No, Sonny Bill and Bryan Gould are both wrong about banks

The New Zealand Herald. 19 April 2017

A few days ago, Bryan Gould wrote an article for the Herald headlined “Sonny Bill has a point about banks amid crisis”.  Almost everything he contended was wrong.

He began by noting that the Labour Party Finance spokesman, Grant Robertson, was arguing for some change in the legal framework within which the Reserve Bank of New Zealand operates.

One of the changes which Mr Robertson advocates is a move away from leaving all decision-making power about monetary policy in the hands of the Governor of the Bank once the Governor and the Minister of Finance have agreed the rate of inflation which the Government wants the Reserve Bank to deliver.  Fair enough – there are arguments for and against the single decision-maker model, and I can understand why some change may be regarded as desirable.

The second major change which Mr Robertson favours was described by Bryan Gould as of no great moment, but in that he was wrong.  Mr Robertson wants to widen what the Reserve Bank is to target with monetary policy from low inflation alone to low inflation plus full employment.  He notes that other central banks, such as those in Australia and the US, operate under legislation which requires them to target both low inflation and full employment.  Quite true: in both countries, the legislation covering their central banks dates back to an era when economists (or at least politicians) believed that monetary policy could deliver both low inflation and full employment.  We now understand that monetary policy has no effect on the level of employment in the long run, and attempts to deliver a higher level of employment through easy monetary policy lead only to higher inflation.

Economists also now understand that it’s impossible to target two different objectives with a single policy instrument.

But Mr Gould went further than Mr Robertson to praise Sonny Bill Williams’ highly negative attitude to banks in general.  He said that banks like to pretend that they provide a useful service to the community by channeling resources from those who have no immediate need for them (savers) to those who do need them (borrowers), charging a modest spread for rendering that service.  

But, said Mr Gould, this “benign view of [bank] operations is inaccurate and misleading.  The banks do not lend you mortgage money deposited with them by someone else.  They lend you money they themselves create out of nothing through the stroke of a pen or, today, a computer entry.  The banks make their money, in other words, by charging interest on money that they themselves create.”

He then goes on to blame this money creation for the housing affordability crisis which Auckland now finds itself in, and to attack the Government for washing its hands of this aspect of the housing crisis.

Mr Gould is not alone in peddling this nonsense, but that certainly doesn’t make it correct.

The banking system does create money.  When Bank A lends money to one of its customers, the customer may use those funds to buy something from somebody who banks with Bank B.  Bank B then finds itself with an additional deposit, a part of which it can lend out to its customers (keeping some of the additional deposit as a liquidity reserve).  So an initial loan may end up considerably increasing the total lending by the banking system.

But from the point of view of each individual bank, it can only lend out a part of the money which its customers deposit with it, or money which it borrows from other sources, possibly overseas.

If individual banks really could create money by “the stroke of a pen or a computer entry”, as Mr Gould contends, why do they bother paying interest on deposits, why do they borrow funds from parent banks overseas, why do they borrow funds in the international market, why do they need to hold some funds in government securities as a liquidity reserve, why do some banks occasionally run out of money when customers lose confidence in them?

As well as being a former Governor of the Reserve Bank, I now chair the small New Zealand subsidiary of the Industrial and Commercial Bank of China, the largest bank in the world.  It would certainly make life very much easier if we could, “by the stroke of a pen or a computer entry”, simply create the money which we lend out to New Zealand borrowers.  Unfortunately, we can’t.

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Copyright © 2020 Don Brash.