There have been three great inventions since the beginning of time: Fire, the wheel and central banking,\u201d American vaudeville performer Will Rogers once said.<\/p>\n
Two engineers-turned-economists \u2014 Krishnamurthy Vaidyanathan and Krishnamurthy Subramanian \u2014 have dared to replace central banking with banking in\u00a0Money: A Zero-Sum Game<\/em>. The book also has a sub-title\u00a0\u201cA Novel Framework of Money: Have Nobel Economists Got it Wrong?<\/em>\u201d<\/p>\n Of the two, Subramanian, the youngest chief economic adviser, government of India (2018-21), is now India\u2019s executive director at the International Monetary Fund.<\/p>\n A central bank is the term used to describe the authority responsible for policies that affect a country\u2019s supply of money and credit. The world\u2019s oldest central bank, the Bank of Sweden, was established in 1668. The Bank of England was created in 1694. Napoleon Bonaparte had set up the Banque de France in 1800. Our Reserve Bank of India (RBI) is relatively young \u2014born in April 1935.<\/p>\n The 11 chapters in this book, divided into three parts, have challenged the conventional wisdom of monetary economists\u00a0\u2014\u00a0the theory of money multiplier and financial intermediation. The money multiplier exists only in the make-believe world of monetary economists, and not in the real world!<\/p>\n It even goes to say that realising its futility, many central banks, including the US Federal Reserve, have abolished the reserve requirement and yet the Indian central bank carries on with the so-called cash reserve ratio for banks (a portion of deposits that commercial banks keep with the central bank on which they don\u2019t earn any interest), \u201cadhering to the flawed theories of monetary economists\u201d.<\/p>\n The authors explain how the money game is played in the Indian economy in a novel way \u2014 like Vyapar, popularly known as Monopoly. They not only challenge the monetary economists\u2019 understanding of money creation but also make fun of them. Their description of money creation is nothing but playing the Monopoly game, the authors say.<\/p>\n \u201cThe roll of your dice (the cause) depends on the number of spaces you move on the board (the effect) whereas in reality, it is the other way round.\u201d Just as there is a play master in the game of Monopoly \u2014 the person who keeps tabs on tokens, properties and dice rolls and initiates auctions and mortgages \u2014 there is a play master in the real-world game of money all of us play.<\/p>\n While the monetary economists describe the central bank as the play master, the book argues that the true play master is the banking sector. So, move over RBI, the commercial banks are creating money and moving the economy.<\/p>\n Basing their heory on cause and effect, to illustrate the point, the authors refer to the phenomenon of making tea \u2014 how it is actually done and how it can be seen.<\/p>\n The water in the kettle boils (effect) when we turn the gas stove on (cause). The tea turns golden brown (effect) as we add milk to it. The teacups are kept on the dining table (effect) after we take them out from the kitchen cupboard (cause).<\/p>\n That\u2019s the real story. But in the \u201cmake believe world\u201d of the monetary economists, the effect precedes the cause.<\/p>\n How will they describe the tea-making process? Water boiling in the kettle turns on the gas stove; the golden colour acquired by the tea makes us add milk and the tea cups bring us from the kitchen to the dining table. You don\u2019t make tea; the tea makes you!<\/p>\n To be sure, this is not the first time the central bank\u2019s role in money creation is challenged. In the\u00a0Quarterly Bulletin<\/em>\u00a0of the Bank of England in 2014, Michael McLeay, Amar Radia and Ryland Thomas have written that a vast majority of the money held by the public takes the form of bank deposits but where the stock of bank deposits comes from is often misunderstood.<\/p>\n One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. Another is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money \u2014 the so-called \u201cmoney multiplier\u201d approach. In that view, central banks implement monetary policy by choosing a quantity of reserves.<\/p>\n The fact is that the commercial banks create money \u2014 in the form of bank deposits, by giving new loans. When a bank gives a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving\u00a0her\u00a0limitless money. Instead, it credits\u00a0<\/strong>her\u00a0bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as \u201cfountain pen money\u201d, created at the stroke of bankers\u2019 pens when they approve loans, the trio have said.<\/p>\n In essence, most of the money in circulation is created, not by the printing presses of the central bank, but by the commercial banks themselves: Banks create money whenever they lend to someone in the economy or buy an asset from consumers. While the central bank does not directly control the quantity of either base or broad money, it is still able to influence the amount of money in the economy by setting monetary policy.<\/p>\n But Pontus Rendahl and Lukas B Freund of the Centre for Economic Policy Research in their paper \u201cBanks do not Create Money Out of Thin Air<\/em>\u201d<\/em><\/strong>\u00a0in December 2019 have challenged this theory. \u201cWhen banks create money, they do so not out of thin air, they create money out of assets \u2014 and assets are far from nothing.\u201d<\/p>\n They have used a simple parable to illustrate how banks create money and what the role of asset-backing is in that process.<\/p>\n \u201cSuppose a PhD student new to the British town of Cambridge \u2026Lukas \u2026 would like to celebrate a day\u2019s worth of work with a pint at a local pub and pay for the drink by issuing an IOU. Unfortunately, the pub refuses to accept the Lukas-IOU. After all, the pub doesn\u2019t know Lukas very well, and it can therefore not trust that he will have the ability to repay the IOU\u2026 Moreover, a third party, say a brewery, would not accept the Lukas-IOU as payment for their restocking of the pub\u2019s beer inventory either \u2026<\/p>\n Fortunately for Lukas, his supervisor\u00a0\u2014\u00a0Pontus \u2014 happens to have a lot of trust in Lukas, and is willing to accept the Lukas-IOU in exchange for a Pontus-IOU in return.<\/p>\n Here is the crux \u2014 the local pub does indeed trust Pontus, and so do third parties (\u201coh, it\u2019s a Pontus-IOU \u2014 that\u2019s as good as the pound note in my wallet!\u201d). Lukas can then get his well-deserved drink by paying with the Pontus-IOU. And the brewery can restock their inventory by paying with the same means.\u201d<\/p>\n Has Pontus created money out of thin air? No. Why would the local pub trust Pontus and treat his IOU as good as money? They trust his ability to screen Lukas\u2019 repayment capacity, so he has a healthy \u201casset\u201d backing up his own IOU. He also happens to have liquid reserves on his savings account.<\/p>\n I am not qualified to endorse or challenge Vaidyanathan and Subramanian\u2019s theory but the book is fun to read. While it shifts the address of the money controller from Mint Road to\u00a0Mumbai’s\u00a0Bandra Kurla Complex where many banks are headquartered, a string of sub-stories, theories and prospects related to money keep the readers hooked.<\/p>\n It talks about\u00a0hundis<\/em>\u00a0\u2014 which are mentioned in Indian mythology much before commercial banks made their appearance in the West \u2014 as well as the latest animal on the money turf, the central bank digital currency, with equal ease.<\/p>\n You may or may not agree with the authors but the book reads like an epic with a central theme \u2014 commercial banks control money creation \u2014 and it urges them to be aware of their strength and contribute to India\u2019s economic growth.<\/p>\n","protected":false},"excerpt":{"rendered":" There have been three great inventions since the beginning of time: Fire, the wheel and central banking,\u201d American vaudeville performer Will Rogers once said. 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