Money as fairy dust

Posted: 26 December 2014 in Uncategorized

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The most common theory of the role of banks, to judge by what my students have been taught, is financial intermediation. The idea is that banks collect the savings of many individuals and then, after keeping some of the money in reserve (to satisfy demands for withdrawals), make loans to socially useful projects. On this view, there is little difference between banks and other, nonbank financial institutions, mostly due to specific government regulations on banks (such as reserve requirements). This view serves to justify both the existence of commercial banks as financial intermediaries (between small savers and large investors) and the failure to explicitly include banks in constructing mainstream models of the macroeconomy.

We saw the consequences of both in the spectacular crash of the financial system in 2008. And we’ve been living with the consequences ever since.

So, we need to go back to square one: do banks create money?

That’s where Richard A. Werner [ht: magpie] steps in. In a recent article, he presents a very useful review of the relevant literature since the early twentieth century—which involves, in a more or less historical progression, three different theories: the fractional reserve theory of banking (according to which banks can collectively create money based on the fractional reserve or “money multiplier” model), financial intermediation (the dominant view since the late 1960s), and credit creation (according to which each individual bank is not a financial intermediary that passes on deposits or reserves from the central bank in its lending, but instead creates the entire loan amount out of nothing).

Werner then reports on his empirical “test” of the three theories. His design was to examine a bank’s internal accounting during the process of granting a bank loan.

The key question is whether as a prerequisite of this accounting operation of booking the borrower’s loan principal into their bank account the bank actually withdraws this amount from another account, resulting in a reduction of equal value in the balance of another entity—either drawing down reserves (as the fractional reserve theory maintains) or other funds (as the financial intermediation theory maintains). Should it be found that the bank is able to credit the borrower’s account with the loan principal without having withdrawn money from any other internal or external account, or without transferring the money from any other source internally or externally, this would constitute prima facie evidence that the bank was able to create the loan principal out of nothing. In that case, the credit creation theory would be supported and the theory that the individual bank acts as an intermediary that needs to obtain savings or funds first, before being able to extend credit (whether in conformity with the fractional reserve theory or the financial intermediation theory), would be rejected.

Which is exactly what Werner found: the bank newly “invented” funds by making a loan and then crediting the borrower’s account with a deposit, although no such deposit had taken place. In other words, in a confirmation of credit-creation theory, the bank created money out of nothing.

Just like fairy dust.

Comments
  1. BRF says:

    great post…this is the kernel of economic truth that needs to be spread far and wide until every citizen knows how our monetary system works along with the other corollary that those who lend at interest must eventually own the entire planet.

  2. BRF says:

    P.S. Nice “greenbacks” or government issued debt free money pictured here.

  3. […] be the case but Hutton gets the order wrong: it’s bank credit that creates deposits (like fairy dust), not the collection of deposits that serve as the basis for the expansion of […]

  4. […] may be the case but Hutton gets the order wrong: it’s bank credit that creates deposits (like fairy dust), not the collection of deposits that serve as the basis for the expansion of […]

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