The truth about banks

7 July, 2016 at 11:26 | Posted in Economics | 11 Comments

When faced with the Great Recession in 2008, macroeconomics was initially unprepared to contribute much to the analysis of the interaction of banks with the macro economy. Today there is a sizable body of research on this topic, but the literature still has many difficulties …

In modern neoclassical intermediation of loanable funds theories, banks are seen as intermediating real savings. Lending, in this narrative, starts with banks collecting deposits of previously saved real resources (perishable consumer goods, consumer durables, machines and equipment, etc.) from savers and ends with the lending of those same real resources to borrowers. But such institutions simply do not exist in the real world. There are no loanable funds of real resources that bankers can collect and then lend out. Banks do of course collect checks or similar financial instruments, but because such instruments—to have any value—must be drawn on funds from elsewhere in the financial system, they cannot be deposits of new funds from outside the financial system. New funds are produced only with new bank loans (or when banks purchase additional financial or real assets), through book entries made by keystrokes on the banker’s keyboard at the time of disbursement. This means that the funds do not exist before the loan and that they are in the form of electronic entries—or, historically, paper ledger entries—rather than real resources.­

kumhof_chartThis process, financing, is of course the key activity of banks. The detailed steps are as follows. Assume that a banker has approved a loan to a borrower. Disbursement consists of a bank entry of a new loan, in the name of the borrower, as an asset on its books and a simultaneous new and equal deposit, also in the name of the borrower, as a liability. This is a pure bookkeeping transaction that acquires its economic significance through the fact that bank deposits are the generally accepted medium of exchange of any modern economy, its money. Clearly such transactions—which one of us has personally witnessed many times as a corporate banker—involve no intermediation whatsoever …

Many policy prescriptions aim to encourage physical investment by promoting saving, which is believed to finance investment. The problem with this idea is that saving does not finance investment, financing and money creation do. Bank financing of investment projects does not require prior saving, but the creation of new purchasing power so that investors can buy new plants and equipment. Once purchases have been made and sellers (or those farther down the chain of transactions) deposit the money, they become savers in the national accounts statistics, but this saving is an accounting consequence—not an economic cause—of lending and investment. To argue otherwise is to confuse the respective macroeconomic roles of real resources (saving) and debt-based money (financing). Again, this point is not new; it goes back at least to Keynes (Keynes, 2012). But it seems to have been forgotten by many economists, and as a result is overlooked in many policy debates.­

Michael Kumhof and Zoltán Jakab



  1. nicely explained

    macroeconomics and accounting are inextricably connected

    (and send Krugman et al to accounting 101 night school)

    • “seems to have been forgotten by many economists”

      not forgotten – never learned and still not

      the GT is dense in accounting logic

  2. In Sweden every time the banks give themselves a dividend, the state has to fill up the riksbank. To me, this looks like banks dividend does not come out of bank liquidity as it does for every other business. Their dividend is national debt.

  3. I am going to demur a little bit. I don’t object to the account of banks financing investment, as far as it goes, but it does not, imho, go nearly far enough into the economics.
    I fear that people are just confused and misled by the emphasis placed on the magic of bookkeeping entries, without any qualifications regarding how banks make underwriting decisions and what the economic consequences are, of the quallity of those underwriting decisions.
    Since inflation (or deflation) are valid public policy concerns with any currency, it might be useful to move on to directly addressing those concerns in some way that goes beyond flip neoclassical references to “printing money”.

    • I think people get confused when told stories about economics that place no emphasis on, (or are just wrong about), the accounting or bookkeeping entries. Why not start with the right accounting? If by properly understanding the accounting we can see that prior savings are not the cause of investment or even necessary for investment to take place, isn’t that a huge deal?

      • If by properly understanding the accounting we can see that prior savings are not the cause of investment or even necessary for investment to take place, isn’t that a huge deal?
        It seems to me that the fundamental problem is properly understanding money and its functions in the economy. The confusion about the role of banks is just an instance of general confusion about how money works. This confusion arises because economists insist on assuming away money as a source of maya, illusion, and talking about the “real” economy exclusively without much awareness of how easily this becomes a path thru the looking glass into a land of nonsense.
        Most of us think of money as something we have to strive to get and struggle to save: that’s our personal experience of money. So, it is startling to hear someone say that banks can just effortlessly create money with a bookkeeping entry. That assertion violates common intuitions and gets attention. I presume it can be pedagogically useful to stimulate students with such a challenge to their preconceptions, if you have something to say afterward.
        Does going into the accounting after the counterintuitive shock educate? I think it might be just more confusion, when it just emphasizes the “magical” aspect of “creating” money with bookkeeping entries.
        What I would prefer to an immediate disquisition on accounting conventions is some explanation of what money is and what it does in the economy to motivate and coordinate. I would say, money is a system of scorekeeping.
        People understand that the players in a basketball game strive to accumulate points for their team’s score, without thinking that the scorekeepers have to fetch points from the vault or will ever in the course of a game be in danger of running out.
        I think that’s a helpful way of reconciling people’s personal experience of money as scarce with a global perspective, where the public policy problem is maintaining the integrity of the scorekeeping.
        So, I am sorta OK with tantalizing people with the realization that Joe Blow who works at the bank is “creating” the money he loans them, as long as they understand the procedures and constraints. If you understand that banks are scorekeepers, and money are the points in the score, then you also understand that the integrity of the scorekeeper is a vitally important public good.
        The OP makes the very useful point that the insistence of economists on talking exclusively about the “real” economy as if money can be collapsed into a numéraire, with no harm done, creates confusion between people’s intuitive understanding of savings as money savings, a hoard of currency or equivalent liquid financial securities like bank accounts, and savings as deferred consumption.
        In the imaginary “real” economy, savings is deferred consumption. In the actual economy, saving is accumulating that hoard. Big difference, possibly. If discussing the accounting leads you to think savings, in the sense of deferred consumption, are not “necessary for investment”, you’ve taken the wrong lesson. All the accounting should do is make clear that spending on investment goods is itself deferring consumption, to the extent that the alternative use of production capacity is to produce for consumption. And, that is a big deal, if that’s clear.
        The larger lesson, though, which I would like a citizen to take away, is the public policy importance of the integrity of money as a scorekeeper. If we cannot utilize our productive resources and provide the material basis for a decent life, because the scorekeeping is out of whack, then we need to fix it. It is a moral imperative to fix it.
        That’s not exactly the sales pitch of a Keynesian, though it might lead to somewhat Keynesian prescriptions in particular circumstances. It think it is better morally and psychologically as a doctrine in which to instruct the democratic citizen than the magic accounting of free money. ymmv

