My description of how the private banking sector interacts with the Central Bank and the Fiscal Authorities seems uncontroversial to me. It seem to arise simply from the widely accepted facts about how these things operate.
Yet, I have chatted with several well known economists offline and read much commentary online. The way they talk about finance dynamics implicitly assumes that my model of the world is incorrect. What I’d want to know is where I am going wrong here.
Part of the problem, I know, is that I tend to state things is a non-controversial matter-of-fact kind of way, especially in person. So, what I am saying may escape people.
Let me lay it out then, in a slightly more aggressive form.
Here is the jist.
1) In a modern financial economy overseen by a functioning central bank “savings” do not represent anything real but are merely a residual.
2) When “savings” are placed into a bank that money is effectively annihilated. From a macro-point of view it ceases to exist.
3) In the US economy when people buy T-Bills, that money is also effectively annihilated. It ceases to exist.
4) When banks lend money, money is lent into existence.
5) In the US economy when the government issues T-Bill, money is lent into existence.
6) The financial system thus operates like a big money black box where cash that goes in is gone from the universe, and cash that goes out is newly created in the universe.
7) All of this happens because prices are what connect economic agents in the market and the price of funds is set by the Central Bank. In the US using T-bills. Since, exchange with a bank cannot in-and-of-itself change the price of funds it is effectively like exchanging with a door to the nothingness.
8) Net “savings” affects the lending rates because when people attempt to buy fewer goods and services aggregate demand falls and the Central Bank responds by lowering the cost of funds. Or, conversely when people attempt to buy more goods and services aggregate demand rises and the Central Bank responds by raising the cost of funds.
9) If the central cannot or does not respond to changes in Aggregate Demand then savings is purely money destruction and borrowing is purely money creation.
10) The credit worthiness of bond can be imagined this way: The banking system will dole out funds in an exchange for bonds. There is a ranking of bonds in terms of which will get funding ahead of others. The lower you are on the ranking the worse your credit. At the same time, the less willing the banking system is to walk down the list the worse your credit.
11) The extent to which the banking system is willing to walk down the list depends in large part on the cost of funds which is determined by the central bank.
12) Increases in the cost of funds thus have a double effect on bonds way out on the list because they both increase the base cost of lending and make it less likely that the banks will get to them at all – ie lowers their credit worthiness.
13) When the Central Bank stands as Lender of Last Resort then that automatically moves bonds up to the top of the list.
14) A bond under Lender of Last Resort status from the Central Bank cannot be a poor credit risk unless the total volume of those bonds exceeds the banking sectors ability to lend.
15) Because of all of this any institution – but most interesting from our point of view Central Governments – can permanently extract enormous amounts of resources from the economy without raising taxing or printing money.
16) Because Central Government sits atop the list it extracts resources simply by pushing other bonds down into worse credit territory or off the list completely. This is a process I refer to as bank extraction.
17) This is key because credit wise it is irrelevant what anyone, anywhere might think of the government’s eventual willingness to pay out of taxes or printing money. They cannot be moved from the front of the list and so they will not be denied funds.
18) A central government which strains it banking system through large amounts of bank extraction will see the private savings rate rise and economic growth slow as both private borrowing for consumption and investment are pushed further down the list.
19) The Central Bank could choose to offset this by allowing higher inflation or it could simply allow the private sector to contract.
20) In any case all bond dynamics are completely anchored by who gets money first versus who gets money last and that is almost completely under the control of the Central Bank, should it choose to exercise such control.