The Credit Creation Theory of Banking is Empirically Verified

The Federal Reserve of the United States.

The Federal Reserve of the United States.

First, let me cite the article I am going to refer to:

Werner, Richard. “Can Banks Individually Create Money Out of Nothing? – The Theories and the Empirical Evidence.” International Review of Financial Analysis (2014). Print.


 

This 18 page article is extraordinary in the amount of research put into it, resulting in a very dense read filled with economical theory and schools of thought.  As with any good works, it unveils a layer of Truth.  Truth has not been obtained in economics, or pretty much anything for that matter, but it brings about a moment of clarity on not only how things work, but how things got to be the way they were.

The article first focuses on each hypothesis on banking theory, and goes into the historical shift among the economists with regards to this issue.  The author decided to let the former economists speak for themselves, and drenched the article with quotes from economists who lived in the late 18th century to modern times.  Then the author was able to do an experiment, and emperically verify one of the hypothesis.  But first, to the three hypothesis of how banks operate, in order from the oldest hypothesis that was favored to the most recent, before this paper was published.

During the firs two decades of the twentieth century, the credit creation theory was the favored theory among economists.  It basically says that when a bank issues out a loan, it fabricates that loan out of nothing.  Following the 1920’s and more up to the 1960’s, the favored hypothesis is that banks utilize fractional reserve banking (the method that I have been using in my own understanding of how the economy works.)  According to this paper, this method basically means the banks are a “financial intermediary,” using their just resources to issue out loans.  They create money out of nothing by what is termed “the multiplier effect.”  A bank can only issue a loan if it has received new reserves, which a fraction will be deposited to the central bank.  The bank only lends out the excess reserves.  Whereby another bank receives a deposit, puts a fraction in reserves, and issues the rest out as a loan.  What this does, is it takes the initial deposit and magnifies the available funds for loans based upon that initial deposit.  If Bank A gets a deposit of $100, the available deposits if put thru enough banks can exceed $9,000.  The banks themselves don’t create the money, however it is the issuance of loans that systemically create money by being deposited to bank after bank.  The most recent hypothesis that has been more or less favored by the majority of economists, is the financial intermediation theory.  First, let’s define intermediation:

Intermediation –>  Being, situated, or acting between two points, stages, things, or persons.

The bank is merely acting as a party to provide services for their customers.  As Keynes puts it:

A banker is in possession of resources which he can lend or invest equal to a large portion of the deposits standing to the credit of his depositors.  In so far as his deposits are Savings deposits, he is acting merely as an intermediary for the transfer of loan-capital.  In so far as they are Cash deposits, he is acting both as a provider of money for his depositors, and also as a provider of resources for his borrowing customers.  Thus the modern banker performs two distinct sets of services.  He supplies a substitute for State Money by acting as a clearing house and transferring current payments backwards and forwards between his different customers by means of book entries on the credit and debit sides.  But he is also acting as a middleman in respect of a particular type of lending, receiving deposits from the public which he employs in purchasing securities, or in making loans to industry and trade mainly to meet demands for working capital.  This duality of function is the clue to many difficulties in the modern Theory of Money and Credit and the source of some serious confusions of thought.

-Keynes [(1930, vol. 2, p. 213)] page 9

Keynes is an interesting figure.  He actually made statements backing all three hypothesis during his career.  Remember, the time frame outlined above talks about the prodominant view on banking theory.  There were probably some economists in the 1960’s thought that the credit creation theory was the most accurate view of how banks operate.  But it is clear, that over a period of time, economists regressed from the actual truth.  However I would argue that fractional reserve banking’s multiplier effect is still present even though credit is being created.

The authors of this study found a small cooperating bank in a small town in Germany.  The two directors of the bank agreed to allow them to monitor their transactions, and reserve amounts.  A small bank is actually a better choice than a big bank, simply because there is less transactions from the general public.  There is another reason why these researchers did not monitor a big bank – the big banks declined for various reasons, most notably the security of their data.  Nevertheless, it would of been a huge headache to pull off this research with thousands upon thousands transactions happening in a day.  So I personally think it worked for the best to do this procedure on a small bank.  And just because it is a small bank, doesn’t mean they don’t operate at the same standards and procedures of other banks.

The researcher took a loan out of 200,000 Euros with no interest, in agreement with the bank directors, and watched the process by which the money was credited to his account.  The process was video taped.  The researcher tested the account, and made small purchases that were a success.  The money indeed had been transferred, and there was no influence by any party, accept the gentlemen responsible for issuing to loan to the account.

The financial statements of the bank, when deducting all the deposits of other customers, revealed that the bank issued credit to the test account, without altering their own reserves, or obtaining money from external sources.  In essence, it is empirical evidence that the credit creation theory is actually a fact – money is created from nothing.

