The Enormous Silence:

Reflections on the Mystery of Money

John Hermann


Although the subject of the nature of money, and of its creation, distribution and destruction, has engaged the attention of some of the planet's finest thinkers during the past few centuries, the fact is that an over-whelming majority of people within every country today remains totally ignorant of the central role that banking plays in the process of money creation. A curtain of silence surrounds the issue generally. Why? The response to this question, by those who have given it some thought and study, depends pretty much on their level of objectivity and training. Many of the post-Keynesian and dissident economists (including the COMER school) maintain that this deafening silence reflects the fundamental disarray of economics as a discipline and its lack of a satisfactory foundation, together with (a) an apparent lack of understanding and/or interest in the workings of the financial system by many professional economists, and (b) an uncritical acceptance and gullibility in relation to the neoclassical doctrines by economists and politicians alike. The British economist Paul Ormerod and the Australian economist Evan Jones have both emphasised in their writings the absence of any scientific basis for contemporary economics and the schizophrenic nature of its practitioners. For all its posturings and pretent-ious jargon, and its earnest attempts to gain academic respectability by utilising abstract mathematical analysis to camouflage the poverty of its (largely linearised) models, the mainstream economics profession has simply failed to demonstrate to the rest of the world that the orthodox theory possesses any real predictive capability. For this reason alone it would be a perversion of the commonly accepted meaning of the word to describe modern economics as a science.

An alternative explanation for the curtain of silence (characteristically held by the far right) maintains that there exists an elaborate and largely successful global conspiracy to suppress the dissemination of information on the modus operandi of the financial system, and much else besides. According to this theory the entire banking sector at the executive level (but not at the branch management level) is party to the conspiracy. The present author is inclined to the view that it would be impossible to maintain such a conspiracy for long, given the access of scholars and researchers to modern means of communication. This is not to say that such a global conspiracy is inherently impossible, but simply that it is unlikely in the present circumstances (it is more probable, however, that there are many small-scale conspiracies affecting the economic and financial systems to varying degrees). The central problem to be addressed would therefore seem to be one of human gullibility, rather than conspiracy.

It is not difficult to find evidence of the confusion and obfuscation surrounding the money issue. A former leader of the National Party in Australia has been quoted as informing his constituents that "banks do not create money". On the other hand many economic reformers have taken the trouble to assemble long lists of quotations from distinguished personalities, including people at the top of the banking profession, in support of the proposition that banks do create money. Recent college economics textbooks, particularly within the USA, provide descriptions of money creation by the banking system via the "money multiplier" mechanism, and even of "fractional reserve deposit expansion". However, one can also find other economics textbooks which avoid the entire issue of the creation of money like the plague. The confusion and the contradictions appear at almost every level. An excellent little book by Australian reformer Ed Burgi (Money Creation: The Great Confidence Trick) has reproduced a recent letter from the secretary of the Reserve Bank of Australia, who absolutely denies that banks create money. Ed also possesses an official letter originating from the economics department of the Reserve Bank of New Zealand which states unequivocally that the commercial banks create around 97 per cent of M3 ! One might be excused for reasonably concluding that such incompatible views, freely expressed by responsible people at or near the apex of the financial system, provide substantial evidence against the position held by the global conspiracy theorists. It is also worth reflecting on the fact that a variety of distinguished scientists and engineers who have been drawn to the subject of money creation have sometimes been granted insights (into financial mechanisms) that are apparently denied to many mainstream economists. Two outstanding examples are provided by the work of British Nobel laureate in chemistry Frederick Soddy, and the United States engineers Theodore Thoren and Richard Warner. Evidently there is a place for the intellectual rigour of scientific method within the discipline of economics, suggesting that the study of scientific method could be included profitably within economics degree courses.

One may investigate the role of banks in money creation in an empirical way by performing a simple statistical analysis of the detailed borrowing and lending data which are so generously provided by the Reserve Bank of Australia within its monthly bulletins. It is quite unnecessary to have any understanding of the financial mechanisms to discover that a strong correlation exists between increases in bank lending and increases in the money supply. By contrast, it will be found that there is no correlation at all between increases in the lending of non-bank financial institutions and increases in the money supply. Nor are increases in foreign "investment" related to increases in the money supply (note that two thirds of foreign investment is in fact debt, so that the outgoing interest and other liabilities often exceed the incoming capital). These empirical results suggest that banks carry out an important function that the non-banks either cannot or will not duplicate, notwithstanding a recent claim put to me by an RBA spokesperson that banks and credit unions operate in essentially the same manner. It has also been suggested to me by people within the economic reform community that credit unions can create money. I will explain below why I think these beliefs are mistaken.

A very interesting thesis written by one of our Queensland colleagues, Henry Hilton (The Nature of Money and Banking: A New Perspective) has examined the historical and jurisprudential aspects of money and banking in some detail. The course of this research has been dominated by issues arising from the ability of the modern banking system to create money ex nihilo. I wish to focus here upon a crucial distinction that has been made, in section III of the thesis, between time deposits and current deposits. This distinction has also been made by M. Rothbard (The Mystery of Money, Richardson & Snyder, New York, 1983). A number of legal judgements in Britain during the past two hundred years have apparently been made on the assumption (erroneously, in Hilton's view) that money deposited with a bank is inevitably to be regarded as a loan. Hilton states:

"...The judges' opinions expressed in these cases, and the consequential principle of law laid down, are wrong for one basic reason: the learned gentlemen have all failed to distinguish between moneys placed for investment purposes, ie time deposits, and those placed at call, ie current deposits. Whereas moneys placed for investment purposes are of the nature of a loan, clearly moneys deposited and payable on demand represent a bailment and not a loan......"

The point being made here is that with current deposits, ie money deposited and repayable on demand, a bank is obliged to repay the money in full at any time that the depositor requires it. Usually the bank pays very little interest and often charges transaction fees, acting essentially as a safe-keeper. According to Hilton, if in their judgements the courts had correctly differentiated between moneys placed at call and moneys placed for investment, then the banks' license to create money would have been effectively removed, since current accounts would be recognised as bailments, requiring 100 per cent reserves to be held. Time deposits would then alone provide the basis for making bank loans.

The above distinction helps to explain several otherwise anomolous features of our financial system. For example the Financial Corporations Act, 1974 (which regulates the activities of the non-banks) states that the primary function of building societies and credit unions is borrowing and lending (ie, intermediation). The words deposit and advance are never used in connection with the operations of these institutions, and will neither be found within any of the clauses of the above Act nor within the aggregate statistics for non-banks regularly published by the RBA. By contrast, the word deposit is always used to describe the activities of banks (eg, see the Banking Act, 1959). In addition, the non-banks do not issue their own cheques, acting only as agents of the banks in this regard, and do not possess facilities for clearing cheques. It is also noteworthy that the Reserve Bank Act, 1959 defines the powers of the RBA to include inter alia (a) the receipt of money on deposit, (b) the borrowing of money, and (c) the lending of money. One might reasonably ask why a distinction needs to be made between deposits and borrowings. Surely the above features are not simply idiosyncrasies arising as the consequence of some historical accident. Finally, by contrast with the demonstrated ignorance of some leading members of the legal profession, most senior bankers, banking historians and modern financial economists appear to have no difficulty at all in comprehending the essential and most important function of commercial banking, namely, the provision of the nation's money supply.