Banks and money creation: who does what?

“Money creation”: for the common man, the concept itself is a bit of science fiction. Here are some elements to better understand the mechanisms.

“Money creation”: for the common man, the concept itself is a bit of science fiction. What makes the billboard run? Under what conditions? How does monetary policy, the main instrument of economic policy in the euro area, affect activity?

Credits, the main source of money creation

Money has two great qualities: firstly to be perfectly liquid – that is to say immediately available and without cost -, secondly to be of little risk in the absence of inflation. strong. But with the development of markets, the proliferation of financial assets tends to blur the distinction between what is money and what is not. In fact, if a financial asset can be quickly and cheaply converted into a payment instrument, its liquidity brings it close to the currency.

The mechanism of money creation has its origin in credits granted by banks. The principle of credit consists in transforming claims on non-bank agents into immediately usable means of payment. In concrete terms, when a bank gives a loan to a client X, the latter has a demand deposit in this bank equal to the amount M of the sum lent. The bank, on the other hand, acquires a claim on customer X. There is, therefore, money creation: the bank did not punt into its reserves to lend the amount M to customer X: it has written a claim in its balance sheet.

But when the customer X reimburses the credit M, the bank clears the claim on his balance sheet: there is therefore at this time destruction of money. The creation of money will have been only temporary. There is, therefore “net creation” of money only when the new credits outweigh the refunded credits.

Treasury bills and currency conversion

Banks can create money in two other ways, but with the same mechanism. First, when commercial banks grant credits to the Treasury, they acquire Treasury bills (Treasury claims). Secondly, banks can credit the account of an agent in exchange for foreign currency: for example, a French industrial paid in dollars will ask his bank to credit his account in euros; in return for this creation of money, the bank will acquire a claim on the United States. This creation of money is, for once, definitive.

The central bank also creates money through two major operations. On the one hand, when commercial banks need money to satisfy the withdrawals of their customers and to build up their reserves, they sell securities to the central bank, which in return credits their account. On the other hand, when a country’s trade balance is in surplus, the net inflow of foreign exchange on the territory leads to the creation of money, and vice versa in the event of a trade deficit.

How can the central bank influence money creation?

Demand for credit, and therefore money creation, closely follows economic activity. In times of expansion, the money supply, boosted by investment and spending by economic agents, will increase, and conversely during a downturn in activity.

For much of the twentieth century, monetary policy was used as leverage to get the economy in case of stagnation, the risk of worsening inflation, or to restrict the money supply in case of overheating, the risk that times to slow down growth.

But after the two oil crises of the 1970s, a consensus emerged in rich countries to focus monetary policy on the fight against inflation. This consensus is still at the heart of the mandate of the European Central Bank.

The main instrument of the central bank is the modulation of interest rates. By increasing or decreasing its key rates, the bank influences the refinancing cost of commercial banks in the money market, on which short-term securities are exchanged for “central bank” currency.

The central bank can also play on the mandatory reserve rate imposed on commercial banks: the higher it is, the less the mass of credits granted to economic agents will be important.

However, the impact of monetary policy on activity is not guaranteed. For example, at present, the anticipated demand of industrialists is low, so a fall in rates (and therefore the cost of credit) has no significant effect on the recovery of activity.

Inflation, deflation: what is the influence of money on the economy?

The quantitative theory of money, formulated by the British economist David Ricardo, highlights the monetary origin of inflation: if prices rise, it is because of a swelling of the money supply higher than the swelling of the production. For Ricardo, inflation is likely to occur when there is a fiduciary currency, and that it is not fully covered by gold. That said, this theory does not take into account that part of the extra money supply can be spared, and not spent.

The Philips curve highlights a negative relationship between unemployment and inflation: in the short run, the higher the unemployment rate, the lower the inflation rate. In times of high unemployment, employees cannot put pressure to increase the level of wages. In the long run, however, according to the supporters of the monetarist school, these two variables are totally decorrelated. This is why, in English, we call NAIRU structural unemployment (ie, long-term unemployment, not related to economic conditions): a non-accelerating inflation rate of unemployment ( non-inflationary unemployment rate) ).

Refinancing of banks: the interbank market

“Banks no longer lend themselves to each other.” This is typically the kind of phrase that can be read every day in the economic papers. What are we talking about exactly? The interbank market is the preferred place for banks to find money. This network is intangible and only works on computer networks, without a trading room. Deadlines are very short: no more than twenty-four hours. The principle is that banks with surplus balance sheets lend their cash to those who need it, with interest. This interest rate varies according to supply and demand. When banks no longer lend themselves to each other, there is a risk of the credit crunch.

In an open market situation (this is the case in the eurozone), the central bank can intervene in this market in order to make it easier for banks to obtain liquidity or, on the contrary, to put them in the Wheels: If it injects cash, the central bank lowers interest rates and facilitates credit conditions, and vice versa.