How do banks create money?

This is one of those questions that make me squirm when I have to answer it on the spot, for a lot of reasons. First, money is an intimate topic to people’s lives. They owe people and institutions money, their savings are in money; money is just an integral part of everyday experience. Explaining the nature of money to someone can be a difficult experience, especially when they understand the answer.

 

Second, there’s the fact that multiple explanations of how banks create money exist. Not only that but neoclassical economics proposes one view that dominates the academic and political discourse (neoclassical economics is broadly the economic point of view that has dominated economics for the last 140 years, with perhaps a brief interlude during the “Keynesian” revolution). In the neoclassical view banks are only able to lend money after depositors have put their cash into a bank. Since governments sometimes require banks to hold a certain amount of money aside (in the U.S it’s 10%), the idea is that the rest of their “excess” reserves are available for lending. This theory plus the US’s 10% reserve requirement has led to one of neoclassical economics’s most appealing teaching example. I think it is valuable to quote N. Gregory Mankiw’s principles of economics textbook at length here because he’s a very clear writer and his book dominates the textbook market (not to mention it gives me a chance to remind people that his students walked out of his class in protest of it’s content last semester here: www.thecrimson.harvard.edu/article/2011/11/2/mankiw-walkout-economics-10 )

 

“Let’s suppose that First National has a reserve ratio of 1/10, or 10 percent. This just means that it keeps 10 percent of its deposits in reserve and loans out the rest… First National still has $100 in liabilities because making the loans did not alter the bank’s obligation to it’s depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people taking out the loans, but they are assets of the bank making the loans because the borrowers will later repay the bank.)

 

…Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits in the bank. Yet when the First National makes these loans, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money.

 

The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary economy, where the $100 of reserves generates $1000 of money, the money multiplier is 10. What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/r dollars of money. In our example, R=1/10 so the money multiplier is 10.”

sector Government Banks Debtors (to the bank) Creditors (to the bank)
Parts of balance sheet assets liabilities assets liabilities assets liabilities assets liabilities
Balance sheet 0 $10 (currently held as bank reserves) $10 reserves.

$90 loans

$100 in bank checking account 0 $90 loans $100 in bank checking account 0
         

 

 

I should add that although this is what Mainstream economics puts in their undergraduate textbooks their is a lot academic literature written and published by Neoclassical economists that qualify or even contradict this story. Indeed the most common defense of neoclassical economics is that the critics either don’t understand it or are criticizing a “caricature” (aka what appears in the textbooks). The table above is a much more detailed (with the implicit sectors made explicit) exposition of the model Mankiw is presenting. If you learn accounting, you find out very quickly that any financial asset is someone/something else’s liability so that they should all sum to zero (The real world contains physical objects that don’t have corresponding liabilities so real world balance sheets should sum to positive values).

 

Notice that in this conception of money creation by banks, the government directly controls the money creation process. If it lowers reserve requirements, excess reserves will appear in the banking system that, according to these theorists, will be lent out, redeposited and lent out again in the “money multiplier” process Mankiw described. If it raises reserve requirements, banks will have to attract more deposits or reduce the amount of loans they are making.

 

This is a very orthodox theory but it is used in more unorthodox circles to defend various policies. Many liberal critics of big banks have criticized them on the grounds of “not lending” even after the bailouts (this being based on the idea that their holdings of excess reserves are and should be available for “funding investment”). The “move your money” campaign is largely predicated on the idea that moving your deposit limits the ability of big banks to lend money and increases the ability of small banks to. The NEED act (HR 2990) introduced by Dennis Kucinich is largely based on the American Monetary Institute’s ideas.

They subscribe to the Neoclassical view of money creation, with the crucial difference that they don’t see the “loanable funds” (the deposit and loan concept described by Mankiw) market as an equilibrating system that balances savings and investment in a way beneficial to all. They see it as a system that allows a privileged few to function as a usurious middle man between government, industry and the public (see: monetary.org). For them returning money creation back to the government simply involves raising reserve requirements to 100% .Recall what Mankiw said above:“If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/r dollars of money.” In this case R=1 so each dollar of reserves is just 1 dollar. To AMI, this means that money is only created when governments spend it into existence. There are some supporters of the NEED act in Occupy Wall Street Alternative Banking Working group.

