Tuesday, July 3, 2012

Modern Money Creation

A fascinating article on VoxEU yesterday about what I’d consider to be shadow banking, and its a fairly clear exposition (excerpt):

The (other) deleveraging: What economists need to know about the modern money creation process
Manmohan Singh & Peter Stella

The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.

One of the financial system’s chief roles is to provide credit for worthy investments. Some very deep changes are happening to this system – changes that surprisingly few people are aware of. This column presents a quick sketch of the modern credit creation and then discusses the deep changes are that are affecting it – what we call the ‘other deleveraging’.

In the simple textbook view, savers deposit their money with banks and banks make loans to investors (Mankiw 2010). The textbook view, however, is no longer a sufficient description of the credit creation process. A great deal of credit is created through so-called ‘collateral chains’.

We start from two principles: credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder. Here is an example.

A Hong Kong hedge fund may get financing from UBS secured by collateral pledged to the UBS bank’s UK affiliate – say, Indonesian bonds. Naturally, there will be a haircut on the pledged collateral (i.e. each borrower, the hedge fund in this example, will have to pledge more than $1 of collateral for each $1 of credit).

These bonds are ‘pledged collateral’ as far as UBS is concerned and under modern legal practices, they can be ‘re-used’. This is the part that may strike non-specialists as novel; collateral that backs one loan can in turn be used as collateral against further loans, so the same underlying asset ends up as securing loans worth multiples of its value. Of course the re-pledging cannot go on forever as haircuts progressively reduce the credit-raising potential of the underlying asset, but ultimately, several lenders are counting on the underlying assets as backup in case things go wrong.

To take an example of re-pledging, there may be demand for the Indonesia bonds from a pension fund in Chile. As since these credit-for-collateral deals are intermediated by the large global banks, the demand and supply can meet only if UBS trusts the Chilean pension fund’s global bank, say Santander as a reliable counterparty till the tenor of the onward pledge.

Plainly this re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, i.e. the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the Indonesian bonds are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.

To get an idea on magnitudes, at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral; since this is pledged for credit, the volume of pledged assets is a good measure of the private credit creation. For the same period, the primary source collateral (from hedge funds and custodians on behalf of their clients) that was intermediated by the same banks was about $3.4 trillion. So the ratio (or re-use rate of collateral) was around 3 times as of end-2007. For comparison to the $10 trillion figure, the US M2 was about $7 trillion in 2007, so this credit-creation-via-collateral-chains is a major source of credit in today’s financial system.

The article then goes on to discuss the consequences that this evolved money creation process is having on monetary policy formulation and developments in the global financial system. For a deeper look into this issue, you can try reading the working paper on which the article is based on.

What’s fairly obvious from the discussion is that central banks and financial market supervisors, like armies and generals through the ages, are fighting the last war – policy instruments, supervisory rules, and theoretical frameworks in use today are designed for a financial system that no longer exists. Its like using lance-equipped horse cavalry to fight machine-gun and cannon-toting tanks.

I’d also argue that even within the context of more traditional bank lending direct to consumers and corporations, what you normally get in the textbooks is almost wholly wrong. Banks continue to maintain reserves based on high powered money, but this is ex-post and not ex-ante the credit creation process – Econoenglish translation: reserves don’t determine the capacity to lend; lending instead determines the level of reserves.

As an aside, how much does the economics profession understand about these changes and how it effects economic models? Looking at the commentary, both from within and without the profession, there’s a clear and dangerous divide between the theoretical and practical worlds, and the sooner that’s bridged the better off we all are.

Technical Notes:

Manmohan Singh, Peter Stella, "The (other) deleveraging: What economists need to know about the modern money creation process", VoxEU, July 2012

Manmohan Singh, Peter Stella, “Money and Collateral”, International Monetary Fund, Working Paper No. 12/95, April 2012


  1. "Econoenglish translation: reserves don’t determine the capacity to lend; lending instead determines the level of reserves."

    Just adding a Steve Keen paraphrase here "Banks create credit money first and these money looks for reserves later"

    Agree that debt growth actually leads to overall economic growth cycle. But level of debt does not determine what type of capital gets created.

    Huge extension of debt can lead disproportionate growth of financial assets(maybe KL and Penang mortgages)as argued by most Austrian. But it could also help to finance real productivity growth and better living standard in a New Deal type of way.

    Debt is a necessity for growth(in the current system), but policies(public and private businesses)determines what sort of growth mixture we get

  2. can u help me understanding the figure 2: an example of collateral chain??? i dont get the part whre the UST enter the money market fund... those who are in the money market fund will secured the UST.. but who will buy it back from money market?? is it the hedge fund or credit suisze???

    as far as i understood, the value of pledge should be higher than the value of collateral, so, hows the process of buying back the UST.. is it the reverse process or the hedge fund will buy back from the money market and at what value?

  3. @hafeez,

    Honestly, I'm a bit hazy about this as well. But from what I understand, ownership doesn't really change. The money market won't "own" the UST, just hold it as collateral against the loan to Credit Suisse. It's not a buy-sell transaction.