Sunday, December 21, 2014

Richard A. Werner — Can banks individually create money out of nothing? — The theories and the empirical evidence

This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".
International Review of Financial Analysis — December 2014
Can banks individually create money out of nothing? — The theories and the empirical evidence
Richard A. Werner


A said...

Can banks choose to go into debt 'out of nothing'? The answer is yes - and you can too.

Ralph Musgrave said...

That paper of Werner’s is about 18,000 words. I think I can answer the basic questions he poses in about one thousandth that number of words….

Do private banks create money? Answer: yes. If you deposit collateral worth $X, a bank will happily credit your account with about $X produced from thin air.

Can that money go into general circulation? Depends. Assuming constant GDP, then that money can only be spent if other person/s are willing to save or hold that money (as pointed out I think by Nick Rowe). If no one wants to hold the new money (i.e. in effect lend to the spender) the hot potato effect means holders of the new money try to spend it away, which raises demand, which is not permissible if the economy is at capacity. (I.e. the central bank would raise interest rates, which would clamp down on the above private bank lending).

And that’s about it. Or have I missed something?

A said...

"Assuming constant GDP"

Why would you want to make such an odd, artificial assumption?

"the central bank would raise interest rates, which would clamp down on the above private bank lending"

Can you prove that is a fact? or is it just another assumption?

Anonymous said...

If I write up and sign a negotiable IOU and give it to, then I too have created negotiable debt out of nothing. When banks do that, we call that negotiable bank debt "money".

But there are some forms of money that can be used to discharge debts, but are not themselves debts for anything else. They are accepted in exchange for goods and services, and for the discharge of debt, merely out of some combination of social convention and legal requirement.

The fact that I can manufacture a personal debt out of thin air does not mean that I possess the power to manufacture the means of discharging that personal debt out of thin air. And the same is true of commercial banks as well. They can create an account for you and credit it with any given dollar amount. But that balance in that account represents a debt of the bank that you can collect on any time you want by demanding the form of money that is issued by the central bank. And the commercial bank cannot manufacture that form of money.

Ryan Harris said...

Why is bank debt unique compared to the debt of a company or individual? Aside from the government guarantee that it trades at par, no discount, with fiat I don't see much difference.

Ralph Musgrave said...


Why assume constant GDP? Because where there are lots of variables and you want to consider the effect of just one variable on just one other variable, it’s an idea to assume “all else equal”, i.e. assume all other variables remain constant.

Re the central bank etc, if private banks put more money into circulation, and no one wants to hold it, i.e. save it, that money will get spent, which will raise demand. If the rise in demand is excessive, then government and/or central banks will then just have to find some way of cutting demand, like raising interest rates. An alternative way of reducing demand would be to cut the deficit.


Your question could be put the other way round: why don’t banks make cars? Come to that, why don’t ship builders run hotels? I guess the answer is that there are barriers to entry into any form of economic activity: capital investment, getting the right skilled staff, etc.

Jose Guilherme said...

When bank lending is a mortgage to buy a newly built house then there is an increase in GDP. Constant GDP simply can't be assumed in this very common case.

Brian Romanchuk said...

Banks do have legal privileges, which is what the paper discusses.

If you created a bank-like institution, you would have to be careful how you structured yourself, as you could end up being classified as a bank attempting to operate without a license.

Take for example money market funds. Although they resemble bank deposits, regulators make sure that they do not bill themselves as such. Additionally, money market funds cannot extend credit to clients directly, in the same way a bank could.

The shadow banking system in aggregate can create credit "out of nothing", but it generally relies on a banking system to allow itself to expand, even if the bank lending is paid off at the end of the day.

A said...


"if private banks put more money into circulation, and no one wants to hold it, i.e. save it, that money will get spent which will raise demand"

new bank deposits can be used to pay down debt, to purchase existing assets, or can be swapped for time deposits or other longer-term bank liabilities (the demand deposit is eliminated in this process). None of this represents higher demand or causes higher inflation.