There is so much to talk about it is hard to start.  I guess I want to start by talking about the field of economics itself.  It’s ironic that the economist in the late 19th and early 20th centuries got it right.  Economists got further and further away from the truth, however when reading the various logic to defend each hypothesis, it is sound, assuming their axioms and assumptions are correct.  That is the core component to economic theory – assumptions.  When reading a theory, or a forecast on our economy going to fail, what are the assumptions?  Are those assumptions accurate?  Because if they aren’t, the logic maybe sound within those assumptions, but without those assumptions everything is moot.  Bernanke himself, the head of The Fed for the longest time, believed that banks were just intermediaries.  This paper reinforced for the the assertion that economics is merely educated guessing.  I follow a blog of an economist.  He basically states that macroeconomics is useless (which is taught everywhere), and discredits theory after theory on issues regarding the demand of money, labor, or trade just to name three.  However he never, I mean never, puts his two cents in.  It’s easy to discredit and criticize something for various reasons that can be seen, it takes guts and is plain harder to provide an alternative.  What economists need is data, and this is a good start.

Because now in the economical modeling, economists know how banks work.  That, obviously, is a central component to creating a more accurate model.  Economists know the interaction between The Fed and the government pretty well, they know how banks work now, the next step is trying to figure out the relationship between The Fed and The IMF, or the world bank.  Then the clearest picture of our economy would take fruit.

I read part of a book from an economist from MIT.  I didn’t finish it it was so bad.  His stance was that the capitalist markets behaved like that of an organism.  It is constantly evolving, so it can never be truly understood, and will always do what is necessary to ensure survival.  In essence, he has no idea.

The point of all of this is to take what economists say in the news with a grain of salt.  Their science is lacking serious data, and a lot of their assertions have core assumptions.  Those assumptions could down right be inaccurate, or there may not be right amount of assumptions.  This influences the train of logic, and can make something sound completely logical be completely false.

By knowing how banks operate, more appropriate fiscal policy can be put into place to prevent high systemic risk.  As stated in the study, current fiscal policy on banks assumes that the banks merely act as a intermediary.  This as we have learned, is inaccurate.

One thing I learned from this paper, is that banks deposit their reserves to The Fed.  Access reserves are either used to issue out loans or to invest.  If a bank can instantly issue out credit, this has no impact on their reserves initially.  However, when the issued loan is paid back with interest, they have essentially increased their reserves out of thin air.  Also, the bank can use old banking theory as well.  They can use a fraction of their deposits to issue loans or invest.  Regardless of how the loans are made, it is deposited in another bank, whereby a fraction is sent to The Fed, and that money can either be invested or loaned out.  What I am trying to say, is that I think the “multiplier effect” is still valid even though banks issue credit out of thing air.  Bank A issues a loan, and is deposited into Bank B.  Bank B takes a fraction of that, and puts it in the reserves with The Fed.  The next loan can be created through credit, however there is still excess reserves from the Bank A loan.  It all depends on the decisions of the bank.  The bank can take that money, or a fraction of it, and invest it.  Or it can us it to issue out more loans.  Whereby the amount goes to Bank C.

I don’t think it is as straight forward as economists put it on both sides of the credit creation and fractional reserve banking.  I think to some extent, both processes are used with current banking.  Regardless if this is true or not, and making an assumption that we know is true, which is that banks use credit creation, banks have a huge impact on the expansion of the money supply.  This is why our economy is so inflationary.  First there is deficit spending of the government (interaction between the government and The Fed), which we know by The Great Depression increases aggregate demand.  That is how America was able to get out of The Depression.  Increasing demand increases prices, and the reason why it increases aggregate demand is because there is more money to spend.  Eventually business owners will raise prices to increase profitability.  Banks, by creating credit out of nothing, increases the amount of money in the economy while keeping higher reserves.  This is accomplished in two parts.  First, if loans are created from thin air, the overall reserves from their customer base remains the same.  Second, once the issued credit and interest rate is paid off, this is a direct deposit to the bank’s reserves.  Higher reserves means more loans by a more traditional approach, or investing in financial instruments.  The creation of credit, in my opinion, contracts the money supply eventually by being repaid with interest.  However it is this multiplier effect between banks that really expands the money supply.  Therefore, it is with my understanding, that banks create money out of nothing, but expand the money supply using the multiplier effect, which was laid out in fractional reserve banking.

In any case, this was a very enlightening read.  Now entities that were a mystery to me aren’t anymore.  That is what I love about reading and learning.  Something just became clear, and it provides a sense of comfort, of knowing, the world around me.  I’m sorry I haven’t updated this blog in a while.  But life has its obstacles, as well as the fact that I have undertaken a pretty big project.  I will never forget this blog.  It may take some time for me to update it, but when I get my hands on that article, book, or study, you better believe I am going to share it to the world.

Thanks for reading.

Wouldn’t it be nice if the average American could create money out of nothing?

 

 

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2 Comments

  1. witok said,

    June 4, 2015 at 3:36 pm

    Oh, yes. Fine. We all get riches.

    Wish for that only if you don´t worry about $300,000,000,000.00 a loaf of bread!

    Like

    • brengleman said,

      June 5, 2015 at 11:33 pm

      It is true that credit creation induces some inflation, and there are other forces of inflation as well. In fact, some economists state any transaction is inflationary. What I have learned, is the concept of markets. Prices will rise, but if they rise to the point that demand for their product or service decreases, then prices will soon drop. Essentially, markets help stabilize prices, and the more money velocity there is, the slower the rate of inflation will become.

      Like


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