Quantity Theory of Disaggregated Credit

Originally sent to VIXCONTANGO subscribers on August 12th, 2021

In 1517, almost exactly 500 years ago, Copernicus invents the Quantity Theory of Money. In its modern form that theory can be reduced to the following famous equation: M * V = P * Q, or

Money Supply * Velocity of Money (transaction frequency) = General Price Level * Real Quantity of Goods

Keep this in mind as we will need it later. Fast forward to 1992 and Professor Richard Werner (pictured above) proposed a new theory of money creation called the “Quantity Theory of Disaggregated Credit” or more simply “Quantity Theory of Credit” which builds upon Schumpeter’s credit theory of money (that money is credit, not a metal). In 2014, he published the first empirical evidence that each bank creates credit when it issues a new loan. He is a well-known academic in both the East and West with public and private sector experience. In 1995, while he was living and working in Japan, he proposed a new monetary policy called “Quantitative Easing” to deal with banking crises which was published in the Nikkei magazine (in Japanese!) and later adopted by the Bank of Japan. Richard Werner is the Father of Quantitative Easing. QE in the US is often associated with Ben Bernanke but it was Werner who created the academic theory that powers this monetary policy. The Bank of Japan ran QE a decade before the US. Werner’s 2001 book “Princes of the Yen” was number one general bestseller in Japan. He also has the honor of being designated as a “Global Leader of Tomorrow” by the World Economic Forum in Davos.

Today I want to cover Werner’s theory because it is critical to understand what is going on in markets and finance today. He gave a great speech at the SORA Economic Forum (the guys behind Polkaswap) which you can watch here. I am basically reprinting what he said in that speech.

There is no “economic growth”. We know this from physics – the laws of thermodynamics. You can’t create energy, you can only transform it. Economic growth is a statistical illusion created in national income accounting by adding up “value add” transactions connected to goods and services but not subtracting the costs such as depletion of natural resources. This “economic growth” concept was created by large banks a century ago in order to find out how much interest they could charge governments when lending to them. This explains why nominal ten-year yields of government bonds (long term interest rates) follow nominal GDP growth and are usually of similar size. If the banks charged more than economic growth (i > g), a “debt trap” would follow. A debt trap is bad because it would cripple the economy and the banks as well because if the debtor defaults the creditor is in trouble. A parasite like the banks needs the host alive so really not a good idea for them to charge usury rates in the long run. The maximum the big banks can charge in interest is the economic growth rate. The banks can also charge BELOW the economic growth rate as it is currently happening. Nominal US GDP growth right now is around 10% while TNX (10-year Treasury Yields) are stuck at 1.5%. That condition is actually very good for the economy if not as profit maximizing for the banks as they would like. Even though banks are printing record earnings numbers as we speak.

Ultimately, “economic growth” is a monetary concept since it measures only monetary transactions taking place in markets and paid for with money. Financial transactions are not part of GDP since GDP tries to measure “value add” transactions. Financial transactions are simply purchases or sales of assets between counter-parties which is just ownership transfer. Ownership transfer is not a “value add” activity – it is a zero sum game. By contrast, activity that produces new goods and services like entrepreneurship adds new value and everybody is better off. Economic growth means that those value add transactions that are part of GDP have increased this year compared to last year.

How do you increase economic growth? If we use Copernicus’ equation M*V = P*Q, to have economic growth that means that you need to have a positive change in M*V and that change should equal the change in P*Q. In other words, Δ (P*Q) = Δ (M*V). Increase in the value of transactions can only come if there is an increase in the money used for these transactions. In other words, for economic growth to be possible, the money supply must grow. To get more Q you need more M if you assume P and V are constant. There is no economic growth without money supply growth. That is a concept that Gold bugs have never been able to understand.

In Neoclassical Economics, or what we call Econ 101 class taught to everybody everywhere, there is the concept of equilibrium between supply and demand that determines prices. That equilibrium makes a breathtaking number of assumptions:

1. Market participants have perfect information
2. Markets are complete
3. There is perfect competition between players
4. Price adjustments are instantaneous
5. There is zero transaction costs
6. There are no time constraints for price setting
7. All agents are rational and seek to maximize profits
8. Nobody is influenced in any way by the actions of others

Except that those assumptions are really bad and don’t actually happen in the real world. People don’t have perfect information, not everybody is in the market all the time, perfect competition is rare, transaction costs are very heavy (see the Island of Manhattan built by transactions costs), there are time constraints all the time, market agents aren’t rational – there is a lot of price manipulation and you have to be a fool to think that there isn’t herding behavior – people absolutely are influenced by societal trends. In Alice in Wonderland, the Queen said that she believed six impossible things before breakfast. In modern day economics, you have to believe 8 impossible things all the time! If probability of all these assumptions are true are 60%, the combined probability is 60% to the power of 8 or barely 1%. And reality is that the individual probability of any of those actually happening is less than 10%.

