The Truth About Banking and Creating Money out of Thin Air

• Banks do not actually take deposits or lend money in the legal sense and are misleading the public
• Banks create money by purchasing securities and inventing fictitious customer deposits, as explained by Professor Werner
• Distinguishing the difference between productive bank lending', which is beneficial, and lending for consumption or asset purchases, which is problematic
• Regulation is needed to guide bank credit and prevent boom-bust cycles
• Germany has avoided crises through a banking system dominated by small community banks

'Productive' Bank Lending Is Key to Economic Stability and Growth

Understanding the true nature of the banking system is essential for investors seeking to navigate economic cycles and financial crises. In an eye-opening conversation, Professor Richard Werner of Warwick University, a leading expert on banking and finance, challenges conventional wisdom and reveals the legal realities and economic implications of bank lending practices. It's probably why gold bugs don't trust fiat currencies.

Productive bank lending refers to the practice of banks extending credit for purposes that create real economic value, support sustainable growth, and contribute to the overall health and stability of the economy. According to Professor Werner, productive lending is characterized by financing activities that generate new goods and services, enhance productivity, and foster innovation.

Examples of productive lending include:

1. Business investments: When banks lend money to companies for the purpose of expanding their operations, developing new products, or improving their infrastructure, it is considered productive lending. These investments help businesses grow, create jobs, and contribute to overall economic growth.
2. Technology and innovation: Bank lending that supports research and development, adopting new technologies, or creating intellectual property is also deemed productive. These activities drive advancements in various sectors, leading to increased efficiency, competitiveness, and economic progress.
3. Infrastructure projects: Financing the construction or improvement of public infrastructure, such as roads, bridges, ports, and telecommunications networks, is another form of productive lending. These projects create jobs in the short term and lay the foundation for long-term economic growth by facilitating trade, connectivity, and productivity.

When banks focus their lending activities on productive purposes, it leads to sustainable economic growth without causing inflationary pressures. This is because the money created through productive lending is matched by a corresponding increase in the supply of goods and services in the economy.

Productive lending can help reduce income inequality and promote a more equitable distribution of wealth. When banks prioritize lending to small and medium-sized enterprises, as is the case with Germany's community banks (Volksbanken and Raiffeisenbanken), it supports the growth of local economies and the creation of jobs across a wide range of sectors and regions.

In contrast to productive lending, Professor Werner warns against bank lending for speculative or consumptive purposes. Lending for consumption, he argues, can lead to inflation by increasing the money supply without a corresponding increase in the production of goods and services. Similarly, lending for the purchase of existing assets, such as real estate or stocks, can fuel asset price bubbles and increase the risk of financial instability.

To encourage productive lending and discourage speculative or consumptive lending, Professor Werner advocates for a system of "credit guidance." Under this approach, regulators would use incentives and disincentives to steer bank lending towards productive activities and away from unproductive ones. For example, regulators could require banks to hold more capital against loans for speculative purposes, making such lending less attractive, while providing favorable treatment for loans that support productive investments.

Overall, Professor Werner's emphasis on productive bank lending highlights banks' critical role in shaping the direction and health of the economy. By focusing on financing activities that create real economic value and support sustainable growth, banks can contribute to greater stability, equity, and prosperity for all.

The Legal Reality of Banking

Contrary to popular belief, banks do not actually take deposits or lend money in the legal sense. This is not just a matter of semantics, but a fundamental misunderstanding of the legal reality of banking. "A deposit is not actually a deposit. It's not a bailment, it's not held in custody. At law, the word deposit is meaningless," Professor Werner states.

When a customer makes a "deposit" at a bank, they are, in legal terms, loaning money to the bank. This may surprise many who assume that their deposited funds are safely held in custody by the bank. However, Professor Werner clarifies that this is not the case. Banks treat customer deposits as loans to the bank, which they are free to use as they see fit.

Similarly, when banks issue loans, they are not actually lending out deposited funds, as is commonly believed. Instead, they are engaging in a legal transaction called purchasing a security. Specifically, banks purchase promissory notes from borrowers, which are essentially IOUs promising to repay the loan with interest. This legal distinction is crucial to understanding how banks create money, as Professor Werner goes on to explain.

Professor Werner's elucidation of the legal reality of banking has profound implications for our understanding of banks' role in the economy. Rather than serving as intermediaries that simply channel funds from savers to borrowers, banks are active participants in the money creation process. This understanding is key to developing effective regulations and policies to ensure the stability and productivity of the banking system.

How Banks Create Money

Professor Werner's research and argument center on the process by which banks create money. He asserts that banks do not simply lend out deposited funds but rather create new money through the act of lending. This process is achieved through the invention of "fictitious customer deposits" when banks extend loans.

To illustrate this point, Professor Werner explains what happens when a bank issues a loan. "What we call a deposit is simply the bank's record of its debt to the public...and its record of the money it owes you is what you think you're getting as money," he says. In other words, when a bank approves a loan, it simultaneously creates a new deposit in the borrower's account, effectively creating new money. This new deposit is not drawn from existing funds, but is created out of thin air."

