You make the tea or the tea makes you?

Move over Reserve Bank of India. It's the commercial banks, which are creating money and moving the economy

“There have been three great inventions since the beginning of time: Fire, the wheel and central banking,” American vaudeville performer Will Rogers once said.

Two engineers-turned-economists — Krishnamurthy Vaidyanathan and Krishnamurthy Subramanian — have dared to replace central banking with banking in Money: A Zero-Sum Game. The book also has a sub-title “A Novel Framework of Money: Have Nobel Economists Got it Wrong?”

Of the two, Subramanian, the youngest chief economic adviser, government of India (2018-21), is now India’s executive director at the International Monetary Fund.

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. The world’s oldest central bank, the Bank of Sweden, was established in 1668. The Bank of England was created in 1694. Napoleon Bonaparte had set up the Banque de France in 1800. Our Reserve Bank of India (RBI) is relatively young —born in April 1935.

The 11 chapters in this book, divided into three parts, have challenged the conventional wisdom of monetary economists — the theory of money multiplier and financial intermediation. The money multiplier exists only in the make-believe world of monetary economists, and not in the real world!

It even goes to say that realising its futility, many central banks, including the US Federal Reserve, have abolished the reserve requirement and yet the Indian central bank carries on with the so-called cash reserve ratio for banks (a portion of deposits that commercial banks keep with the central bank on which they don’t earn any interest), “adhering to the flawed theories of monetary economists”.

The authors explain how the money game is played in the Indian economy in a novel way — like Vyapar, popularly known as Monopoly. They not only challenge the monetary economists’ understanding of money creation but also make fun of them. Their description of money creation is nothing but playing the Monopoly game, the authors say.

“The roll of your dice (the cause) depends on the number of spaces you move on the board (the effect) whereas in reality, it is the other way round.” Just as there is a play master in the game of Monopoly — the person who keeps tabs on tokens, properties and dice rolls and initiates auctions and mortgages — there is a play master in the real-world game of money all of us play.

While the monetary economists describe the central bank as the play master, the book argues that the true play master is the banking sector. So, move over RBI, the commercial banks are creating money and moving the economy.

Basing their theory on cause and effect, to illustrate the point, the authors refer to the phenomenon of making tea — how it is actually done and how it can be seen.

The water in the kettle boils (effect) when we turn the gas stove on (cause). The tea turns golden brown (effect) as we add milk to it. The teacups are kept on the dining table (effect) after we take them out from the kitchen cupboard (cause).

That’s the real story. But in the “make-believe world” of the monetary economists, the effect precedes the cause.

How will they describe the tea-making process? Water boiling in the kettle turns on the gas stove; the golden colour acquired by the tea makes us add milk and the tea cups bring us from the kitchen to the dining table. You don’t make tea; the tea makes you!

To be sure, this is not the first time the central bank’s role in money creation is challenged. In the Quarterly Bulletin of the Bank of England in 2014, Michael McLeay, Amar Radia and Ryland Thomas have written that a vast majority of the money held by the public takes the form of bank deposits but where the stock of bank deposits comes from is often misunderstood.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. Another is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called “money multiplier” approach. In that view, central banks implement monetary policy by choosing a quantity of reserves.

The fact is that the commercial banks create money — in the form of bank deposits, by giving new loans. When a bank gives a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving her limitless money. Instead, it credits her bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as “fountain pen money”, created at the stroke of bankers’ pens when they approve loans, the trio have said.

In essence, most of the money in circulation is created, not by the printing presses of the central bank, but by the commercial banks themselves: Banks create money whenever they lend to someone in the economy or buy an asset from consumers. While the central bank does not directly control the quantity of either base or broad money, it is still able to influence the amount of money in the economy by setting monetary policy.

But Pontus Rendahl and Lukas B Freund of the Centre for Economic Policy Research in their paper “Banks do not Create Money Out of Thin Air” in December 2019 have challenged this theory. “When banks create money, they do so not out of thin air, they create money out of assets — and assets are far from nothing.”

They have used a simple parable to illustrate how banks create money and what the role of asset-backing is in that process.

“Suppose a PhD student new to the British town of Cambridge …Lukas … would like to celebrate a day’s worth of work with a pint at a local pub and pay for the drink by issuing an IOU. Unfortunately, the pub refuses to accept the Lukas-IOU. After all, the pub doesn’t know Lukas very well, and it can therefore not trust that he will have the ability to repay the IOU… Moreover, a third party, say a brewery, would not accept the Lukas-IOU as payment for their restocking of the pub’s beer inventory either …

Fortunately for Lukas, his supervisor — Pontus — happens to have a lot of trust in Lukas, and is willing to accept the Lukas-IOU in exchange for a Pontus-IOU in return.

Here is the crux — the local pub does indeed trust Pontus, and so do third parties (“oh, it’s a Pontus-IOU — that’s as good as the pound note in my wallet!”). Lukas can then get his well-deserved drink by paying with the Pontus-IOU. And the brewery can restock their inventory by paying with the same means.”

Has Pontus created money out of thin air? No. Why would the local pub trust Pontus and treat his IOU as good as money? They trust his ability to screen Lukas’ repayment capacity, so he has a healthy “asset” backing up his own IOU. He also happens to have liquid reserves on his savings account.

I am not qualified to endorse or challenge Vaidyanathan and Subramanian’s theory but the book is fun to read. While it shifts the address of the money controller from Mint Road to Mumbai’s Bandra Kurla Complex where many banks are headquartered, a string of sub-stories, theories and prospects related to money keep the readers hooked.

It talks about hundis — which were mentioned in Indian mythology much before commercial banks made their appearance in the West — as well as the latest animal on the money turf, the central bank digital currency, with equal ease.

You may or may not agree with the authors but the book reads like an epic with a central theme — commercial banks control money creation — and it urges them to be aware of their strength and contribute to India’s economic growth.

The writer, a consulting editor of Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd

His latest book is Roller Coaster: An Affair with Banking

To read his previous columns, log on to https://bankerstrust.in

Twitter: TamalBandyo