Guest Post: If Credit is Not Created Out of Excess Reserves, What Does That Mean?

By George Washington of  Washington’s Blog.

We’ve all been taught that banks first build up deposits, and then extend credit and loan out their excess reserves.

But critics of the current banking system claim that this is not true, and that the order is actually reversed.

Sounds crazy, right?


But as PhD economist Steve Keen pointed out last week, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

And as Edward Harrison writes:

Central to [Keen’s] ideas is the concept that demand for credit creates loans which create reserves, which is the opposite causality of what one sees in neoclassical economics.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
– 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
– Economist John Kenneth Galbraith

[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.
– Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.
– Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.
– Graham Towers, Governor of the Bank of Canada from 1935 to 1955

Indeed, some critics of the current banking system – like Ellen Brown – claim that the entire credit-creation system is an accounting sleight-of-hand, and that banks simply enter into loan agreements, and then obtain the reserves later from the Fed or in the open market. In other words, they claim that banks extend money first, and then increase their reserves on their books later to cover the loans.

So What Does It Mean?

So what does it mean that loans and debt are created first, and then reserves and credit come later?

There are several results.

First, it makes it less likely than most people think that the giant banks will increase the amount of money they’re loaning out to individuals and small businesses. Specifically, since loans are made before new infusions of government cash (Kydland and Prescott), there is not a simple cause-and-effect relationship. So the bailouts to the banks will not necessarily encourage them to make more loans. Indeed, the heads of the big banks have themselves said that they won’t really increase such loans until the economy fundamentally stabilizes (no matter how much money the government gives them).

As Mish writes today:

A funny thing happened to the inflation theory: Banks aren’t lending and proof can be found in excess reserves at member banks.

Excess Reserves

In practice, banks lend money and reserves come later. When defaults pile up, the Fed prints reserves to cover bank losses. Thus, those “excess reserves” aren’t going anywhere. They are needed to cover losses. It’s best to think of those reserves as a mirage. They don’t really exist.

Second, if banks won’t increase their lending in response to government funds, then that argues against inflation and for continuing stagnation in the economy.

Is This Method of Credit-Creation Unsustainable?

Going beyond what most economists believe or will publicly discuss (and going beyond what I have any background or inside information to confirm) – monetary reformers like Ellen Brown argue that the entire banking system is based upon a fraud. Specifically, she and other monetary reformers argue that the banks have intentionally spread the false reserves-and-credit first, loans-and-debt later story to confuse people into thinking that the banks are better capitalized than they really are and that the Federal Reserve is keeping better oversight than it really is.

Moreover, many monetary reformers argue that the truth of loans-before-reserves is hidden in order to obscure the alleged fact that the entire financial system is built on nothing but air. Specifically, Brown argues that unless more and more debt is continually created, since money creation follows debt creation, what we think of as the money supply will shrink, and the economy will crash. In other words, they say that we a massive, ever-expanding debt bubble has been blown for many decades, and that the myth that banks make loans out of their excess reserves helps to fuel the bubble.

Some evidence for that argument comes from a September 30, 1941 hearing in the House Committee on Banking and Currency, where the then-Chairman of the Federal Reserve (Mariner S. Eccles) said:

That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

Monetary reformers argue that the government should take the power of money creation back from the private banks and the Federal Reserve system.

Do the monetary reformers go too far? If so, what should the reality of the way credit is created mean for us and the stability of the economy?

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  1. George Washington Post author

    As always, thanks to Yves for letting me guest blog. If anything in this essay is considered over-the-top, inaccurate, flakey or otherwise distasteful, the responsibility is entirely mine, and not Yves’.

  2. Peter T

    The essay is not over the top, but there seems to be little experience in history of a modern economic system where the banks cannot create money. After all, this was the way the British conquered their empire, and everybody followed their successful example. It is scary to base our economy on an untested money system, even if its fairer (the government sets the money by FIAT, so the government, that is all, should reap the benefit, not the bankers).

    1. joebhed

      It was scary for Abe Lincoln, too.
      But Greenbacks worked perfectly for the country.
      Though not too well for Abe in the end.
      The Chicago Plan for Monetary Reform laid it all out.
      As you said, it was the Brits making the Colonies’ own money system illegal that was a primary cause for our Declaration of Independence.
      If the Colonies could do it, why can’t this country?
      Admitting, it’s scary, but somebody should be working on the exit-strategy from the banksters’ debt-money system.
      Sooner than later.

