Who Knew!? Banks Create Money out of Nothing

This recent paper by Richard A. Werner should be of interest to Post Keynesians:

Richard A. Werner, “Can Banks individually create Money out of Nothing? — The Theories and the Empirical Evidence,” International Review of Financial Analysis 36 (2014): 1–19.

From the abstract:

“This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). … This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, ‘out of thin air.’”

I do not mean to be snide or devalue this paper, which I suppose must be seen as a sign of progress in mainstream economics, but surely many economists and historians who have paid attention to the nature and history of modern banking already know that the empirical evidence demonstrates that banks create money out of nothing.

I also feel that plenty of economists with a “fractional reserve theory of banking” also recognise that banks create money from nothing too and are therefore also advocates of the “credit creation theory” of banking.

Despite that, this is an excellent paper, especially its comments on the need for better financial regulation and the inadequacy of the Basel regulations (Werner 2014: 2, 17–18). Werner provides a really useful literature review of the supporters of the “credit creation theory” of banking and their writings (Werner 2014: 2–6).

He lists Knut Wicksell, Henry Dunning Macleod, Hartley Withers, Schumpeter, Robert H. Howe, Ralph Hawtrey, Albert L. Hahn, and Keynes (at least in the Tract on Monetary Reform [1923]) as leading advocates of the “credit creation”/endogenous money theory of banking, and how this view even seemed to be widespread by the 1920s (Werner 2014: 6).

Werner also notes how the correct “credit creation theory” was displaced from the 1930s–1960s by advocates of a “fractional reserve theory of banking” that denied that individual banks can create money, even if the banking system in the aggregate does (Werner 2014: 7).

Paradoxically, Keynes by the time of the Treatise on Money seems to have endorsed the “fractional reserve theory” and, worse still, in the General Theory the financial intermediation theory (Werner 2014: 7, 9), a point which was noted with dismay by Schumpeter (Werner 2014: 9). One of the most interesting aspects of Werner’ paper is how Keynes’ regression to the “financial intermediation” theory of banking in the General Theory had a terribly bad influence on neoclassical synthesis Keynesianism and modern mainstream neoclassical economics, which owing in part to Keynes and the work of James Tobin and others has reverted to the “financial intermediation” theory (Werner 2014: 9–10).

This has been a stark and embarrassing regression in knowledge by mainstream economics, and Werner is absolutely right to complain that “since the 1930s, economists have moved further and further away from the truth, instead of coming closer to it” (Werner 2014: 16).

But, strangely, on p. 11 of the article Werner seems to be saying that “Post-Keynesians” also endorse the “financial intermediation” theory of banking (Werner 2014: 11), which is a most bizarre error.

The important empirical evidence that Werner provides was his personal borrowing of €200,000 from the Raiffeisenbank Wildenberg e.G. bank (in a town of Lower Bavaria) in August 2013, and the bank’s disclosure of how this occurred in accordance with its standard internal credit procedure, accounting practices, balance sheet and IT procedure (Werner 2014: 13–14). The bank did not borrow extra reserves or obtain new “deposits” before it made the loan, and its reserves remained fixed at €350,000 both immediately before and after the loan transaction (Werner 2014: 14). The daily account statements of the bank, obtained by Werner, demonstrate that its accounting activities and balance sheet contradict both the “fractional reserve theory of banking” and “financial intermediation” theory (Werner 2014: 14–15).

This is Werner’s (somewhat rhetorical?) conclusion:

“Thus it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air.” (Werner 2014: 16).

I suppose Post Keynesians should be very pleased indeed with this conclusion, but will be dismayed by the (as far as I can see) total lack in Werner’s article of any reference to their work on banking and endogenous money which already reached this conclusion decades ago.

One final point can be made about Keynes: most probably Werner is right that Keynes’ exogenous money approach in the General Theory of Employment, Interest, and Money (1936) has had a pernicious effect on the modern theory of banking, but, as far as I know, Keynes reverted to the endogenous money theory in his article “Alternative Theories of the Rate of Interest” (1937: 247, 248), where he stressed the finance motive as a basis of endogenous money. Perhaps the trouble is also that many economists have not bothered to read what Keynes wrote after the General Theory.

