How Banks Create Money and Impact of Credit Booms

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“Explain how banks create money and use the insights from Kindleberger and Minsky to discuss why credit booms can result into financial crises.”

Money is generally any token or commodity that is widely acceptable as a means of payment which has several functions in the economy. First of which is that money is primarily a medium of exchange. It is a way for a person to trade what he has for what he wants. In the absence of money people would need to exchange services and goods directly which is called barter. Secondly, money serves as a unit of account, which is a consistent means of measuring the value of things. A unit of account is an agreed measure for stating the prices of goods and services. Money also serves as a store of value, it holds value over time. Although money is not the only thing that stores values as houses and land also fulfil this function, however, money is different as it can be exchanged immediately for other commodities.

Owing to the interpretations of the Bank of England in 2014, money has taken a fourth function as an IOU as money is considered a form of debt. This stems from the idea that the modern economy is not only an exchange economy but a credit economy. Since people may not want to exchange at the same time and in reality different people want different things at different times An IOU is a promise to repay someone at a later date which allows for this problem to be solved. Money is a special form of IOU as it is a financial asset and it is universally trusted.

In the modern economy 97% of broad money in circulation are bank deposits. Bank deposits are created by commercial banks are independent of changes in base money. The process of money creation begins as commercial banks create money by making loans. The loans created then make deposits. The loans which become deposits then flows into the circulation and increases the overall money supply. This is the system of fraction reserve banking whereby, banks loan out a fraction of the deposits made, depending of the required reserves. The other percentage (excess reserve) is money which the banks can loan out. This leads to a cycle of loaning. The amount of money created can be calculated from the initial loan can be calculated via the money multiplier. However, there are implications to this endogenous money creation model such that the money multiplier model is not valid. Instead of deposits leading to new lending as in this model it is the loans that create bank deposits, as the newly created money is used for purchasing goods.

Scholars such as Minsky (1977) and Kindleberger (1978) have argued about the nature of the financial system and the credit system in that the financial system is liable to generating economic instability through endogenous credit booms. In their view, the credit system was not simply a propagator of shocks hitting the economy, however, it usually was the shock. The credit system seems very able to create its very own shocks, using the judgement from prior times of credit growth performs as a predictor of financial crises. The trend of past credit growth allows for the forecasting and prediction of a banking crisis. This is owing to the use of long-run historical data which displays the growth rate of lending which emerges as the single best predictor of future financial instability. This ties with the first theorem of Minsky’s Financial Instability Hypothesis in that ‘the economy has financing regimes under which it is stable, and financing regimes in which it is unstable’ (Minsky 1992: 7f). There are certain ways that the agents act in the lead up and during a period of financial instability based on their expectations which can lead to a change in the rigidity and entrenchment of the process of lending.

Minsky’ Financial Instability Hypothesis analyses cycles marked by a basic cycle in which borrowers and lenders take on increasingly more financial risk, Additionally, the period as a whole was marked by a super-cycle involving financial innovation, financial deregulation, regulatory capture, and changed investor attitudes to risk such that for instance, the risk of financial fragility greatly increased by decline in the quality of this indebtedness. This was due to the loan officers’ attitude to loaning as they became more daring, ignored information essential to evaluate the capacity of borrowers to service loans, and in providing loans that involved expectations of refinancing and/or sale of assets. This therefore led to a decline in the amount of required loan documentation, a decline in the quality of the documentation provided and a decline in the quality of the loans provided. Adding to this financial deregulation in the form of abolition of credit controls allowed for a freer credit creation.

According to Minsky, after a prolonged period of prosperity, the expectations of both firms and banks tend to become more optimistic, and uncertainty rises, and Ponzi and speculative finance become tradition. Then for example, a change in expectations or an increase in the interest rate caused by endogenous forces or due to the tightening of the monetary policy. This results in Ponzi and speculative units no longer being able to meet their financial commitments, which causes them to sell assets of default. This leads to crises or debt deflation As a result, speculative and Ponzi units are no longer able to meet their financial commitments, leading them to either default or sell assets. This leads to debt deflation and crisis.

Kindleberger’s model is based on a set of assumptions on expectations, rationality and the diversity of agents. One assumption is that people behave more or less rationally in times of stability. In spite of that, at times composed departures from rationality occur which then leads to an ascent and burst bubbles which can in some instances lead to financial crises. Aggregate rushes of irrationality such as this are often alluded to as herding behaviour. Herding behaviour can be displayed when agents in the economy do not analyse the current situation carefully yet duplicate others’ investment decisions.

Another assumption/explanation “is that of mob psychology, a ‘group think’ which is when essentially each one of the members in the market changes his or her views at the same time and moves as a ‘herd’” (Kindleberger and Aliber, 2011, p. 42). Alternatively, herd behaviour can be displayed in the case when “various individuals change their views about prospective developments in markets at different times as part of a continuing process; most start rationally and then more of them lose contact with reality” (ibidem, p. 42).

Despite not knowing which alternative the fundamental driver of herding behaviour is, this deviation from rationality is a crucial aspect of the depiction of financial crises developed by Kindleberger. Herding behaviour propels investors to synchronise on buying assets when it would not be rational to do so, with the effect of inflating bubbles. Herding behaviour invites non-professional investors to unite the market members in their “euphoric” buying. Another key aspect in Kindleberger’s explanation of crises and bubbles is the dynamical development of expectations during a financial crisis “that is the culmination of a period of expansion and leads to a downturn” (Kindleberger, 1978, p.3). According to Kindleberger, a typical element of financial crises is that a specific change in expectations steer each stage of a crisis. Expectations have a tendency to become over-optimistic during the period of bubble formation and lead to overinvestment in the market affected by these expectations. Hence expectations are not secure over time, when the bubble draws close to its pinnacle, expectations move back to over-pessimism frequently immediately. Due to this change in confidence and belief, investors scramble to sell their investment which then in turn leads to the market collapsing.

In conclusion, both scholars, Minsky and Kindleberger agreed on the fact that financial crises are credit booms gone wrong and that the combination of increasingly risky lending, practices and deregulation have more negative consequences. Minsky’s contributes in that he expands on the idea of endogenous instability. that stability in the economic system generates behaviours that produce fragility, and increasing fragility makes the system more prone to an unstable response. Kindleberger draws on this and explains that the expectations and rationality of the agents whom act as a ‘herd’ which can be over optimistic and over pessimistic can cause the market to crash.

 

 

 

 

References

  • Caverzasi, E., 2014, Minsky and the Subprime Mortgage Crisis: The Financial Instability Hypothesis in the Era of Financialization, Bard College Levy Economics Institute Working Paper No. 796,
  • Kindleberger, C. P., 1978, Manias, Panics, and Crashes: A History of Financial Crises, New York: Basic Books, revised and enlarged, 1989, 3rd ed. 1996.
  • Kindleberger, C. P., and R. Z. Aliber, 2011, Manias, Panics, and Crashes. A History of Financial Crises, sixth edition, Palgrave Macmillan.
  • Minsky, H. (1992), ‘The Financial Instability Hypothesis’ Bard College Levy Economics Institute Working Paper: 74.
  • Pasotti, P., and Vercelli, A., 2015. “Kindleberger and Financial Crises,” Working paper No.104, Financialisation, Economy, Society & Sustainable Development (FESSUD) Project.

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