  3. mikkel

    “Moreover, many monetary reformers argue that the truth of loans-before-reserves is hidden in order to obscure the alleged fact that the entire financial system is built on nothing but air. Specifically, Brown argues that unless more and more debt is continually created, since money creation follows debt creation, what we think of as the money supply will shrink, and the economy will crash. In other words, they say that we a massive, ever-expanding debt bubble has been blown for many decades, and that the myth that banks make loans out of their excess reserves helps to fuel the bubble.”

    While true, I don’t think that this is really the take home message. I mean that is the case in any capitalist monetary system, even though hard money enthusiasts claim it’s only a property of fiat systems (which while true in aggregate is not true for individual industries…which is why there have always been bubbles and crashes).

    The corollary is that consumption, which means resource utilization, must continue to rise exponentially until it is not supported by either the human made constructs or the environment. Of course this is Marxist critique of capitalism 101.

    Cynically speaking, it is an observation that has no solution. Yes it appears that banks are the tail that wag the dog, but would it matter the other way around? There will still be political favoritism and pressure to have policies that lead to massive debt bubbles which then reach their Minksy moment and collapse. This will be true as long as debt and interest exists..but societies with no interest and little debt see economic stagnation and “wealth” inequality at even higher levels. The problem isn’t with the models, it’s that people are people.

    However I would argue that this empirical evidence basically destroys the root of monetarism.

  4. OrganicGeorge

    I grew up in a small town where everybody knew each other. One day, in the 1960’s I was having lunch with the local banker when he said he was going to grow the bank so he could sell it off to a regional bank and that he needed to make more loans to attract their attention.

    I asked him where he was going to get more deposits from our small community. “I just need to make the loans” he said “deposits are a facade, loans grow the bank”

    A year later he sold the bank at a premium without increasing the deposit base.

    Theory; meet application.

  5. Burk

    Hey, people, thanks for the economics 101. The emergency money being sent to the banks was to prevent a bank run and financial crisis by giving them a backstop and everyone else confidence. Simple as that.

    What loan officers do have to look at (at least until the advent of leveraged “investment” banking) was the reserve requirement for their loan base. The Fed sets their reserve requirement (say, 10%), and banks are not allowed to lend more than a multiple of that amount. That is what restricts lending. If a bank has more deposits than its reserve requirement, then fine and dandy. But it doesn’t need more, and of course doesn’t want more if it is not making money on the depositor spread. But banks have to have some deposits in order to make loans. Otherwise you would have banks that make loans and have no deposits, but we don’t.

  6. David Merkel

    This agrees with my theory that there should be a total leverage limit on the economy — I have some ideas on how to enforce such a limit, but none strike me as practical without a willingness for radical change.

  7. Jesse

    If Credit is Not Created Out of Excess Reserves, What Does That Mean?

    Not a whole lot actually.

    Banks balance their books. They have a series of complex transactions, but at the end of the day they balance the books and meet their requirments for reserves.

    They meet those reserves in a variety of ways, some of which have changed over time as banking has changed. A significant innovation was the ‘sweeps’ programs initiated in the mid 1990’s.

    As someone has pointed out before on this blog, banks do not control the level of excess reserves. It is a function of the Fed’s balance sheet.

    But, it is true that banks are not lending. Bank credit has fallen through the floor.

    I show a chart of this, and try to deal with it in a blog entry today, coincidentally enough.

    The notion that the Fed cannot create money, cannot monetize debt, is obviously disproved. The only limitation on the Fed’s ability to monetize debt is the value of the dollar and the bond, and I would expect the dollar to fail first since the Fed will do all that it can to support the bond.

    The banks will lend when the risk reward swings in their favor, and they have balance sheets that are sufficiently stable to allow them to lend.

    Why will they do this? Why do you breathe? It is how banks survive.

    The Fed is paying interest on reserves for a purpose. It is not meaningless.

  8. mannfm11

    yves, George and others. I have contended this for years, having written about deflationary forces since 2001 around the net. It is quite interesting how widespread your comments have been, having found them on Mish’s site, this site and Steve’s site. It is hard for people to understand that banks create the money and we deposit it back into the bank. The credit crunch was actually that Citi and a few others made so many loans that they couldn’t get the deposits back. The explanation was that banks wouldn’t lend to each other, when in fact the banking world knew Citi was and probably still is broke.

    The strange thing is tha money and banking and some economics courses come right out and say banks create deposits by making loans, then they get into this reserves nonsense, like it has to come first. Truth is the banks never have needed the reserves since the FDIC put up the smoke screen of delusion of insurance. Truth is that the only money in the world that can pay the claims of the FDIC is in the accounts it insures. But, even when there was a need for reserves, they were only needed after the loan base had been expanded to the point that it would need more reserves. Banks don’t exactly fall over themselves to get reserves from the Fed because it entails giving up interest bearing treasuries for non-interest bearing cash.

