The credit creation theory of banking — the only theory consistent with empirical evidence

7 Jan, 2015 at 14:08 | Posted in Economics | 10 Comments

In the process of making loaned money available in the borrower’s bank account, it was found that the bank did not transfer the money away from other internal or external accounts, resulting in a rejection of both the fractional reserve theory and the financial intermediation theory. Instead, it was found that the bank newly ‘invented’ the funds by crediting the borrower’s account with a deposit, although no such deposit had taken place. This is in line with the claims of the credit creation theory.

athink-biga1Thus 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. The implications are far-reaching.

Henceforth, economists need not rely on assertions concerning banks. We now know, based on empirical evidence, why banks are different, indeed unique — solving the longstanding puzzle posed by Fama (1985) and others — and different from both non-bank financial institutions and corporations: it is because they can individually create money out of nothing.

The empirical evidence shows that of the three theories of banking, it is the one that today has the least influence and that is being belittled in the literature that is supported by the empirical evidence. Furthermore, it is the theory which was widely held at the end of the 19th century and in the first three decades of the twentieth. It is sobering to realise that since the 1930s, economists have moved further and further away from the truth, instead of coming closer to it. This happened first via the half-truth of the fractional reserve theory and then reached the completely false and misleading financial intermediation theory that today is so dominant. Thus this paper has found evidence that there has been no progress in scientific knowledge in economics, finance and banking in the 20th century concerning one of the most important and fundamental facts for these disciplines. Instead, there has been a regressive development. The known facts were unlearned and have become unknown. This phenomenon deserves further research. For now it can be mentioned that this process of unlearning the facts of banking could not possibly have taken place without the leading economists of the day having played a significant role in it.

Richard A. Werner

Added: Indeed, there certainly has been a “regressive development.” Things that were known facts back in 1948 have somehow been unlearned and become unknown …
 

[h/t lasse]

10 Comments

  1. Banks and Credit (1948)
    Coronet Instructional Films

    BTW
    Vet inte om det är noterat på bloggen att den kände MMT:isten Stephanie Kelton blivit Demokraternas Chief Economist on the Senate Budget Committee, iofs “bara” minoritetssidans Chief Economist men ändå.

    • Stort tack. Synnerligen intressant!

  2. För den som inte orkar, hinner eller kan läsa Werners artikel på engelska har jag skrivit ihop en sammanfattning på svenska: http://flutetankar.blogspot.se/2015/01/nu-empiriskt-bevisat-banker-skapar.html
    Och tack för detta intressanta tips, Lars (och alla andra spännande saker du skriver om)!

    • Tack själv 🙂
      Kanon att denna viktiga forskning får spridning även i Sverige.

  3. Well this is only correct… In appearance. Banks do create something, but it is definitely not money, else there would be no need to bail them out during a crisis as they would not be able to default on their IOU, which are, deposits. As such, cases like Lehman Brothers or other would not be possible. Second, that would mean that there are exceptions to the legal rules on money counterfeits, which is, to be honest, rather absurd. What banks do however, is, create credit, which is not the mean of payment itself as much as a mean to delay the payment i.e. not the money, but the mean to delay the payment in it. Credit is a powerful tool : it allows banks to manage a huge amount of transactions with very little money in reserves. By doing transactions via credit, they can allow themselves to only pay each others regularly the differences between what they owe to one another. For example, 20 euros could be used to pay for an infinite number of transactions, as long as the net difference between what is owed is inferior or equal to 20 euros. The problem is, if a bank does not have the funds to provide what it has promised to pay by crediting, it is forced to default. This is why commercial banks always need reserves, even though (as, for example, in Canada) there are no reserve requirements : it is simply to pay for the transactions they credited each other. Paradoxically as such, the more a bank credits accounts (and creates deposits through that channel), giving the opportunity for more transactions within and between banks to occur, the more actual money i.e. central bank or state money is needed to keep the system running. I guess we’ll have to wait another 20 years however until mainstream economics connect the dots with “empirical evidence”

    • I actually liked this comment a lot, in particular the examples, and I see no conflict between my view (which is mainstream) and what is written above. In fact, I often tell my students that banks do not create money per se. They instead have created a secondary market for debt which is so liquid that debt itself becomes traded in the same way as money. But there is a large difference between this view and creating money “out of thin air”. In the latter case, banks could not, akin to a central bank, go bankrupt.

      • Money comes in different forms. Just because banks cannot create high powered money, it does not follow that they cannot create credit money at will.

        In fact, anyone can create credit money (e.g., negotiable bills of exchange, negotiable promissory notes, negotiable cheques): the problem is getting it accepted. The banks have the power to get theirs accepted and have access to a supply of reserves from central banks that is essentially supplied on demand — even if the CBs control the price of reserves.

      • So no conflict then. This is basic new Keynesian story.

        I would actually recommend John Moore’s Clarendon Lecture on this topic “Evil is the root of all money”, where “evil” refers to the non-acceptance/distrust of individually created money and how banks circumvent this problem. It’s available online.

      • The problem is not actually only to get it accepted, it is also, to redeem the IOU when it is due (which is, in fact the act of paying)… Legally, only high powered money (banknotes, but that is also the case of reserves) is accepted as a legal tender which is the way to do the aforementioned thing. The way the legal tender function of States’ money is insured, is by making it be used to redeem taxes and tithes. Trust only plays a role in extreme cases, when there is too little or too much money emitted. If the central bank does its job reasonably well, taxes and tithes are enough to make IOUs accepted by everyone.

  4. Hi thank you for a nice introduction for this theory.


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