Sunday, December 15, 2019

Yes, Banks Create Money Out Of Thin Air — Brian Romanchuk

Unfortunately, money has not yet been abolished from economic theory, and we are stuck with pointless debates about banks and money creation. The latest salvo is "Banks do not create money out of thin air" by Pontus Rendahl, and Lukas B. Freund. As the title of this article suggests, Rendahl and Freund are incorrect in their assessment.
I assume that the Rendahl/Freund article is a followup to previous arguments, such as a Thomas Hale article I discussed recently. Since I just addressed the topic, I will keep my comments here as short as possible. (I am responding to the article since it is likely that I will do a book on fractional reserve banking, which will be an overview of incorrect theories that keep popping up. Very similar in style to Abolish Money (From Economics)!)
Since this is a key point in understanding Institutionalist/Post Keynesian/MMT view of endogenous money, I am going to elaborate a bit on it.

While the statement that banks create money out of thin air simply means that issuing a credit to a depositor's account is balanced on the bank's books by debiting a loan account. The former is a bank liability and the latter a bank asset. Thus, the process is self-funding. No priors are involved operationally. When a loan is approved and signed, a bank asset is created and a customer's deposit account is credited with a bank liability. The bank agrees to provide the funds on demand and the borrower promises to service the loan on time. The M1 money supply increases in the amount of the deposit created by the loan. The new "money" is a bank credit entered on the bank's spreadsheet by keystrokes. That's it!

The criticism is that this is just the calling attention to an accounting identity that is an artifact of double-entry, and nothing much follows from it. Banks are still constrained by bank regulation such as liquidity requirements, and credit extension is constrained by credit standards.  So the objection is that "banks create money out of thin air" is rather empty with respect to the reality of banking although it may be formally true in an accounting sense.

This objection misses what the debate has been about. The claim based on false assumptions is that banks loan out either bank reserves (liabilities of the central bank) or depositor savings (liabilities of the the bank to customers). In addition, there is also the false assumption there is a fixed amount of "loanable funds" based on the amount of savings available to loaned out. These false beliefs are still commonly held not only by the public but also by many "experts." So it is necessary to challenge them to establish the truth about how money & banking actually works

The assertion that banks generate "money" by crediting deposit accounts (M1) in exchange for a term debt obligation (loan) at interest as a bank asset and revenue generator is correct. (Loan repayment reduces M1 in aggregate correspondingly as the loans on the issuing banks' books are reduced.)

The assertion that banks "create money out of thin air" does not imply that the constraints of banking practice don't apply, not does it overlook them. It is simply concerned with how the money supply is affected by bank operations in extending credit. No prior requirements are in place, like the need to have bank reserves or customer deposits beforehand.

It is also true that the banks have to meet certain requirements. No one is claiming that just because loans create deposits, the banks can loan without limit. First, prudent banking requires adhering to credit standards so banks are constrained by creditworthy loan applicants, and secondly, banks have to meet requirements imposed on the banking system by regulatory bodies that require asset-liability management. Banks have ALM departments that do this based on loan approval, to which they are alerted by loan officers.

This only scratches the surface of banking. To understand it it more depth, consult Eric Tymoigne's The Financial System and the Economy — The Principles of Money & Banking.

The point is that the assertion, "Banks create money out of thin air," is true, even if it is stated simplistically. It is aimed specifically at commonly held misunderstandings involving accounting, bank operations, and banking practice, such as banks needing bank reserves prior to lending, hence being constrained by a money multiplier, which is still taught in many textbooks. Or that banks lend out customer funds, which is a common belief among the public.

This also related to inflation. The commonly held assumptions imply that money creation by banks is not inflationary, owing to either the money multiplier or loanable funds, whereas the revelations of MMT about the money creation by government, which also creates money by keystokes, is potentially catastrophically inflationary unless bridled by imposing disciplines. Actually, the ability of banks to create loans "from thin air" is the more concerning matter. In addition, public debt issued by currency sovereigns is default risk free operationally. Private credit is not.

Bond Economics 
Yes, Banks Create Money Out Of Thin Air
Brian Romanchuk


Matt Franko said...

"Banks do not create money out of thin air" = Reification error...

You cant correct this cognitive error by employing even more figurative language.... ie "yes they DO create money out of thin air".... ie NOT.... HELPING...

No training I ever received in Finance and Accounting Science ever told us that accounting entries "come from thin air!" like this in figurative language...

Stick to the Science and you won't have to deal with these reification errors in the first place...

Peter Pan said...

Banks can create profit out of thin air. Why they loan out those profits is a mystery.

S400 said...

There is no training in Finance and Accounting Science that says banks profits can create profits out of thin air there for it doesn’t exist.

Adam1 said...

Any economist who thinks the banking system doesn't create money out of thin air should be forced to answer why a profit maximizing entity would offer any lines of credit? Do they really think a profit maximizing bank is sitting on deposits paying depositors interest waiting for someone to use a line of credit they have at some point?!?!? There are billions of dollars in home equity lines of credit and the industry standard is only about 50% utilization. So banks are sitting on billions in unused/lent deposits? You wont find that true on their balance sheets. The fact is that as those lines are used they will find the liquidity to fund those payments... the system automatically generates the liquidity as needed (absent a crisis and a central bank asleep at the switch). The money supply is elastic.

Peter Pan said...

Banks who could actually create money out of thin air, would keep the money for themselves. They sure as hell wouldn't loan it out to anyone. What would be the point?

So we tell a less exaggerated story. We say that banks create loans and lines of credit, which have the effect of temporarily increasing the money supply. As the loan is paid of, this decreases the money supply. If the loan is written off, the loss also decreases the money supply.

We tell the other side of the story; about debtors who have the power to reduce the money supply, simply by paying the principle owed on their loans.

André said...

"'Banks do not create money out of thin air' = Reification error..."

No reification error at all.

In the context that was given, 'Banks create money out of thin air' clearly means 'Banks have the capacity of issuing deposit liabilities at will', which is a fact, not a reification error.

Yes, economists do like to use figurative language, and yes, I do think this detrimental good science and meaningful debates. It just confuses people and creates ambiguity. This seems to be a good criticism, at least for me. But 'reification error' is another story.

Another valid criticism is that the word "money" in economics is heavily ambiguous, so I have the opinion that it should be eliminated. Instead, people should be more precise, replacing "money" for the correct term they want to communicate, be it "bank reserves", "demand deposits", "liquid assets", "wealth" or whatever. But, in this specific piece of text, the authors clearly are using "money" to express "bank deposits".

S400 said...

Can we create thin air out of banks? That’s the question still waiting to be answered.

Peter Pan said...

Air is pretty thin at the Bank of Bolivia HQ.

Alphonse said...

We’re you taught “loanable funds” or “fractional reserve” or does your complaint go deeper (or shallower)?

Genuine questions because I am not understanding what you’re getting at.

Bob Roddis said...

The entire system is illegal, unconstitutional and the cause of the boom/bust cycle. It was concocted to slowly transfer wealth from the masses to the elite while being too boring and incomprehensible for the masses to grasp. The problems it claims to solve do not exist but instead are caused by the system itself.

The entire system is a monstrous criminal fraud.