  4. Thank you Bruce for the reply. I have to say that (perhaps unfortunately) my understanding right now is that prior savings are not necessary for investment in our system of money, banking, and government. This may be wrong, but I really want to understand why it would be wrong if it is. It seems to me that if there is any value to a currency that being able to create that currency, whether by banks or government, will always allow resources to be diverted to investment purposes. Even in the unlikely situation of full and most efficient employment of all resources. Regardless of prior savings. The increased investment more or less causes the increased savings. I know that everyone says the S=I thing is an identity and that we are not supposed to make causal inferences from it one way or the other. But I really really want to do that in this case. But I am also willing to be shown wrong.

    • I know that everyone says the S=I thing is an identity and that we are not supposed to make causal inferences from it one way or the other. But I really really want to do that in this case.
      So, you are just as confused as the rest of us. Welcome to the club.

  5. Bruce W said:

    ” I would say, money is a system of scorekeeping.”

    Are you not confusing money (balance sheet items) with income flow accounting – the old stock/flow distinction?

    I would also quibble with this:

    “In the imaginary “real” economy, savings is deferred consumption. In the actual economy, saving is accumulating that hoard.”

    I would say saving is income not consumed – why introduce the word “deferred”?

    I would also say that you should be careful with your use of saving/savings. I would say “saving” is what is not consumed out of income and that “savings” are what is hoarded.

    • As sources of confusion, stock / flow distinctions take a back seat to the difficulty of distinguishing analytical theory from operational models and economic behaviors from accounting conventions.
      When I wrote, “money is a system of scorekeeping”, I mean that people calculate their economic behaviors and risk-taking on the basis of monetary values. Bankers are not turning valves on flows of money income so much as they are simply authenticating the scores and brokering insurance. Credit is not about stocks and flows of money; credit is about bridging time and contingencies.
      When I formed a consultancy some years ago, I went to a bank and took out a home mortgage, arranged a line of credit providing overdraft protection, got the bank to back my bid to lease premises and some office equipment. There was no flow of savings involved. They were lending me my own money, but I needed a different profile of obligations and risks over time than when I was drawing a salary; I would be waiting on larger, but also more irregular payments from clients than from my former employer and I was responsible for a new stream of regular expenses that went well beyond my household commitments. Characterizing this activity as the bank creating money is provocative, but by itself not very enlightening.

      Not so long ago, the U.S. created a worldwide financial crisis because bankers were no longer bureaucratically vetting properly home mortgage lending and securitization. They stopped checking whether the prices of houses made sense or whether the people buying them had sufficient income. This is what I mean by “score-keeping”. And, I am contrasting that with the image of the man in green eye shades “creating” money.
      I appreciate what you are saying about the distinctions between “saving” as a behavior with (an on-going stream of) money (income) and “savings” as a hoard of money or ownership claims in the form of financial assets.
      But, you are leaving aside the point I was making about the true significance of claims made by economists about “saving” in the theoretically imagined “real economy” where money is just a numéraire. In that theoretical imaginary where money hardly exists, “saving” is deferring consumption. That’s the world of “loanable funds” — there are no funds, per se; what is being “loaned” is claims on production.
      This matters to the Keynesian claim, made in consistency with the accounting conventions of the national accounts, that investment and saving are two aspects of a single transactional behavior. Investment is purchasing current production for other-than-current consumption. As such, it is also “saving”.
      The confusion arises because our everyday experience is with money, where saving is something we do with money and its financial near-equivalents. Money is not, itself, a production good. We can “save” it, put it aside without engaging in any transaction at all, and even when we do exchange money for a bank deposit, say, we are not bringing forth production of any good — neither a consumer good nor an investment good is being produced.
      Whether it is “necessary” in any policy-relevant sense for people to hoard money for investment to take place cannot be answered by the conventions of the national accounts. Or, I will venture, by a stunted theoretical imagination sketching out hydraulic flows of currency tokens.

  6. Kumhof and Jakab say:

    “The problem with this idea is that saving does not finance investment, financing and money creation do.”

    I am wondering here, do they mean “saving” or do they mean “savings” – they have used both words? They probably mean “saving” (i.e. the income flow element).

    Investment can also be financed by companies drawing on their own savings (dishoarding) or drawing on the savings of their shareholders through equity capital raisings (dishoarding). However, saying this does not change what they are saying above.

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