A new way to think about the creation of money

By Clark Johnson

Commercial bank lending creates money — a process that ought to contribute to efficient, welfare-enhancing deployment of resources. In a new book, Making Money Work, Matt Sekerke and Steve H. Hanke call “[c]redit creation to support new bankable projects . . .  the jet fuel of the banking system.” A productive banking system works by collecting “information in multiple domains to make more investable projects bankable.” Competition in banking, at its best, is about overcoming information asymmetry between lender and borrower sufficiently to make previously rejected projects less uncertain in their market prospects. Thus, competition should generate new credit products.

That may be how things work in an economic model world. Here in the real world, the authors take a jaundiced eye toward what they view as the typical operating model of non-bank finance: small, asset-light initial investments, where larger projects struggle to get off the drawing board. A productive money-creation system, in contrast, should allow derisked bank lending to “amplify” risk capital available from intermediated sources. The authors argue that commercial banking has become hidebound, unwilling or unable “to configure new bankable projects.” They argue that innovation in finance — the “necessary investments in information, contracting and secondary marketability to support lending at large scale” — are now happening in private equity firms and other capital market intermediary firms often called “shadow banks.”

The Gramm-Leach-Bliley Act of 1999 completed the transformation of U.S. bank holding companies into universal banks, which meant that trading and banking books would be managed under the same roof. A consequence has been that low-risk projects that should be bank-financed are “cannibalized” by the capital market side of the business. Doing so wastes the risk-absorbing potential of the latter. As do the Basel capital and liquidity rules, the GLBA thus leans against use of bank lending to support new bankable projects — and by extension, leaves investable projects rationed out of capital markets.

Sekerke and Hanke point to current bank regulation as constraining a more productivity-enhancing role for banks. Following defaults on U.S. bank loans in Latin America during the 1970s, G10 countries directed a BIS committee to develop cross-country capital rules. The Basel I Accord (1988) encouraged banks to hold government and agency securities, claims on other OECD banks, and mortgages by establishing low-risk weights on them. In contrast, the accord placed high-risk weights on corporate credit, commercial real estate and asset-based lending. As Basel I was implemented after 1992 (and reinforced by post-financial crisis Basel III liquidity and reserve requirements), the weight of U.S. bank balance sheets shifted from loans to securities. Within loans, the share shifted away from the non-financial business sector in favor of residential mortgages.

When we understand bank lending as a vital economic function, one strengthened by competition for information and for developing new products, rather than as a fragile quasi-utility, then bank management can move from focus on worst-case outcomes to pricing. Making Money Work offers portfolio modeling themes for improving bank risk-return adjusted profitability. In concept, similar models can be used for both regulatory structures and internal bank management.

Making Money Work introduces a concept of money neutrality: that money supply should equal money demand not only in the aggregate but across sectors. Public monetary interventions can create non-neutrality — for exampIe, bank regulations often favor extension of credit to housing and consumer goods sectors. Quantitative easing following the financial crisis introduced other distortions. Reinvigorated bank competition, as the authors describe it, would advance money neutrality in bank lending.

The authors highlight one monetary non-neutrality in particular: that involving most real estate credit. Real estate has value for the labor and capital invested in it — and also for rent, that is, the yield on land over and above the value of inputs to production. Tax shields allow land to be depreciated like other investments, even though land itself does not lose value. Thus, the value of real estate includes the capitalized value of its land rent. Land becomes easy  bank collateral; it takes up balance sheet space that should better be deployed for innovative credit. An annual tax on the value of land (such as a Georgist tax), excluding value of any improvements, would be economically efficient — “monetarily neutral” — hence would make real estate a more productive vehicle for bank lending and money creation.

In its call for making both derisked and risk capital more productive, Making Money Work should become a lamp light for understanding, and potentially reforming, the way banking and finance work in the U.S.

Clark Johnson is the author of Uncommon Arguments on Common Topics: Essays on Political Economy and Diplomacy.