserve creation on 72 00:07:30,120 --> 00:07:38,040 demand. What do I mean by that? It means that if a bank goes to the central bank and asks it can I have 73 00:07:38,040 --> 00:07:44,920 some more reserves the central bank will almost always just create them and lend them to that bank. 74 00:07:45,640 --> 00:07:51,960 So yeah as you can imagine that kind of does away with this reserve requirement limit on money creation. 75 00:07:51,960 --> 00:07:59,080 If central banks create more money on demand then banks will ask for more if they are ever at risk 76 00:07:59,080 --> 00:08:04,680 of hitting the reserve requirement ratio. And if that wasn't enough for those of you living in any of 77 00:08:04,680 --> 00:08:14,840 the following countries Canada, the UK, New Zealand, Australia, Sweden and Hong Kong in your countries the reserve 78 00:08:14,840 --> 00:08:22,200 requirement is zero percent. And it has been so for years. How is that going to limit any money creation? 79 00:08:25,880 --> 00:08:31,480 So bank money creation is not limited by reserve requirements. But if it's not limited by reserve 80 00:08:31,480 --> 00:08:39,240 requirements does this mean that banks can just create unlimited amounts of money? No not quite. Yes banks 81 00:08:39,240 --> 00:08:47,160 create money when they lend out money. But they are not the only party involved. They need their customers 82 00:08:47,160 --> 00:08:54,440 to demand for loans. Banks cannot lend if no one is willing to borrow. This could be an explanation of 83 00:08:54,440 --> 00:08:59,240 what is happening in much of the industrialized world. Even though central bankers are trying their 84 00:08:59,240 --> 00:09:06,120 hardest to motivate banks to lend more by lowering the interest rates or by buying out debt. Lending 85 00:09:06,120 --> 00:09:12,760 has been slow to pick up. Not very surprising since many of their customers are already to their necks in 86 00:09:12,760 --> 00:09:19,640 debt. Another reason why banks cannot keep on creating more and more money is that the law requires that they 87 00:09:19,640 --> 00:09:25,640 have a certain amount of their own capital to back up their loans. In many economies this ratio is 88 00:09:25,640 --> 00:09:32,280 something like seven to eight percent. Like with reserve requirements this does not however put a hard 89 00:09:32,280 --> 00:09:38,840 ceiling on the total amount of money banks can create. Why? Because banks can issue more capital 90 00:09:38,840 --> 00:09:45,000 which the public can purchase. That being said this does not really make it too difficult for banks to expand 91 00:09:45,000 --> 00:09:50,920 too rapidly. Especially since multiple banks compete with each other. If one bank starts lending too much 92 00:09:50,920 --> 00:09:57,960 its stock price might tank. Therefore banks will often voluntarily hold liquid assets that are slightly 93 00:09:57,960 --> 00:10:05,000 above the required ratio. This also leads us to the third constraint on bank lending and that is liquidity. 94 00:10:05,000 --> 00:10:12,360 Banks are also required to hold a certain percentage of their asset as any liquid asset. This includes cash 95 00:10:12,360 --> 00:10:18,440 but also reserves and also short-term debt with other banks. And even if this wasn't required by law 96 00:10:18,440 --> 00:10:23,240 people might start believing that a bank has expanded too quickly and will not be able to pay 97 00:10:23,240 --> 00:10:29,800 out the money they have there. Even in our modern day and age bank runs still take place. Yes the central 98 00:10:29,800 --> 00:10:36,760 bank will lend reserves or cash to these banks if they made sensible loans. But if they didn't they can still 99 00:10:36,760 --> 00:10:43,960 fail. If that happens small savers will get their money back from the central bank. But it can take up to 100 00:10:43,960 --> 00:10:50,440 half a year for the central bank to reimburse them. So therefore the threat of a bank run is still there. 101 00:10:50,440 --> 00:10:57,160 This limits the ability of banks to expand too quickly. Again it's not a hard limit but it is a limit 102 00:10:57,160 --> 00:11:04,280 nonetheless. So that was that. Let's hope you're now cured from the money multiplier myth that is still being 103 00:11:04,280 --> 00:11:10,840 peddled by some outdated textbooks and youtube videos. Let's say that's not entirely the case. 104 00:11:10,840 --> 00:11:16,760 You're not entirely convinced by everything that I've just said. Then I've left some links with further 105 00:11:16,760 --> 00:11:24,760 readings for you down in the description of this video. Alright, but before you go to those readings 106 00:11:24,760 --> 00:11:27,720 let's do a quick recap of this video. 107 00:11:27,720 --> 00:11:38,360 Yes banks create money. No this doesn't happen by taking your cash and then lending and lending it 108 00:11:38,360 --> 00:11:44,360 out all over again until they reach the reserve requirement ratio. In fact the reserve requirement 109 00:11:44,360 --> 00:11:50,760 ratio is not a hard limit on bank money creation. Why? Because central banks are willing to create new 110 00:11:50,760 --> 00:11:58,920 reserves for banks that are healthy but in need of cash. So that does away with the reserve requirement 111 00:11:58,920 --> 00:12:04,840 limit. Does that mean that there are no limits to bank money creation? No, that's not the case. 112 00:12:04,840 --> 00:12:12,280 There are still limits. Remember banks can still go bust. What are these limits? These were the public's demand 113 00:12:12,280 --> 00:12:20,120 for debt. These were capital requirements and these were liquidity ratio. This has very important 114 00:12:20,120 --> 00:12:27,560 implications for all of you central bankers or armchair central bankers like me. If reserve 115 00:12:27,560 --> 00:12:32,600 requirements do not put a ceiling on bank money creation, how can the central bank hope to have 116 00:12:32,600 --> 00:12:39,880 any control over all of that money? That will be the topic of next week's video. If you're interested in 117 00:12:39,880 --> 00:12:47,160 central banking, finance and macroeconomics, please consider subscribing to this channel. I'm currently 118 00:12:47,160 --> 00:12:53,800 thinking about doing a bi-weekly release schedule of new videos. Now if enough people subscribe to this 119 00:12:53,800 --> 00:13:01,080 channel, I might be able to increase that number of videos. If you like the video, you can also really 120 00:13:01,080 --> 00:13:08,680 help me out by dropping a like and if you're still in doubt on some aspects of this video, comment down 121 00:13:08,680 --> 00:13:15,560 below and I will actually go into the comment section myself and be there for discussions with you on the 122 00:13:15,560 --> 00:13:18,200 topics of bank money creation.