The key to explaining today’s markets is to know where the money is coming from. Understanding how the money in the economy is created will help us interpret the policies of the central banks and rationalize some irrational market behaviours.
Money — the blood of the economy
We can think of money as the cash in our wallet, the balance on our bank account or the limit on our credit card. The sum of all individual money holdings makes up the total money supply in the economy. To the economy, money is like a blood in the living organism. It transfers all the vital supplements to each par of the body as well as transfers essential information. Similar to the blood pressure, if the flow of money is too low, the economy will be sluggish and at risk of falling into recession. High pressure or too much money, on the other hand, can cause unexpected consequences like inflation or asset price bubbles.
Who creates and control the amount of money in the economy?
Usually, when we think about the money, we think of coins and paper money which we have in the wallet. However, in today’s world, cash is only a small part of the money which we have at our disposal. Money in circulation (as it is called professionally) accounts for only 2–3% of the total amount of money in the economy. The rest is digital money — electronic records in the bank accounts (think of your bank account or credit card balance).
We know that the central bank in each country prints banknotes. So we know where that 3% comes from. But who creates and controls the other 97%?
The financial system nowadays is very complicated, but to simplify things, we can say that the majority of money is created in the banking system. The common knowledge of how banks work relied on banks being financial intermediaries. According to that definition, people put their savings in the banks as deposits and banks turn these deposits into loans to other households or businesses that need money. So banks work as a middle man between those who have excess cash and those who don’t have it enough.
Banks are not what you think they are
It turns out that this theory which is taught in most schools and universities is not entirely correct. The main challenge to that theory is that the bank is not just an intermediary in this process. Banks can create money “out of thin air”. You might be thinking it is impossible to make money out of nothing.
To illustrate that point lets imagine an example. If I give an IOU (I own you) note worth $100 to a friend, and he accepts it, we have created credit. My friend has an asset worth $100, and I have a liability of the same amount. No cash exchanged hands. Later, my friend can sell that note to his sister if she trusts my creditworthiness. She then has a claim on me, and we just created money. If my reputation for paying back the debt is high enough, my friend’s sister can sell that IOU further and even borrow against it from others. That initial IOU note can exchange hands multiple times and be used as collateral for creating even more credit. We have created money.
It might be easier to understand if you realize that any banknotes that we are using have almost no intrinsic value. Its nothing else than IOU created by the central bank that issued it (otherwise known as fiat money). It’s worth as much as it’s written on it because we trust the authorities that issued it. The agent we are transacting with has to trust that issuer as well — otherwise, they would not accept the payment. When people lose confidence in the authorities (be it because of inflation or other reason) value of the money can quickly evaporate.
Willingness to lend is what matters the most.
That is how today’s banks work. They can create money by lending to each other out of nothing. As long as confidence and trustworthiness of the banks are unshaken, they can operate freely in creating credit. Of course, there are some regulatory constraints on how much money can be created that way. Yet, banks are hardly ever limited by those constraints. The most significant factor which drives credit and money creation is the willingness to lend, or in other words, risk appetite. There have to be households, companies or other institutions that want to borrow, and there have to be banks willing to give credit.
A capitalist economy is a financial system.
The truth is that the whole modern economic system is based on this financial architecture. That is why the financial sector has grown so big relative to the real economy. The entire economy suffers when credit creation stops for some reason (as in the Great Financial Crisis from 2008–2009). Surprisingly, the link is not as strong the other way. The dependency of the financial sector on the strength of the real economy is not as obvious. The detachment process has been happening for the last few decades. However, never before has it been so evident as today in the COVID-19 world.
Why has the financial sector detached from the real economy
Why do we observe that detachment? As noted before banks can create money when they want to. But in times of economic shock, the confidence is very low, and banks are not willing to lend to each other. That is when the central banks step in. Each independent central bank can create as many liquid reserves (money that the central bank uses to settle payments with other banks) as they wish to. The way it works is via quantitative easing (QE). The central bank buys government (or corporate) bonds from the banks in the secondary market. Banks then deposit the amount of transaction on the accounts of the central bank. Again, there is no cash involved in that transaction. Its an accounting operation. Central bank balance sheet increase on the asset side with the value of bonds it purchased and on the liabilities side by the reserves that banks placed. Reserves are nothing else than the electronic record showing how much the central bank “owns” to banks. As such, there are almost no limits to how big the financial sector balance sheets can grow.
Yet, creating reserves by the central banks does not mean that the central bank is “printing money”.
Credit growth vs GDP growth
Of course, there is hope that one day the banks will use the liquid reserves and convert them into loans. That will, in turn, stimulate the economy. However, there is an interesting phenomenon which we observed over the last few years. Credit growth in the economy was robust, but it had a limited impact on the growth of GDP. The explanation lies in what that credit is used for. There are broadly three ways the extra credit can be channelled:
- It can be used on the loan which will expand productive projects (e.g. building a new factory, replacing old equipment, investing in new technology) and then it boosts GDP and wealth of the society.
- New loans can also be spent on consumption. If households decide to take loans in the banks to spend it on goods or services, it also stimulates the growth of GDP. However, it does not necessarily increase the amount of goods and services the economy produces. In this case, new credit would most likely lead to higher inflation. As people’s demand is growing, it is not matched with a larger supply of goods. Prices need to rise. As a result, GDP grows but so does inflation. The wealth of society remains unchanged.
- New credit can also be spent on purchasing assets (e.g. equities, bonds, real estate), thus causing asset price inflation. We have seen over the last few years. The economic growth was pretty meagre everywhere in the world, but the prices of some of the financial assets skyrocketed. Interestingly, there was no corresponding rise in observed inflation. The standard inflation measures simply do not capture financial asset prices.
Assets price inflation
The last point explains, to a large extent, what is happening today. Most of the world is going through extraordinary slowdown induced by locking down much of the economy. Yet, some financial indices are trading as if the economy has already returned to normal. The gap between financial assets and the real economy has never been larger. Neither has been the extent of central bank intervention in the markets.
It doesn’t mean that banks are creating money which is spent on equities. Yet, there are many asset classes where the valuations are squeezed thanks to central bank asset purchase programs (e.g. government bonds) partially. The lower the expected returns from defensive asset classes, the more investors are forced into riskier investments in search of attractive returns. That is what is driving equities to new highs despite the worries about a recession.
It is not necessarily an adverse outcome. We know one of the channels that the central banks are impacting markets is through confidence. The higher the equities go, the more likely investors and consumers return to normal behaviour. However, without money finally ending up in productive projects, authorities are creating significant risks.
The biggest one is destroying the healthy benefits of capitalism in promoting productivity growth and innovation. In each crisis, bad companies go bankrupt, making room for better companies to show up. Now, this mechanism is broken. “Zombie” companies which rely on a cheap source of funding (or government subsidies) are harming long term growth prospects.
Central bank policies also create a massive moral hazard in the markets. Investors learned that the central banks would step in to support the markets if they fall too much. As a result, people tend to take too risky investments.
Finally, overleverage and the size of the financial sector leads to asset price bubbles and overvaluation. It doesn’t support building wealth for the majority of the population. Instead, it creates imbalances and inequalities. There are growing risks that once the next bubbles burst, the real economy will suffer hugely.