Sunday, May 18, 2014

Schrödinger's Money

The latest Quarterly Bulletin from Bank of England has raised an always intriguing topic on the agenda: How commercial banks create money when they extend loans. Many commentators, Paul Krugman among others, have correctly pointed out that this is nothing new.

I must say there is something very assuring about a central bank saying that money is created "out of nothing" (ex nihilo); you can know it's true. I have never heard of a central bank trying to mislead the public to think that money is created out of nothing, but I can think of many cases when the exact opposite has happened - a central bank has said that money is not created out of nothing, even when it is.

I find it interesting that this truth about money creation comes as a surprise -even to many professionals- every time it is stated. Could there be something in it that just doesn't make sense to us even when explained?

We are often told how the money we deposit in a bank is actually lent out to borrowers, so that strictly speaking the money is not in the bank, and the bank only has a certain amount of money, a fraction of the total deposits, available for satisfying the requests from deposit-holders who want to withdraw their money. This is still today the prevailing explanation of how banking in a fractional reserve banking system works.

What has been so fascinating about the prevailing explanation has been the parallel between it and "Schrödinger's cat". The money simultaneously is in the bank and it is not. As depositors we act in the economy knowing that our deposits are available to us more or less whenever we need them, and deposit insurance schemes and central bank support to banks (as the "lender of last resort") have made it clear that this is the case. The money is in the bank. And as borrowers we have got, in the form of a loan, money from the bank that is said to be actually money belonging to depositors. So the money is with the borrower. It's not in the bank.

The prevailing explanation made more sense when we used currency, cash, to a larger extent. It was clear that not all the currency remained in the bank once we had deposited it there. But with electronic money this has got even more complicated. Money that is transferred to our demand deposit account is just 1s and 0s. No currency was involved in the transaction. And we can at any moment log into our Internet bank and observe that the 1s and 0s are still there. Therefore, as Bank of England explains, it's not really depositors' money that is lent to borrowers, but money created "out of nothing". This is comparable to revealing that Schrödinger's cat multiplied inside the box - so that there was one cat dead and one alive.

If the money for lending is created out of nothing, why does the explanation with its Schrödinger's money still prevail even among economically literate people? Isn't it time to finally get rid of it? Once that is done, someone of course needs to explain us how something can be created out of nothing...

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