    The more you learn about lending, usuary and debt in general, the more you understand why it was the money changers that Jesus attacked and why Moses prohibited the charging if interest. Also, the book of Genesis explains that debt to Pharoah was the basis of bondage in Egypt.

  9. Phillip Huggan

    “Hey, people, thanks for the economics 101. The emergency money being sent to the banks was to prevent a bank run and financial crisis by giving them a backstop and everyone else confidence. Simple as that.”

    FDIC insurance prevents bank runs. B.Clinton, Greenspan and GWB killed the laws against roulette, not FDIC insurance. This was a jack to prevent rich people from losing bond portfolios, at least for now. Banks were 40% of all USA profits then and probably are still there. Next time around, next week, next decade, you still won’t know how to run a Crown bank (one single example would’ve been priceless) and you certainly won’t have 0% interest rates to give to your wealthiest citizens. Oh well, done is done.

    1. Phillip Huggan

      …I define a Crown bank as pay limits. Solvent after initial capitalization (no bailouts ever). Firing all dummies. Only trading vehicles the majority of execs/board understand. That’s all. Can mimic private portfolios or can target public goods (employment, energy, pollution, whatever)disproportionately in loans. Maybe subject to anti-trust if too big to fail.
      Just one of them would’ve provided a model for the USA economy what to do if bankers screw things up again and the world isn’t there to permit 0% interest rates.

  10. Reino Ruusu

    Reserves are not controlled by the central bank just as long as interest rates are the policy target instead of the total quantity of base money. Interest rate targeting guarantees that new reserves are “automatically” created, as interest rates would rise sharply if the banking system would run out of reserves.

    This is not necessarily a problem in itself. There are even worse problems associated with direct targeting of base money. Maybe a hybrid system would be better. A little less certainty in the stability of interest rates would induce a bit of caution into excessive risk taking.

    A bigger problem is the relative quantity of credit in the system. This is mainly affected by the cash reserve requirement ratio.

    If the reserve requirement ratio would be higher, the quantity of deposits would be higher relative to the quantity of outstanding credit, as each dollar of credit would result in more dollars of base money. As the reserve requirements have dropped since the 1970’s, so has the ratio of deposits to credit.

    Cash reserve requirements also have an effect on the cost of credit creation. If there are no reserves, banks (in aggregate) have no cost in creating deposits, except the opportunity cost, as the existing asset base is untouched. This results in banks making ever more marginally profitable investments with ever more leverage, until there are no real opportunities left.

    Reserve requirements force banks to give up interest-bearing assets for creating credit. This puts a lower limit on the expected profitability of new credit.

    All this has happened in the name of efficiency, which is not a bad thing in itself. Unfortunately there is such a thing as too much efficiency. It is called over-optimization, and can result in catastrophic failure. Tune the engine too much, and it blows. Just ask anybody who has been involved with drag racing.

    Here’s a hypothesis: In any system, there is always a trade-off between safety and efficiency.

  11. joebhed

    I have spent a bit of time on NC trying to get the attention of Yves and her learned following to the core issue that is being raised here by the likes of Washington, Keen, Mish, Ellen Brown, Ed Harrison and others, who are kicking the tires of Nassim Taleb’s more recent revelation having to with something called debt.

    Noted Fed economist and author of The Chicago Plan for Monetary Reform legislative proposals, Mr. Robert Hemphill, laid out the problem that we are all discussing in the most clear and succinct manner in his discussion of the need for “a permanent money system”.

    Hang on folks, there should be no surprise here that it is NOT fractional-reserve banking using the debt-money system. That is the opposite of a permanent money system – by design.

    I discuss why we NEED a permanent money system with my Kettle Pond compatriot Peter Young in this brief Utube episode.

    Follow Robert Hemphill’s quote, and you can see the folly of Stimulus II – the task at hand is understanding the task at hand.

    ” This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system.

    If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation.

    When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.” -Robert Hemphill

  12. Ingolf

    As Jesse and Burk suggest, reality lies somewhere between the conventional view of banking (and credit creation) and the view put forward in this post and many of the comments.

    Banks can certainly create new credit, but only within the bounds of their ability to satisfy their obligations to the banking system when borrowers draw down and spend the credit granted. In part, in a fiat fractional reserve system, this depends on whatever reserve requirements are imposed. One (but only one) of the reasons why credit has been able to expand so greatly in recent decades is because those requirements became almost derisory.

