Monday, December 22, 2014

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.

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.


  1. Replies
    1. Yes, I missed that! He distances himself from "endogenous credit supply" theory of Post Keynesians.

      He also gave a talk at the Post Keynesian Economics Study Group in 2012 or 2013 on this "Quantity Theory of Credit ":

  2. FYI, Werner isn't a neoclassical. He, Skidelsky, and I were speakers together at an event in 2009 in Switzerland.

    He knows all about PKE--Moore, Lavoie, Wray, etc., etc.

    He "gets" banking, obviously, but we had significant disagreements on the operational details of fiscal policy.

    Very nice guy.

    Scott Fullwiler

  3. We could say that this endogenous money question (who's first, who's not) does not serve R. Werner. But I like the guy, his Quantitative Theory of Credit is a good synthesis equation for working on speculative credit. And he is the father of QE, and dam good expert on Japanese monetary policies.

  4. His "empirical" test seems a little bonkers and likely to resolve nothing. He seems to misunderstand how bank reserves function. I don't think anyone believes that banks draw down reserves to make a loan. That doesn't mean that banks aren't, at least some of the time, constrained by their level of reserves in making loans. It's a regulatory requirement, not an accounting requirement.

  5. This is technically correct but practically irrelevant. The bank will still need to debit its reserves and bring its reserves into line with regulations by the end of the day that the borrower spends the money, which he's obviously going to do or else he wouldn't have borrowed it. In effect all the bank has done here is create a credit line. The bank hasn't yet actually lent out any funds, as it hasn't yet delivered any currency or reserves to the borrower or to another bank.

    1. The bank will use reserves to clear its obligations with other banks/financial institutions, but most money in our modern monetary system consists of the "bank money"/credit money of demand deposits and demand deposit-like accounts, which is largely created by new loans.

      Since central banks generally meet the demand for new reserves from the banking system, our monetary system is endogenous and money supply largely demand-determined.

      " In effect all the bank has done here is create a credit line. "

      ...which constitutes **new** broad money.

      "The bank hasn't yet actually lent out any funds, as it hasn't yet delivered any currency or reserves to the borrower or to another bank."

      The bank does not "lend" reserves: it uses reserves (high-powered money) to clear its obligations with other banks or vault cash/ATM cash to clear to obligations to its demand depositors, including people it has made loans to by setting up new demand deposits.

    2. Tom, you could say the bank has lent funds and then immediately borrowed them back, by issuing a deposit instead of cash.

  6. It is incorrect to put the focus solely on deposits in this way, and then conclude that "banks create deposits out of nothing". It is entirely misleading phrase. Deposits are not money in isolation, deposits are accounting entries used by banks to identify the beneficiaries of its assets. There are two sides to a T account. The actual source of value in the banking system is the assets, the loan contracts, and those are created not by the banks ,but by the banks customers. Its is significant that the paper concludes that banks create money out of nothing while the same paper totally ignores that the experiment included a pledge to that bank which is then ignored as if it was of no value.
    If it was a real life transaction then after the deposit was spent the borrower would sell something, valued to deposit holders, to honour the loan contract.

    1. That the borrower must promise to repay an equivalent amount of money in his newly created demand deposit account does not refute the truth that most money is "bank money"/credit money in the form of demand deposits and demand deposit-like accounts, which are created by the banks in response to demand for them.

      Anytime people use debit cards or EFTPOS to pay for goods and services they are clearly using bank money to effect real transactions.

      The fact that the bank has to clear with other banks using high powered money does not refute this truth either.

    2. I agree the banking credit system working with customers does create transferable deposits endogenously However deposits are not money in there own write. They only exist as half of a T account, and the value part of a T account is created not by banks but by their customers.

  7. The key point that everybody misses in this debate is that the fractional system and intermediation system both introduce a serialisation requirement into the banking system.

    As a systems specialist I spend a lot of my time *removing* serialisations from business processes because that allows things to operate in parallel in different departments. It is much more efficient to operate in that manner.

    Banks are always fully funded and they maintain their deposits sufficient to cover their loans. But, importantly, they don't do that in any particular order. The lending and treasury functions are asynchronous and operate via a slush buffer and a price determination.

    Since lending takes longer than obtaining deposits, treasury have information about roughly how much funding they need at any particular point in time via the normal sales pipeline information that demonstrates how many loan requests generally turn into loans advanced.

    And that's before you take into account the fact that time deposits do not stop anybody spending anyway. I still have an asset - wealth. And I know when it matures. Therefore I can alter the expectations of people selling things by making enquiries and purchase orders to *settle* at the maturity date.

    Somebody who is deprived of assets via taxation (say) cannot do that with certainty.

    The whole concept of there being any restriction in the system is flawed at the most basic of levels.

  8. The paper totally misunderstands Tobin. Tobin's intermediation theory is a theory of endogenous money.

    Sure mainstream models use "intermediation" as an excuse to ignore finance, but this is not what tobin was doing in his important banking papers.

    (he did have some papers with models that just ignored finance if I remember right. The two papers to read by him on banking are "Commercial Banks as Creators of “Money”" and "The Commercial Banking Firm: A Simple Model").

    What Tobin was arguing against was the ability of banks to create infinite amount of money. This should be obvious, since banks are capitilist firms that have balance sheet constraints. This is very similar to Minsky and should not be controversial to post Keynsians.

    Lots of hetrodox people seem to have a this idea that bank deposits are somehow the true form of money. I think this is because they are still holding onto vague notions of commodity money and the quantity theory. To really embrace endogenous money, you need to abandon the idea that banks are special.

  9. On Keynes & Endo, I don't think Werner has Keynes or Schumpeter (on Keynes) right. Cf. p32 of Geoffrey Harcourt's On Skidelsky’s Keynes and Other Essays, citing Sheila Dow's "Endogenous Money" in Harcourt & Riach's A ‘Second Edition’ of the General Theory Volume 2, which goes into much more detail.

    "A plausible case can be made that Keynes was always an endogenous money person. Opinions to the contrary are over-influenced by the dominance of The General Theory in people’s knowledge of Keynes and by not realising that for his purposes there, it was sensible to take the supply of money as a ‘given’, not exogenous, only that its determination was put to one side because of the stage of the economic process from which it was most suitable to start analysis of his central, new issue "