BIBLIOGRAPHY
Keynes, J. M. 1937. “Alternative Theories of the Rate of Interest,” The Economic Journal 47.186: 241–252

Werner, Richard A. 2014. “Can Banks individually create Money out of Nothing? — The Theories and the Empirical Evidence,” International Review of Financial Analysis 36: 1–19.

Mutuum versus Bailment in Banking

From an early 19th century treatise on bailment law:

“In ordinary cases of deposits of money with banking corporations, or bankers, the transaction amounts to a mere loan or mutuum, and the bank is to restore, not the same money, but an equivalent sum, whenever it is demanded. But persons are sometimes in the habit of making, what is called, a special deposit of money or bills in a bank, where the specific money, as silver or gold coin, or bills, are to be restored, and not an equivalent. In such cases the transaction is a genuine deposit; and the banking company has no authority to use the money so deposited, but is bound to return it in individuo to the party.” (Story 1832: 66).

The two legal contracts here are as follows:

(1) mutuum (sometimes called faenus/fenus when interest was part of the contract [Buckland 1925: 273]) or loan for consumption, in which ownership of the thing lent is transferred from creditor to debtor, and only something of the same quality, type and quantity is repaid.

(2) depositum regulare or bailment (and also called special deposit), in which a person retains ownership of the thing given to another person for safekeeping.

These legal concepts go right back to ancient Roman law and were known in the Middle Ages.

Fractional reserve banking normally involves the mutuum contract (and a variant on the mutuum called the “irregular deposit” or depositum irregulare) and, when banking on fractional reserves became important in medieval and early modern Europe, this was the primary contract used between bankers and their clients, not that of bailment (even though no doubt such bailment contracts were made too).

This is confirmed by the evidence of some of the earliest British goldsmiths’ notes.

These must be understood as IOUs or negotiable credit/debt instruments payable on demand (though sometimes with receipt of the initial amount left with the banker), with the statement “I promise to repay upon demand ...,” which explicitly demonstrates to us that these were IOUs or debt records, not certificates of bailment (Selgin 2011: 11).

An early example of a goldsmiths note is one issued by the London banker Feild Whorwood in 1654. This is both a receipt for the sum delivered to the banker (but not a certificate of bailment) and, without any doubt, a promissory note:

“Recd [i.e., received], ye [the] 16th [December] 1654 of Sam Tofte the some [sum] of Twenty five pounds w[hi]ch I promise to repay upon Demand I say R[eceived]
P[er] me*
Feild Whorwood
interest of both £2-05-0.” (Melton 1986: 101).

* = by me.

The nature of the contract entered into by Sam Tofte (the holder of the bank account) and the banker Feild Whorwood is made perfectly clear to us by the words of the banker: “I promise to repay upon Demand ....”

This was a receipt of money to the banker given by Sam Tofte as a loan or mutuum, and one re-payable on demand, with interest. It was no bailment contract.

The idea that the earliest goldsmiths were only engaged in bailment and that fractional reserve banking simply arose by fraud is not supported by the historical evidence.

BIBLIOGRAPHY
Buckland, W. W. 1925. A Manual of Roman Private Law. Cambridge University Press, Cambridge.

Melton, Frank T. 1986. Sir Robert Clayton and the Origins of English Deposit Banking, 1658–1685. Cambridge University Press, Cambridge.

Selgin, G. “Those Dishonest Goldsmiths,” revised January 20, 2011
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709

Story, Joseph. 1832. Commentaries on the Law of Bailments, with Illustrations from the Civil and the Foreign Law. Hilliard and Brown, Cambridge.

Richard Werner on “The Quantity Theory of Credit”

An interesting talk here by Richard Werner on the “The Quantity Theory of Credit” at the Post Keynesian Economics Study Group, including a critique of the quantity theory, the nature of banks and money and credit creation:

Richard Werner, “The Quantity Theory of Credit,” 30 October.

One has to scroll down in the link to the 6th talk to listen to the MP3 and see the slides.

Towards the end of the talk, there are some inventive solutions to the Eurozone crisis. Also, Victoria Chick points to this discussion of the nature of money here.

The critical discussion that follows is also insightful.