    So yes, I think Keen’s right in saying central bank money creation tends to follow (and thereby effectively validate) credit creation that has already occurred, but without that validation the growth would soon have come to an end.

    Jesse’s point that “excess reserves” are almost entirely under the control of the central bank seems to me an important one. Individual banks can try to get rid of their excess reserves, but the banking system as a whole can’t. Nor do excess reserves in themselves say much about whether banks are lending or not. All that the current extreme level of these reserves means is that, if banks were so inclined, they would be able to vastly expand their lending before running up against reserve requirement issues. Right now, they’re clearly not so inclined, with bank credit actually shrinking. (The NY Fed put out a useful study on this whole question of excess reserves).

    P.S. I’ve just been over and read Jesse’s post “Confessions of a ‘ Flationary Agnostic”. Definitely worth a visit.

  13. Charles

    When I started ny banking career in a small town branch of a French Bank, the first thing I learned from the branch manager was that “les credits font les depots” (Credits make deposits). And that was not presented as crazy cutting edge economic theory, but rather as classic banking wisdom !

  14. Siggy

    I thought that everyone understood that loans preceed deposits. I am better informed now to understand that many did not apprehend this fact.

    Our current economic problem is many faceted and dynamic. At its core, however, it is a problem of excess credit money. Loans that have been made to parties who are incapable of servicing the debt. This group includes sub-prime borrowers and the securitized loan pools that are at the effect of defaulting borrowers.

    The magnitude of the unserviceable debt is difficult to apprehend. The social dysfunction imbedded in this debt is the stuff of revolutions. There is no easy nor palatable resolution before us. The hard answer is that our fiat currency, fractional reserve system was a failure the day it was initiated.

    It’s not that the level of required reserves is too low, its that the loans that created the deposits that were the basis of the ‘loanable funds’ were made to parties who lacked the capacity to repay. In a way, easy credit is its own poison pill. Now fiat currency, that is a subtle problem. When created, it causes limited harm. Over time its effect is minimally noticed. There is inflation or perhaps more properly the persistent, albeit gradual, loss of purchasing power.

    Our central bank, the Federal Reserve is a government chartered oligopoloy. The Federal Charter that grants their existance should be examined. I say dispense with interest rate targets, dispense with employment targets; instead, focus on the one thing that will have lasting effect and restore health to the banking system. The charge of the Federal Reserve should be to preserve the purchasing power of the dollar.

  15. john c. halasz

    “There is inflation or perhaps more properly the persistent, albeit gradual, loss of purchasing power.”

    Hey, bud! There’s a reason it’s called “currency”.

    “The charge of the Federal Reserve should be to preserve the purchasing power of the dollar.”

    You mean the “strong dollar” policy, so beloved of Wall St. and the MNCs, which got us into this mess?

  16. David Pearson

    Loans precede deposits, and excess reserves exist because banks don’t want to lend them out; but this does not mean the Fed is powerless over the money supply.

    The Fed, by raising inflation expectations, can generate demand for loans. The demand comes from a simple fact: when faced with inflation, actors want to borrow and spend today, and pay back tomorrow in cheaper dollars. So, if the Fed so chose, it could promise 5% inflation for the next five years, and the excess reserves would doubtless be lent out.

    Of course, deflationists would argue the Fed’s inflation promise would hold no water — it would simply be ignored, because the Fed has no credibility when it comes to producing that inflation. They would further argue that the lengths the Fed would have to go to to prove otherwise would tip us into hyperinflation, and the Fed would never do that. These are valid points, but they underestimate both the Fed’s credibility and the willingness of speculators to generate loan demand. The latter dynamic is commonly referred to as the “carry trade”, and it is already underway at a good clip. If the Fed, for instance, promised zero interest rates for five years, its entirely possible the carry trade alone would generate enough dollar devaluation (against other currencies and commodities) to produce inflation.

    So deflationists are right: excess reserves are a function of loan demand. They are wrong in that the Fed is already influencing inflation expectations through its policies. That these expectations have not yet shown in TIPS is besides the point: the TIPS forecast is a median of deflationary and inflationary outcomes — two fat tails on the probability distribution, so that the median tells us little.

  17. Hugh

    Money creation however it is done is about trust. The danger to us is that the housing bubble going bust, the financial meltdown, and the ongoing and unaddressed problems stemming from them put that trust at risk.

