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

Tim Johnson — A moral case for bank money

Another take on the controversy.

Money, Maths and Magic
A moral case for bank money
Tim Johnson | Lecturer (associate professor) in the Department of Actuarial Mathematics and Statistics, Heriot-Watt University, Edinburgh

Nick Edmonds — Ledger Accounting for the Monetary Circuit

Some of the basics for double-entry book-keeping are as follows:

1. We can generate any number of ledgers for different items or stages in a process. Note that a ledger does not necessarily relate to something that we might think of as a balance sheet item. Purchases and sales have ledgers as well, even though these are purely income items. We may decide to be more or less aggregated with our ledgers, depending on what we want to record. For example, we might have a single purchase ledger or we might have a number for different types of purchase.

2. A debit is any of: an increase in the value of an asset, a decrease in the amount of a liability, or an item of expenditure. A credit is any of: a decrease in the value of an asset, an increase in the amount of a liability, or an item of income.

3. Each time we put a credit in one ledger, we must put an equal debit in another ledger.

Some of these ledgers may look familiar. In particular, the ledger for a deposit account is essentially the same as the depositor's bank statement. The statement dates will not typically coincide with the dates at which the bank is drawing up its own accounts but, apart from that, they record the same entries and balances.

The most interesting thing I think about this exercise is that we are seeing what bank money actually is. In other words, this process is not simply a record of money movements - it is the actual money movements themselves. If the non-bank agents maintain their accounts with the same bank, then nothing else is going on, beyond what we see here. (If they have accounts with different banks, then each bank (and maybe the central bank) will need to make entries and there will also be wire confirmations, but the essence of the money movement is still just the entries in the ledgers.)

Another thing worth noting is that the transactions have a specific date, but no time. Although there is an increasing use of real time gross settlement, it is not an essential feature of the way ledger money works. This means that there is no fact of the matter as to in what order payments occur during the day.

Reflections on Monetary Economics
Ledger Accounting for the Monetary Circuit
Nick Edmonds

When a bank creates a deposit by making a loan it is making a promise to credit other accounts at the depositor's discretion. In this way the depositor's asset is moved to another account, and if the account is in another bank, then the band's deposit liability is transferred to the recipient's bank for crediting to the recipient's account. This involves the original depositor's bank to credit the reserve account of the recipient's bank, thereby drawing down its own reserve account, an asset account. This leaves the loan outstanding as an asset of the original borrower's bank. 

Nothing changed other than ledger entires but money was moved from account to account. Some of that was bank money in deposit accounts and some, in the case of interbank transfer, was government money (reserves) in the payments system. The only physical exchange perhaps involved checks, but increasingly banking is done electronically, all by keystrokes. Unless cash is withdrawn in the process or paper checks exchanged, the procedure is notional rather than actual and notational instead of physical.

Dan Kervick — Do Banks Create Money from Thin Air?

It is sometimes said that commercial banks in our modern monetary system create money “from thin air”.  While there is truth in this metaphorical claim, the metaphor can also be seriously misleading, and leads some to attribute powers to commercial banks that are actually retained by the government alone under our system.  It is worth trying to get clear about all this.

New Economic Perspectives

Do Banks Create Money from Thin Air?

Dan Kervick

JKH — ‘Loans Create Deposits’ – in Context

Introduction
Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Realism
‘Loans Create Deposits’ – in Context
JKH
(h/t Kevin Fathi via email)

Money & banking 101. Very clear step by step exposition of what goes on in contemporary banking wrt to institutional arrangements, how the accounting works, and what the institutional implications are. A chief implication is that bank money involves risk and banking is therefore an exercise in risk management to great degree.

Steve Randy Waldman — What is a bank loan?

When a bank makes a loan, does it create money “from thin air“? Are banks merely intermediaries, where “if people are borrowing, other people must be lending“? I consider these sorts of questions less and less helpful. Let’s just understand what a bank loan is, in terms of real resources and risk.

Read it at Interfluidity
What is a bank loan?
by Steve Randy Waldman