The implications of this money-creation process are profound. Banks create the money supply...97% of the money supply is created by banks as fictitious deposits. This means that the vast majority of money in circulation is not created by central banks or governments but by commercial banks through lending.

This money-creation power of banks has significant consequences for the economy. Banks creating money through productive lending, such as financing business investments or new technologies, can lead to economic growth and stability. However, when banks create money for unproductive purposes, such as consumption or asset purchases, it can lead to inflation, asset bubbles, and financial instability. Policymakers and the general public poorly understand this money-creation process, leading to misguided regulations and economic policies. Recognizing the reality of bank money creation is essential for developing effective strategies to promote economic stability and growth.

One potential solution is to guide bank lending towards productive purposes through targeted regulations. He proposes a "credit guidance" system that would incentivize banks to lend for productive investments while restricting lending for speculative or consumptive purposes. This approach could help to stabilize the economy and promote long-term growth.

Another important factor is the structure of the banking system itself. In Germany, where a large number of small, community-oriented banks prioritize lending to small and medium-sized businesses. These banks are less likely to engage in speculative or unproductive lending, and have historically been a key driver of Germany's economic success. In contrast, a highly concentrated banking system dominated by a few large banks, such as that found in the UK, may be more prone to unproductive lending and financial instability. Promoting a more decentralized and diverse banking system, with a greater emphasis on community banks and local lending, could help to mitigate these risks.

Overall, Professor Werner's insights into the money creation process of banks offer a compelling challenge to conventional economic thinking. By understanding the true nature of bank lending and money creation, investors and policymakers can develop more effective strategies for promoting economic stability and growth. Whether through targeted regulations, structural reforms, or a renewed emphasis on productive lending, the ideas put forward by Professor Werner provide a valuable framework for navigating the complex world of modern finance.

The Importance of Productive Lending

Given the profound impact of bank lending practices on the economy, effective regulation is crucial to ensure economic stability and prevent the boom-bust cycles that have plagued many countries in recent decades. The current Basel capital requirements approach as fundamentally misguided, as it fails to recognize the true nature of banks as money creators rather than mere financial intermediaries.

Instead of focusing on capital ratios, a "bank credit guidance" system could directly influence the allocation of bank lending. Under this approach, regulators would incentivize banks to prioritize lending for productive purposes, such as business investment and technological innovation, while restricting lending for speculative or consumptive purposes. The simplest and most effective form of credit guidance would be to ban bank credit for financial transactions. By preventing banks from lending to purchase existing assets, such as real estate or stocks, this measure could help curb asset price bubbles and reduce the risk of financial crises.

Moreover, that credit guidance could be used to promote specific economic and social objectives, such as reducing inequality or supporting the transition to a more sustainable economy. By directing bank lending towards sectors and activities that generate positive externalities, regulators could harness banks' money-creation power to drive long-term economic development and social progress.

However, Professor Werner acknowledges that implementing effective credit guidance would require a significant shift in the prevailing regulatory paradigm. It would require policymakers to recognize the inherent flaws in the current approach and embrace a more proactive and targeted form of bank regulation.

The Need for Regulation

Furthermore, Professor Werner suggests that credit guidance should be complemented by structural reforms to the banking system itself. He argues that a more decentralized and diverse banking system, with a larger role for community banks and local lending, could help to promote more productive and stable forms of bank lending.

Given the profound impact of bank lending on the economy, we need targeted regulation. The Basel capital approach is ineffective since it mistakenly treats banks as mere financial intermediaries rather than money creators. Instead, bank credit guidance restricting lending for financial transactions is the simplest form of bank credit guidance is to simply ban bank credit for financial transactions...They shouldn't get access to the public privilege of money creation.

Germany's Unique Banking System

Professor Werner highlights Germany as a country that has avoided crises even without explicit credit guidance. He attributes this success to a banking system dominated by numerous small community banks that prioritize productive lending to small and medium-sized enterprises. These banks, known as Volksbanken and Raiffeisenbanken, have been the backbone of Germany's economic prosperity, Professor Werner explains, with not a single one requiring a public bailout or causing depositor losses in 200 years.

The City of London: A Peculiar Entity

In a surprising revelation, Professor Werner points out that the City of London, the heart of the UK's financial sector, is technically not part of the United Kingdom. "The City of London is outside the United Kingdom...It's really shocking," he remarks. This peculiar status, dating back to 1688, means that the City of London is also not part of the European Union, as it lacks the requisite democratic elections. Professor Werner's observation underscores international finance's complex and often opaque nature.

Professor Richard Werner's insights shed light on the profound impact of bank lending practices on economic stability, growth, and inequality. Understanding these dynamics is crucial for investors to evaluate macroeconomic risks and opportunities. Professor Werner's analysis suggests that regulatory reforms guiding credit towards productive purposes and a more decentralized banking system akin to Germany's could foster a more stable and equitable economy. As policymakers and market participants navigate the challenges of the modern financial system, the perspectives raised by Professor Werner offer valuable guidance and a call for a fundamental rethinking of how banking operates.