  18. Simon

    People in or around the banking profession and economics learn how money is created and then move on to discover the even more wonderful and abstract ways such an ephemeral quality can be manipulated.

    They forget how repelled their minds were by the concept and how many times they had to readdress themselves to the it in order to absorb it properly. They feel superior because it is a concept that when mastered allows access to the corridors of power and prestige.

    Imagine how the cafe worker, the factory worker, those who toil and scrimp and save to sweep a few dollars together to put a deposit on a house or a car or for a business would feel if they knew that, the banker behind his walnut desk in his opulent office in the imposing architecture of his building, simply took their deposit, made a note in a ledger book and loaned into existance the vast, vast majority of the money to be deposited in their account, so they could aquire the object of their desire and spend the rest of their life paying interest to the bank.

    People just don’t understand that they are bonded to a fiction. Those that do understand mostly don’t care.

  19. mock turtle

    ah so now, at last, i learn the secret reserved for the degree of knights templar…money is created out of thin air

  20. albrt

    What I have been wondering lately is whether the Fed can really mop up excess liquidity in the future if the bankers have basically stolen a large percentage of the Fed/Treasury money instead of keeping excess reserves sitting around the bank while hoping for future loan expansion. In other words, I strongly suspect that a lot of the liquidity is leaking out of the credit channels and may not respond to minor hydraulic adjustments of banker incentives by the Fed.

    After all, it’s really the customers who create the new money by creating loan demand at rates that are feasible for the banks. If a bunch of former bankers have the seed money they need to drive loan demand, the Fed is going to have a much tougher time incentivizing the left-behind bankers not to make the loans.

  21. Uncle Billy vs. Mont Pelerin

    Do all or most academic economists know this? I took a single macroeconomics class in college, and besides the expression “bah-sket uff guts” the only things I remembered over time was the concept of the multiplier and the fact that deposits precede loans. Was that professor lying to us at the time?

  22. Ingolf

    Money is created out of thin air, but only by central banks. Only they have the right to create base money (currency and reserves), the fiat money equivalent of gold or silver specie. What the banking system helps to create through the fractional reserve system is also “money”, but the way in which it’s created is somewhat different.

    In making a loan, banks certainly credit money to a customer’s account without (literally) having to first shift it from somewhere else; the result is callable funds for the client and an IOU of some form from the client to the bank, so the books balance. As soon as the customer draws down those funds, however, the bank must be in a position to honour its commitment to pay, either by drawing on existing reserves, receiving fresh deposits, borrowing them from other banks or, at worst, from the central bank. In that sense, it’s freedom of action is strictly limited.

    So, although as a rule loans do precede deposits, I think there’s a danger of misrepresenting things by expressing in this fashion. We mustn’t forget the unavoidably symbiotic relationship between banks and the central bank with its capacity to provide reserves and generally backstop the system. As long as a bank is operating comfortably within its reserve limits, it can of course create new loans in the knowledge that it will not be caught short. As those loans (and ones from other banks in the financial system) are drawn down and spent, each bank within the system can expect to receive its share of deposits from the recipients of that spending. Some portion of the deposits that result go out again in fresh loans, are spent in turn, return as fresh deposits and so on, more or less ad infinitum. In this sense, if the whole system is in an expansionary phase (and the central bank is, where necessary, willing to be accommodative) then credit creation can occur very rapidly without apparently straining the system.

    The resulting accumulation of longer term IOUs from customers (whether mortgages, personal loans, instalment debt, corporate lending, securitisations or whatever) in large part set against much shorter term IOUs (demand deposits, time deposits, CDs and so on) from the bank to its clients, over time becomes ever more extended and hence, ultimately, fragile. The only limits are those set by reserve requirements (almost irrelevant in recent times) and confidence. It all finally relies on confidence, in the banks, the broader system, and of course in the central bank and government.

    We got a decent preview late last year what happens when confidence evaporates.

  23. fresno dan

    What “mikkel” said.
    If one accepts that banks hold as “assets” what everyone else would call “liabilities” it seems clear that banks can create “money” (or more accurately credit).
    Nice system, except for reality – the fact that you make a loan doesn’t mean the loan will be paid back.
    And it also seem obvious to me that a lot of the credit created by the shadow banking system through leverage is gone, than a lot of the “money” that supports asset prices has been destroyed.