Another view is presented (usually) by the Post-Keynesian school . They look at the correlation between reserves and broader money creation but think that Neoclassical economics has the causation reversed. Rather then banks needing deposits (and thus reserves) to make loans, they see banks making loans which create deposits and then seeking out reserves later. In Neoclassical economics (as alluded to above) savings and investment is balanced through the loanable funds market. The variable that adjusts to balance these two things is the interest rate. If there are more (less) savings being offered as loans then borrowers willing to borrow them, the interest rate is supposed to fall (rise) until equilibrium is reached. Post-Keynesians in contrast envision a central bank with a target interest rate that will intervene to inject reserves when demand for reserves rises to prevent (unplanned) rises in interest rates and withdraw reserves to prevent (unplanned) falls in interest rates. For them the money supply expands and contracts to accommodate the (profitable) financing needs (and desires) of (credit worthy) economic actors including corporations, other financial institutions and households.

I personally (as in not Occupy Wall Street Alternative banking working group) subscribe to the Post-Keynesian view. For some Theoretical and empirical defenses of the Post-Keynesian position see Schumpeter’s book, Basil Moore’s empirical work and definitive book, and a sampling of federal reserve publications cited below. I hope that was helpful. Feel free to ask questions because I’m sure I lost many of you along the way. There are wide reaching and differing implications of each of the views above (and nuanced positions that differ from both) so please ask for clarification.

 

Works Cited

Delreal, Jose A. “Students Walk Out of Ec 10 in Solidarity with ‘Occupy’” The Harvard Crimson. Harvard University. Web. 23 Mar. 2012.

<http://www.thecrimson.harvard.edu/article/2011/11/2/mankiw-walkout-economics-10/>.

Kydland, Finn E.; Prescott, Edward C., “Business Cycles: Real Facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review 14 (2): 3–18

Holmes, A. R. Operational Constraints on the Stabilization of Money Supply Growth. Controlling Monetary Aggregates. F. E. Morris. Nantucket Island, The Federal Reserve Bank of Boston: (1969) 65-77 .

Mankiw, Nicholas Gregory. Principles of Economics. Mason, OH: Thomson South-Western, 2011. Print.

Moore, Basil J. Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge [England: Cambridge UP, 1988. Print.

Moore, Basil J. “The Endogenous Money Stock.” Journal of Post Keynesian Economics 2.1 (1979): 49- 70. Print.

Schumpeter, J. A. The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press. 1934. Print

 

8 thoughts on “How do banks create money?

  1. Useful to see the explanations from economic schools. However, economic schools cannot the factsets. The simple fact is, every dollar in circulation comes into being from a loan agreement. It disappears from circulation when that loan is repaid. Every deposit comes from a loan agreement somewhere. Some people have better access to dollars in circulation so they accumulate surpluses. But, everyone of those dollars while in circulation remains outstanding in somebody’s bank loan somewhere. So, interesting to see the way economic schools avoid these basics. The part about interest due on loan principal not even being created in the money supply is the $64K question that needs answering. The asset grab triggered in the credit crunch at the finale is setup right from the very beginning of the musical chairs game. Positivemoney.org.uk has some pretty good scoop on all this. The US is very behind, but our media and universities are so tightly controlled by private money interests. And, it is no surprise that economics schools avoid these basic function facts with all sorts of notions of interests rates, etc. Keynesianism was made for private banker profits from public debts. Marxism doesn’t even treat the privatized money supply as an issue in the game. Very interesting!

    • did you miss where i said “If you learn accounting, you find out very quickly that any financial asset is someone/something else’s liability so that they should all sum to zero (The real world contains physical objects that don’t have corresponding liabilities so real world balance sheets should sum to positive values)”?

      I didn’t focus on your comment because it is not where the crux of the disagreements over money is. everyone accepts the accounting, the question is the causality between “central bank” or “inside” money and bank loans.

      “Keynesianism was made for private banker profits from public debts. Marxism doesn’t even treat the privatized money supply as an issue in the game. Very interesting!”