In other words, perfects markets don’t exist. Textbook economics is a fairy tale. Demand does not equal supply. Markets are rationed. Rationing in one market affects other markets. Information, time and money are all rationed – there is a limit to them and distribution isn’t perfect. Different market players have different levels of information, time and money or simply put different “market power”. In rationed markets, market power is the primary driver behind market prices. Market power is used and abused. Rationed markets are determined by quantities, not prices. The outcome is determined by whichever quantity is smaller – demand or supply (the “short-size principle”). Thus, government intervention in markets is a “distortion” and “undesirable” only in the theoretical world of Econ 101 general equilibrium economics (which is what libertarians believe so strongly). Since markets are rationed and skewed, government intervention can actually improve market outcomes by checking market power abuse.

There were 3 main theories of banking:

1. Financial Intermediation Theory
2. Fractional Reserve Theory
3. Credit Creation Theory

“Financial Intermediation Theory” says that banks are intermediaries in the private sector and they gather deposits from savers and then lend them out to productive enterprises (or debtors). That theory forms the basis of what we call “private money” and what I called “Medici money” in prior writings. And this is the theory of banks and money that most people are familiar with and accept easily. In this theory, banks don’t create money supply neither individually nor collectively. Money comes from client deposits (already exists).

In “Fractional Reserve Theory”, there is a Central Bank and all banks put a reserve aside with the central bank. This reserve is used to clear interbank payments and allows banks to make payments to each other. New loans in the economy are extended out of new reserves. New reserves can get created by the central bank. This is the basis for “public money” or what I also called “Lincoln money” in prior writings. In this theory, banks create money collectively but not individually. In other words, a committee of private sector and government bankers like the Fed jointly creates new money when they increase the reserves or loosen the reserve requirements. This fractional banking theory has much resistance in the public because it is a little bit more complicated and centralizes the power of money creation to the mysterious Central Bank. And in addition, money can be lent out that doesn’t exist and people simply don’t want to believe in magic. Whether the public likes this theory or not, you can in fact lend more than you have in deposit since depositors rarely pull out their deposits over time and particularly those at the Central Bank. Banks can leverage those deposits as much as 8x according to international banking regulations (Basel III). The only reason Central Bankers get away with this “atrocity” is because this is a key way to produce economic growth that wouldn’t exist otherwise. If banks could only lend what they had on deposit, the economies would be much smaller.

The 3^rd theory is called “Credit Creation Theory” of banking and says that banks aren’t just intermediaries – they are the center of the economy and money gets created only when they lend. Thus banks create money ex nihilo (out of nothing) both individually and collectively. Werner did empirical tests of all 3 theories and found out that Financial Intermediary and Fractional Reserve theories are wrong and not consistent with evidence and that only the Credit Creation Theory is correct and consistent with real-world evidence. Or in other words, banks are the center of the economic universe and they create money out of thin air when they make lending decisions. Any theories and economic models that don’t reflect this reality about banks (that they create money individually and collectively) can’t be used to describe our economy.

There is a BIG discrepancy in how neoclassical economists (and therefore the public) view banks and the banks’ actual status in the real economy. Economists think that banks are deposit taking firms that lend money. In the real world banks don’t take deposits and don’t lend money. Get a load of that! Banks actually “borrow” money from their clients. In law, client “deposits” are loans to the bank. When I put my money in the bank, the money is not on “deposit” (held in custody by the bank). It is owned and controlled by the bank, not the depositor. That is because the “depositor” lends money to the bank and becomes a “general creditor” to the bank. The bank records a “credit” on behalf of the customer in its records of its debts. When it comes to “lending”, banks don’t lend money either. They purchase “securities” – the loan contract is a “promissory note” (or a “security”) that the bank acquires. The bank does not payout the money referred to in the loan contract. Instead, the banks records a “credit” on behalf of the customer in its records of its own debts to the public.

This is how money gets created: when the bank lends, it in fact “purchases” a loan contract from the borrower and records this as an asset. The bank now owes the borrower and has a liability. The bank records this in the 2-sided accounting ledger as a fictitious customer deposit to balance the assets and liabilities. The bank pretends the borrower has deposited the money. And voila, we have a new money in the system. The money appears out of thin air since obviously it wasn’t transferred from anybody else. It appears because a loan was made!