  24. But What do I Know?

    I, too, would like to recommend Jesse’s ‘Flation Agnostic piece. It seems to me that no matter how corrupt, rotten, and theoretically unsound the monetary fractional-reserve banking system is, people will accept it as long as it works–i.e., as long as I can keep getting something for my money. My biggest concern is that the Powers That Be will be unable to start the inflation machine by conventional means–increasing credit–and that they move on to the next method–just giving everyone currency. If people ever figure out that the money can be created out of thin air and credited (or removed, but we won’t go there right now) to their (or more precisely, other people’s accounts) the desire to hold that money will be diminished–slowly at first, then accelerating into a catastrophic failure of our system of production.

    If I can’t use money to motivate the supermarket to give me food, what will I use?

  25. MarcoPolo

    What is it that I don’t understand? Who cares about the causality? What’s the point of this chicken/egg exercise? It’s the Fed that creates money (reserves) out of nothing. Not commercial banks. And fine, when borrowers are over-leveraged the Fed can create all the “reserves” it wants and is as if “pushing on a string” as borrowers won’t borrow anyhow and banks, at that point, won’t lend to unqualified borrowers. Which is all they can find. The “reserves” stay on deposit at the Fed. Nothing is accomplished.

    Until it is. The good outcome is that the borrowers de-leverage, become credit worthy, and the banks begin lending. And boy do they then have the reserves to draw on! The issue is how to constrain that lending to productive uses rather than consumptive ones while maintaining incentives to savers and confidence in the currency.

  26. wally

    1. debt is money is debt is money is debt is money.
    2. money is not a ‘thing’, it is just a marker
    3. when there are more markers than things, people lose trust in the ‘reality’ of the marker.
    4. credit collapse ensues.

  27. joebhed

    Recommended reading here should be Stephen Zarlenga’s book: The Lost Science of Money.
    We have learned-ones stating that ONLY central bankers create money out of nothing, not commercial bankers – we must ask: what is money?
    In order for ME to loan YOU $5, I must HAVE the $5, therefore it must already exist.
    Not true for the banksters.
    Have you read “The Legalized Crime of Banking”?
    The day you walk in and take out a $20,000 loan, that money DOES NOT EXIST until you sign the PN and the loan contract.
    Thus, ALL commercial banks create money out of thin air.
    I thought this was a given.
    It has been stated by both Bernanke and Paulson, that the “commercial banks” have created only 50 percent of the money growth over the last ten years.
    So, from where did the balance of money growth come into existence?
    Can we say investment banks?
    Any bank or non-bank that creates either money or non-money that is DENOMINATED IN U.S. dollars is creating “money”.
    Come on gang.
    There’s a reason the money system is in shambles.

  28. Siggy

    I’ve read all this stuff and I’ve been wondering.

    An increase in the supply of ‘money’ leads to a decrease in its purchasing power. The public on apprehending this circumstance seeks higher wages, families seek more income (the wife goes to work, the children go to work) producers seek higher prices and an inflation cycle is set in motion.

    The public, seeing the purchasing power of its currency in continual decline seeks protection. Hard assets seem to offer the best protection. After all, owning the means of production is to be truly wealthy. And if I can’t own a factory, maybe I should own stocks, they seem to work well over time. And so we get asset bubbles. Greenspan couldn’t see it coming, more likely he chose not to. There is this disease of some of the highly educated, they seem to have an infinite capacity to seek and find the data that confirms what they believe. That is, markets are inherently efficient, thank you professor Fama.

    Why not simply save. Saved dollars depreciate by way of their loss in purchasing power. Better buy a nice big house, better buy a nice big Hummer, better spend it today because it wont buy as much tomorrow. What do we do tomorrow when we’ve spent all our money? What do we do when no one will lend to us?

    There was a time when credit was created with pen and ink, today its electronic impulses, little on and offs, digital bips flowing through a mother board. Whether pen and ink or electronic pulses, credit is created as a concept and a contract. Credit is money in its most ephemeral form. The efficacy of credit lies in the ability of the borrower to honor the loan contract, to repay the loan. That is the point of difficulty, the system fails because the borrower can’t repay the loan.

    We need to focus on the ability to repay. We need to focus on the reduction of debt to a sustainable level. We need to focus on the insidious erosion of purchasing power which has joined with profilgate borrowing for the purpose of consumption as opposed to borrowing for the purpose of production.

    We need to consider a monetary unit that maintains its purchasing power. We need to reintroduce the concept of thrift. Argue all you want about mechanics of banking, we must come to the recognition that we cannot borrow our way to prosperity. We must reinstitute the natural punishments of bankruptcy and recognize that no institution can be too big to fail. We need to prosecute fraud.