      This is highly inaccurate. have you read any of Keynes writings? or Marx’s? Both talk about money and banking extensively. Marx spends a lot of time on the issues with compound interest.

      B, this was a basic explanation of how banks create money. I’m trying to go one step at a time. It is not very fair to expect me to explain all of the mechanisms and problems with Banking and the economy in one blog post.

    • By the way, I think you completely missed the point B. The Positive Money crowd is just like the American Monetary Institute. They accept the orthodox story about causality running from bank reserves to bank loans. They think no private actor will be able to create money if there was 100% reserve requirements. I think this is not true because I think the causality is reversed. Higher reserve requirements function as an implicit tax on banks but not one that restrains lending all that much. It’s similar to the central bank raising it’s interest rate in that the cost of a banks liabilities must be recouped in the revenue from it’s assets. In other words a bank would raise lending rates in response to higher reserve requirements to preserve their profit margin. Their proposal won’t restrain bank power. The real action in banking is surrounding capital requirements.

  2. My concern is not about what has already been written by any of those economists. I know how that system works and has worked since 1700s in places like England. I know how writers’ texts are selected and amplified for future generations within the academy and the publishing world. And, also which ones are suppressed. The activities of the Mercantilists to shape economic thought by picking and choosing who got published and remembered are studied by historians.

    My interest is with the fact that there is NEVER enough money in circulation to return BOTH loan principal AND the interest due on the loans that created that money in the first place. Loan principal alone is the only money in circulation. There is never any money created to repay interest. Interest is only repaid by a first borrower insofar as that first borrower can get extra money from a second borrower to repay his/her first loan and so on and so forth. Someone at the end of that cycle is going to lose private property solely because there was not enough money in circulation created by the banks loans in the whole-system, not due to any personal failure of any kind. Interest can only be paid on loans outstanding while new loans are being made, while debt is increasing. Increasing debt is the only way the system survives until the asset grabbing begins. Which we are now witnessing all over the world with the implosion of public debts for which there was never enough money in circulation to repay. This is a ponzi scheme pure and simple! The System is setup from day one without enough cash in circulation which means hard assets have to be seized somewhere down the line to reverse all the debits and credits written onto the books of both banks and borrowers. This is a great explanation for how wealth concentrates into few and few family office hands over a few generations (and several boom and bubble bust cycles). It is also a great explanation for the social evils that arise from this system. Prophet Mohammad spotted as much!

    My comments were not directed at you so you shouldn’t be taking any thing personally. I don’t know where that comes from. My comment in no way suggests your blog post is inadequate. My comment represents my reflections about economic theories. My comments were directed at the status of play of current academic economics. Which is like the film Inside Job shows and many other investigators work, a bought and corrupted “profession”. My comments have nothing to do with you or your blog post. My comments are directed at the system. I am not concerned about any individuals in this business, and will never make any comments about any of them. I am concerned about the System. Shifting analysis from system to individual is a classic standard deflection tactic!

    BTW insulting remarks like “you completely missed the point” are no way to engage in discourse, unless you are Bill O’Reilly! Let’s just reexamine and figure out who missed what point, and keep it at a system discussion!

  3. I understand the equal asset/liability. I have David H. Friedmans book on Money & Banking. The 100 dollar example is good but think for a minute what you are saying. If I have $10 you want $9, when I loan you that nine I should have only $1 dollar in assets and $20 dollars liability. I understand that this is the physical way of seeing it but…. This proves that they take our signature on a note as the collateral, thus they accepted a tendered note in exchange for the check that is written. Title 12 sect. 1813 (L) tells you the term of deposit is notes, drafts, ect. has to be considered as the equivalent as money!! Barron’s dict. of accounting terms says Credit is a entry made by an entity on the liability side of its ledgers, in accounting the assets decrease when credit is given in a loan. So if that’s true then explain why the banks assets increase? They accepted a note that carries with it cash value! They just endorse it and send it to another bank and then there ledgers go back to their pre loan level. This is the fraud in the banking system, The Money & Banking book also says that credit cards aren’t a medium of exchange (money for goods, services) because it merely extends credit (debt) to the bearer. So the bank doesn’t give you consideration for you at all!

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