This dynamic confers a new status on banks – they are special! Banks create the money supply. Unlike non-bank financial institutions, banks create money via credit creation. Bank credit and deposits are created simultaneously. Credit creation is a unique measure of money as it is injected into the economy and that measure can be disaggregated by the use the new money is put to. Banks decide who gets newly created money and for what purpose. Banks reshape the economic landscape through their loan decisions. Now we know why central banks conduct their “true” monetary policy by guiding bank credit. When new money is created by the central banks, it can either land in non-GDP transactions (which is Asset Markets like stocks/real estate) or in GDP transactions (Real Economy). The Real Economy is further subdivided into Consumption (consumer purchases) and Investment (productive purposes such as productivity enhancement, technology innovation, etc). Roughly, the formula looks like this

Δ CR = AM + I + C

Δ CR = new credit/new money

AM = Asset markets like stocks, bonds and real estate

I = Investment into products and services (supply side)

C = Consumer consumption (demand side)

Where the money lands in the economy is further guided by the legislative branch or Congress in what is called Fiscal Policy. Fiscal policy can redirect the money to Investment or to Consumption (consumers) via tax cuts, subsidies and other forms of stimulus. If Congress does NOT direct new money creation into the Real Economy, then all the money goes into Asset Markets like stocks and bonds and inflates their prices. Before the COVID pandemic in 2020, most of the new money creation in the economy via QE ended up exclusively in the asset markets because Republicans (in the Presidency, House or Senate) don’t believe in “picking winners and losers” in the economy and thus refrained from directing the flow of new credit coming from QE to Investment or Consumption. There is a particular reason GOP doesn’t like directing new credit to Consumption – inflation. Money that goes to consumer spending but not to investment results in more dollars chasing the same amount of goods and thus results in consumer price inflation which is unsustainable and not perceived to be good for society. On the other hand, if you direct money to Investment, you get more goods for a fixed amount of consumption and then you get deflation which GOP views as positive and contributing to real wealth (buying more stuff for the same amount of money). This is what has been going on pre 2020 and if you remember many libertarian Gold bugs argued in 2008 that QE will result in consumer price inflation and were proven to be dead wrong over the last decade. Inflation went nowhere for a decade. Why? Because new credit wasn’t directed to consumption. The only directing of credit were tax cuts which directs money to Investment which puts a lid on prices. So the Gold bugs were simply dead wrong. I mean you can’t possibly be any more wrong than that! Absent fiscal policy directing money specifically to Consumption, you simply can’t get consumer price increases at all. It just can’t happen.

During the COVID pandemic we saw a different paradigm emerge – some of the money went to the Consumer (pandemic UI, broad stimulus checks, etc) and some went into Investment (Pfizer vaccine production, military spending, etc). As a result we see CPI readings that are higher. But those higher CPI readings are going to be transitory because we are not printing $2000 checks for each family every few months. The new fiscal policy by the Biden administration is not THAT expansive. There was certainly an output gap to be filled last year and earlier this year. However, the Biden administration is not going abandon Consumption entirely – the child tax credit is a move in that direction to firm up consumption and thus inflationary readings. If there was any criticism of monetary policy in the 2010s is that it didn’t achieve the 2% inflation target that it set for itself. Why? Because all money went into Asset Markets and Investment. That in turn pushed interest rates lower which then gave the government a lower capacity to stimulate the economy without additional money printing in the case of a recessionary shock. The Fed does want inflation to be 2% and interest rates to 2% so that it can stimulate the economy with the least amount of money printing. By that standard, the 2010s were a debacle. Which is not surprising because that is the first time US politicians and government administrators were learning how the Quantity Theory of Disaggregated Credit works. But from what we have seen so far from the Biden administration, they are much better practitioners than the GOP policy makers that preceded them and that is encouraging.