  29. Pat Shuff

    “The CDO machine,” he writes, “resembles some giant monetary snowblower, scattering dollar bills into the open hands of underwriters, investment banks, investment managers and rating agencies.”

    What are CDOs, you ask? “Stacks of debts,” Grant says in his martini-dry voice. “Debts on the asset side of the balance sheet, debts on the liabilities side. They resemble banks without walls — or depositors or regulators.”

    –James Grant

  30. MarcoPolo

    I’m with Siggy. Joebhed, I guess I better read that book because I don’t understand a thing you said.

    Surly, if I borrow $20,000 from my bank he taps the reserves in the banking system by borrowing from a bank that has reserves even if he has no reserves of his own. And those reserves in the banking system were already created by the CB. But thank you for that post as I really hope to sort that out.

    1. joebhed

      To Marco

      “Surely, if I borrow $20,000 from my bank he taps the reserves in the banking system by borrowing from a bank that has reserves even if he has no reserves of his own.”

      Surely, if you have read many of the other comments here, there is agreement that, not.

      I don’t know how the fact that the banks create the loan-money on the spot via a book-entry can be made any clearer legally than in the case of the Federal Reserve Bank of Minneapolis and the First National Bank of Montgomery County against one Jerome Daly in what has become known as The Credit River Decision.

      It’s kind of funny if you read it because the Judge said that only God can create something out of nothing.
      Finding against the banks, by the way.

  31. Richard Werner

    Credit creation drives the economy. For equilibrium in any market, symmetric, perfect information is a minimum requirement. On our planet, this is not available. Hence all markets are rationed. The short-side principle applies in rationed markets: whichever quantity of demand or supply is smaller will determine the outcome. There is unlimited demand for money and credit. Thus the credit market is supply-determined. Who supplies our money and credit?

    At the core of the crisis is the problem that the creation of our money supply has been privatised – a long time ago, without any debate about whether this is a good system. 98% of our money supply is created by private, profit-oriented operators, the banks. Governments never even asked them to make sure that they use this privilege wisely, by creating and allocating the money in a sustainable fashion. The crisis is about the misuse of this privilege.

    There are some basic rules. Credit created for productive purposes, for the creation of new goods and services that have a likely market value in excess of their component costs, is non-inflationary. It can be done at any time, even when the economy is at ‘full employment’. This is what old-fashioned banking is about. It is sustainable in a narrow sense. But it does not generate rapid bank expansion, windfall profits and overflowing bonus pools for the bankers. So bankers, when told by governments to go out and maximise their short-term profits, will prefer the other type of bank credit. Unproductive credit creation for transactions that are not part of GDP. In other words, credit creation used for financial transactions. This creates asset bubbles, and always looks good and feels good at the time: everyone is making money, and banks’ books look great, bolstered by asset collateral rising in value. But credit creation for financial transactions is always unsustainable in aggregate and will always result in bad debts; if large, it will not only bankrupt the speculators (of the last round) but also the banks. As soon as the music (financial credit creation) stops, asset prices fall.

    Thus all that is needed to prevent asset bubbles and banking crisis is a rule to restrict bank credit for transactions that are not part of GDP. Credit controls. All central banks used to do this, and it worked well. Today only China admits to employing this tool, thus reflating first of all economies after the crisis. Central banks have either downplayed or officially abolished this tool – not because it did not work, but because it made it obvious that central banks were fully in control. Today central banks present theories by economists such as Woodford, which argue that central banks have no power and control – least of all over the money supply or the banking system – and other tall tales.

    I have detailed all this in dozens of publications over the past 17 years. In English, see for instance my 2005 book ‘New Paradigm in Macroeconomics’, Palgrave Macmillan, which has chapters on the ‘recurring banking crises’, warning about the looming banking collapse in the UK, or my 1997 paper in the academic journal Kredit und Kapital, both of which present some of the overwhelming econometric evidence. A model of disaggregated credit flows explains the many Japanese macroeconomic puzzles that have confounded mainstream macroeconomics to this day.

    For details on how central banks play the banks and manipulate economies, see my 2003 book Princes of the Yen, M. E. Sharpe. All books available via amazon. Go for the paperback version.

    For more, see also the website of the Centre for Banking, Finance and Sustainable Development at the University of Southampton, UK.

    Warm regards,
    Richard A. Werner
    Professor of International Banking
    University of Southampton

  32. MarcoPolo

    Joebhed — to the extent that we have “fractional reserve” lending I understand. That creates money. That’s the multiplier effect the Fed hopes for while pushing on that string.

