Money fascinates me. Generally because of my lack of it. As the fog lifts from our Covid-afflicted economy, an understanding of money and banking will be crucial for policymakers.
The vast share of modern money consists of bank loans. The banking sector creates money through its lending in the form of computer credits. The ability of private banks to magically create money should unnerve any diehard conspiracy theorist.
But this dark art is little understood, and not widely taught in economics courses. There is an old saying in finance: "Why rob a bank when you can own one?"
Early banks were goldsmiths. Merchants deposited gold and other precious metals with them for safekeeping and were issued paper receipts. These receipts began being used for trade. They became known as banknotes.
Goldsmiths then realised they could issue extra "receipts" that could be used by borrowers as money. They could earn interest on these "receipts". They didn't need all of them to be backed by gold because it was unlikely everyone would want their gold back at the same time.
This process still provides the basis for modern banking.
Instead of issuing receipts, banks issue loans by giving borrowers computer credits. If everyone wanted physical notes and coins at the same time, they simply don't exist. The entire system is based on trust and confidence and illusion.
The ability of the banking system to create money is largely constrained by viable borrowers who have the collateral and incomes to service their debts. Bank lending tends to surge during boom times as incomes and employment rise and shrink during hard times. The booms and slumps are magnified as a result. A type of feedback loop.
A little-appreciated role of central banks is to act as "the lender of last resort" to the banks if confidence suddenly evaporates. Central banks are there to prop up the banking system in the event of disaster, even though it may be self-inflicted. The banking system is too fundamental to the modern economy to be allowed to fail. Herein lies the problem.
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The fragility of the financial system was viciously exposed during the 2008 global financial crisis (GFC). Central banks were forced to provide life support for their financial sectors. Covid-afflicted economies are also liable to challenge the stability of the financial sector through a number of avenues.
As unemployment rises and incomes fall, the banks will be very wary of bad debts. They are already providing debt holidays to tens of thousands of households. They will be hesitant about new lending. Their first priority will be to protect their own capital and solvency.
New Zealand interest rates are at historical lows. Experience from the GFC suggests this is unlikely to lead to a sudden surge in bank lending. Banks will be wary of lending and borrowers will be wary of debt in such uncertain times.
If overall bank lending falls, this reduces the money supply. This puts further downward pressure on total demand and wages and prices in our economy.
The Reserve Bank has committed itself to injecting up to $60 billion of "new money" into the economy through quantitative easing. This mainly involves buying local and central government IOUs. We are fortunate in having our own currency because we can create as much of it as we want.
This is not a recipe for long-term economic prosperity but it is unlikely to cause inflation in the current situation if the banks are hesitant to lend. The real concern for our Covid economy should be deflation rather than inflation.
• Peter Lyons teaches economics at Saint Peter's College in Epsom and has written several economics texts.