The property boom has become almost a cliché of an example that economic growth doesn’t benefit everyone equally.

It has increased wealth for those who already own a home, but has driven up the cost of living for those who have not yet bought a house or are struggling to buy one. Some people may be lucky enough to inherit a house from their parents, but most people will resort to getting a loan from a commercial bank.

The number of loans being generated by banks and pumped into the property market plays an important role in the Maltese economy – yet it has been largely ignored in public discourse, which could have detrimental effects in the future.

The two largest financial crises in the last 100 years – the Great Depression and the Great Recession – both occurred due to a lack of understanding of the role of banks in the economy. In both cases, banks created billions of dollars by approving new loans and channelling them into assets, such as stocks and property.

This was because the economy had been booming for many years and these assets were considered profitable. Obviously, the boom did not last forever, and eventually thousands of people lost their homes and wealth due to the speculative behaviour of bankers and businesses.

Crises like these are not only rooted in speculation but also in a misunderstanding around the way banks work. In the UK, a poll conducted by research agency ICM showed that 74 per cent of people think that they are the legal owner of the money in their account, when in reality it is the bank that legally owns this money.

The idea that banks store your money safely in an account is one of the most common misconceptions surrounding banking.

The numbers in a bank account are a record that the bank needs to repay you at some point in the future, meaning that your bank balance doesn’t actually represent the money that the bank is holding on your behalf. 

Another misconception is that banks take money from savers and lend it out to borrowers. This implies that if no one wants to save money, then no one would be able to borrow, and, in general, saving money is beneficial for a country so that more money will be available for business and investment.

The two largest financial crises in the last 100 years both occurred due to a lack of understanding of the role of banks in the economy

So, the amount of investment in the economy depends on the general propensity to save. This is the primary way banking is taught in most university economics courses but this theory fails on two accounts.

Firstly, banks create new money whenever they issue a new loan and, as a result, do not need deposits in the first place.

Secondly, this approach infers that what is good for the individual is good for the group. If one person saves it is good for the individual, however, if everyone decides to save more, less goods and services are purchased, which decreases spending in the economy and will result in lower demand in the economy, meaning fewer jobs.

The final misconception is that of the money multiplier approach.

This theory holds that for every deposit put into a bank, that bank can lend out that money but must save a small amount of that deposit as a reserve.

For example, if a person places €100 into their bank account, and the bank must save 10 per cent of that deposit as a reserve, the bank can lend out €90 from that deposit and keep the remaining €10.

The problem here is that it implies that banks first require people to deposit money before it can give out loans, which is wrong.

So, how do banks really work?

Banks individually create money ‘out of nothing’ by granting a loan.

By granting a loan the individual bank extends its balance sheet by creating simultaneously a loan (asset) and a deposit (liability).

Once a loan is repaid, that money is destroyed again. As such, money creation is neither constrained by savings nor by reserves, but rather by demand for loans as well as by profitability and solvency considerations of the banks.

What is scarce is not money or deposits, but ‘good’ borrowers.

Banks are pivotal to the functioning of the economy but are profoundly misunderstood, both by the public and leading economists – and this has major consequences for our economy.

For example, at the University of Malta, teaching about banks in the economics course is restricted to the money multiplier approach.

In turn, the current and future generations of Maltese graduates and economists view banking in terms of this flawed approach.

As we saw earlier, banks played a major role in the last major financial crisis. Models that incorporated private debt and the credit creation theory predicted the crisis, yet mainstream models failed to do so.

It is crucial that the approach outlined above is taught at University not only to reflect real-life practices but also in order for economists to predict future financial crises in Malta.

Matthew Attard is a co-founder of Rethinking Economics Malta.

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