    1. joebhed

      Please, now that you have raised the “fractional-reserve” option, I hope we can talk the other option of full-reserve banking.
      I happen to agree with one comment that this “deposit-first versus loan-first” dialogue is kind of silly. Like the chicken-or-egg question, what does it matter?

      The only relevant factors have to deal with how the system, whether loan or deposit ‘driven’, either helps or hurts the current financial predicament, for lack of a better word.

      When you apply Fisher’s debt-deflation theory to the debt-based monetary system, it is obvious that it is the fractional-reserve banking system that lays the entire foundation, for lack of a better word, for the pro-cyclicality of the debt-money system that is feeding the deflationary spiral.

      What are needed today more than anything else are macro-economic measures that are counter-cyclical, and the establishment of full-reserve banking goes a long way to not only put the chicken and egg question to rest, but to restore some needed stability and confidence in the nation’s money system.

      We need to set the five-year goal of full-reserve banking, for both deposit and savings banking, and operate the money system and monetary policy to support that transition.
      The Austrians are right about abolishing the Fed’s fractional-reserve banking system, and moving towards full reserves.

  33. Matt H.

    The technical aspects of this discussion focus heavily on what happens when a bank extends a loan. Setting all considerations of interest asside for a moment, consider the following…

    If you’re Chase and you have an asset account, Receivable Loan Payments (A), and a liability account, John Smith’s Demand Account (L), then when John Smith comes in for a $10,000 loan, presumably you’ll debit A and credit L $10,000.

    Perhaps someone could clarify what happens if this loan is an auto loan and John Smith leaves with a $10,000 check made out to Jane Doe (the car seller.) Perhaps that someone could further clarify what happens when Jane Doe takes that check and deposits it with her bank – a different bank – Citi.

    I’m guess that upon Jane depositing the check with Citi, Citi will debit an asset account, Deposits, and credit a liability account, Jane Doe’s Demand Account, $10,000. That night, Citi submits the check to Chase to clear.

    Three questions:
    (1) How does Chase give Citi money? (Is it via a a central bank transfer?)
    (2) How much money does Chase give Citi?
    (3) How does this transaction affect the reserve requirements of each bank at the end of the day?

    1. Matt H.

      I’m starting to answer my own questions as I think about this. Someone please correct me if this is wrong. (1 & 2) Chase gives Citi the full $10k via a central bank transfer. (3) Both banks have new reserve balances with the Fed (Chase’s balance is $10k less, Citi’s is $10k more) and both bank’s reserve “requirements” are adjusted by the same amounts (Chase’s requirement is $10k less and Citi’s is $10k more.)

      If this were the only transaction to have occurred that day then obviously Chase would have needed 100% reserves backing John’s loan check. But of course this wouldn’t be the only transaction. Suppose another equal transaction happens to occur that same day, but in the opposite direction. Then in that case, the two loaned checks, Chase’s and Citi’s would each cancel each other out and neither bank would have to transfer anything to the other bank. In that case, both banks would have loaned out $10k without spending a dime and now have future collections against that loan as an asset.

      Of course, there will be thousands of the transactions each day and it would be absurd to expect they’d all perfectly cancel one another out. So the important question is, after all the checks are added up, which bank owes a balance of reserves to the other. Suppose Chase loaned out $1M (they made 100 $10k car loans) and Citi loaned out $950k (95 $10k loans.) Then, at the end of the day, Chase would need to transfer the difference of $50k in reserves to Citi. Thus, Chase made and cleared $1M in loans on merely $50k in reserves.

      Again, I am not certain about this, but it does seem consistent with Rothbard’s Mystery of Banking. Someone back me up!

  34. cityeyrie

    No problem with the original premise of this, every independent economist and banker confirms the fact that money is created by banks as loans. As Galbraith and others have pointed out, the problems arise when more money is created than can be justified by the production of actual goods and services within the economy.

    What people here are not talking about is the other side of all this – that interest and fees on the loans (and eventually the principal) created by banks out of thin air have to be paid in money of ‘real value’ – that is, money extracted from somebody doing real work, or from real resources. This is why what normal people would consider a liability – a debt – is considered by bankers an ‘asset’. This is also why our current monetary system is at the root of both human and environmental poverty.

    As long as this process is controlled by people seeking private profit there is little hope for any movement advocating economic and environmental justice.

  35. ANY1!

    To paraphrase the famos spoon speach from the Matrix:

    Do no try to manipulate money, that’s impossible. Instead, only try to realize the truth.

    What truth?

    There is no money.

    There is no money!?

    Then you will see that it is not money that is being manipulated, but only yourself…

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