What is one side effect that can go egregiously wrong under this model? Obviously, lack of Fiscal Policy to direct money to Investment and Consumption can result in all the new credit creation/new money going to the Asset Markets. When you have sustained broad bank credit growth exceeding nominal GDP consistently for a long time, you end up with a banking crisis. Too much of the money in the economy is trapped in the banking sector. That is what led to the banking crisis in Japan in 1990 and in the US in 2008 – mismanagement of bank credit creation. Now the question is why do bank crises keep happening if Central Bankers know all of this? The answer is “Revealed Preference”. Central bankers actually do want this to keep happening. Warner calls this “Central Bank Risk” or giving way too much power to central planners (like the Central Bankers) and not ensuring meaningful accountability. You could see this complete lack of accountability and dangerous hubris in 2019 when for absolutely no economic reason, Powell lowered interest rates from 2.75% to 0.5% and launched QE of $80 billion per month in September of 2019. That was done for nakedly political purposes to ensure that the economy is juiced up above its normal capacity ahead of the 2020 election and ensure that Republicans retain majority in the Senate and Trump gets reelected. We really just witnessed one of the worst Central Bank mismanagement in the history of the US. And Jay Powell was a chief actor in those decisions.

Warner calls this regulatory preference to generate crises “Regulatory Moral Hazard”. Bureaucrats create crises and then help defuse the crises and as a result they get rewarded with bigger regulatory powers by Congress. In effect, central bankers get rewarded for each crisis they create. As result, over the past 50 years Central Bankers have become more powerful than ever before. During that time period the amplitude and frequency of business cycles has increased. They actually are not business cycles anymore but credit creation boom/bust cycles. These are now recurring boom/bust cycles artificially created by banking crises of the central bankers own invention.

Over the past 20 years, Central Banks have used monetary and regulatory intervention to reduce the profitability of ordinary and small banks driving them out of business. Over 5000 small banks disappeared in the US and Europe for a total of 10,000 during this time. As a result credit creation has increasingly been centralized in a few big banks. Now via a central bank digital currency (CBDC), Central Banks want to enter into a competition with their private sector counterparts (JP Morgan, Bank of America, etc) which they regulate and start to control the credit creation process directly. A recent speech by Fed government Chris Waller addressed some of these issues brilliantly and you should read it. Such a move means that banks will be driven out of business entirely and will disappear.

The next banking crisis will finish the banks off and push all the credit creation into the hands of the Central Bank (the Fed). Werner doesn’t like that because this is what led to the decline of the Soviet Union. This new West banking model looks a lot like Soviet-style central monetary authority. Warner credits the demise of the Soviet Union and the ascent of China on the centralized and decentralized nature of their banking systems and resulting centralization/decentralization of credit creation. After the fall of the Soviet Union in 1990, China established thousands of regional banks and delegated credit creation to them. Warner credits the resurgence in the Chinese economy with this decentralized credit creation process and mourns the centralization happening in the West at present. He thinks that economic growth will go to zero if we adopt a centralized central bank model of money creation.

That is why central bankers prefer the “degrowth” narrative and claim that we need “zero growth” for environmental reasons. This is not true in reality because economic growth isn’t harmful to the environment since if you remember the start of this article – economic growth is simply a statistical illusion and entirely a monetary phenomenon. What is harmful to the environment are harmful activities and those need to be regulated directly instead of regulating the banks in an attempt to achieve that same result. Green economic activity instead can be a boom sector and can result in high economic growth – if banks are allowed to create money for this activity. Werner bemoans that Central Banks have propagated the abolition of cash in order to be able to enforce negative interest rates (withdrawals from your bank account) and have proposed universal basic income (UBI) to deal with large-scale unemployment by implementing a central bank digital currency (CBDC).

Ultimately, Werner tacks in the other direction entirely and favors a high level of decentralization of the banking system and of credit creation. He points out that countries with large amounts of banks also have healthier and recession-proof economies. He points out that Germany has the highest number of “industry champions” – companies that are in the top 3 of market share in their industry. Not coincidentally, Germany also has the highest number of banks by a factor of 3 or 4 over peers like United Kingdom, Spain, Italy or France. The propensity to lend to small companies is in small banks. Big banks don’t lend to small businesses. The fact that small banks lend to small businesses in a weaker economy tends to smooth out the boom/bust cycles. Werner points out that Germany’s highly decentralized banking system has resulted in smoother boom/bust cycles over the past 20 years. Germany has 70% of money creation generated by 1,500 community banks.

Werner proposes the following reforms to the banking system:

• Ban bank credit transactions that don’t contribute to GDP (asset transactions)
• Create a network of many small community banks which lend for productive purposes and return all gains back to the community creating real choice and options in banking.

Competition in banking is only ensured if large commercial banks are forced to compete against such community banks. This is partially what is happening with crypto right now where you have decentralized lending protocols like AAVE and KAVA put credit decisions in the hands of the public. Ultimately, you have to look at crypto industry as an industry whose goal is to decentralize credit and money supply creation back into the hands of the public and act to counterbalance the ongoing centralization of credit creation activity in the establishment (big banks and central banks).