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

Lars P. Syll — Schumpeter–an early champion of MMT

Keeper quote from Joseph Schumpeter. He nailed endogenous money as "credit money" and observed correctly how "money" gets created by banks' extending credit — "they create deposits in their act of lending." This effect is now amplified through non-bank and quasi-bank financial institutions.

The contemporary financialized economy runs largely on privately created credit. This has an even greater effect than Schumpeter likely anticipated. Economists' ignoring this unduly limit the scope of their models by failing to include money & banking, and finance. The result is "surprise resulting from exogenous shock." In other words, the conventional economists were looking in the wrong direction owning to oversimplification of their models of an economy. 

To say that this resulted in "great embarrassment of the profession in the fallout from the global financial crisis would be an understatement. But conventional economists still have not dealt with it by including a correct approach to money & banking and finance. Nor have institutional arrangement been changed to prevent a repeat, perhaps on an even grander scale.

Hyman Minsky was a student of Schumpter at Harvard. Minsky drew out some conclusions from Schumpter's view that became the financial instability hypothesis. Randy Wray, MMT economist and perhaps the most published author on theory of money, was a student of Minsky.

Although Schumpeter eschewed being associated with any particular economic school of thought, he is often considered as belonging to the Austrian school of economics and he was an Austrian national. Hyman Minsky also eschewed association with a particular economic school, but he is often characterized as a Post Keynesian.

MMT has roots in many previous economists and economic schools, although it is usually associated with the Post Keynesian. But here is Wray associated with Schumpeter through Minsky. MMT economists also acknowledge their debt to Abba Lerner, a student of Friedrich Hayek who is generally associated with the Austrian school of economics, too.

Incidentally, the chapter in which this quote occurs is worth reading in full. Here is the citation:

Joseph Schumpeter, History of Economic Analysis, Allen & Unwin, 1954, reprinted by Tayor & Francis, 1986, p. 1080
in CHAPTER 8 Money, Credit, and Cycles, 7. BANK CREDIT AND THE ‘CREATION’ OF DEPOSITS, pp. 1076-1083.

Schumpeter doesn't take credit for originality in this, citing Keynes's Theory of Money, for example. He does criticize Keynes for again mudding the waters in the General Theory. See footnote on page 1080.

Lars P. Syll’s Blog
Schumpeter — an early champion of MMT
Lars P. Syll | Professor, Malmo University

Hans Gersbach — Sovereign money: A challenge for science

There has been an intense academic and policy debate on what monetary architecture is the most appropriate recently, but many issues are still unresolved. This column looks at the circumstances under which the current system and the sovereign money system yield the same outcomes, the core arguments in favour of the current system, and what advantages a sovereign money architecture might offer....

Vox.eu
Sovereign money: A challenge for science
Hans Gersbach | Professor at CER-ETH - Center of Economic Research at ETH Zurich and CEPR Research Fellow

Brian Romanchuk — Primer: What Limits Bank Lending?

The unfortunate fact that bank deposits are considered money has one side effect: our mysticism about money extends towards banking. The apparent ability of banks to "create money out of thin air" seems unfair, and this leads to questions about what limits their ability to lend. The answer is a lot simpler than one might suspect. For any other business (with the possible exception of the resource industry), output is largely constrained by their ability to find customers that they can sell their product to. The business of banks is lending. By analogy, the ability to find customers that they can profitably lend to limits their growth....

Bond Economics
Primer: What Limits Bank Lending?
Brian Romanchuk

Lars P. Syll — The origins of MMT

Knut Wicksell on credit money, and J. M. Keynes on state money aka "chartal"money, where "chartal" means a token. States issue tokens that they alone are permitted to issue whose nominal value the state sets in the unit of account it establishes. "Modern" money is both credit and chartal money rather than a commodity used as a numeraire in barter.

Max Weber also discusses this in Economy and Society: An Outline of Interpretive Sociology, p. 76 (available at Archive.org).

"Money" we call a chartal means of payment which is also a means of exchange. An organization will be called a "means of exchange," "means of payment," or "money" group insofar as it effectively imposes within the sphere of authority of its orders the conventional or legal (tormol) validity of a means of exchange, of payment, or money; these will be termed "internal", means of exchange, etc. Means used in transactions with non-members will be called "external" means of exchange.

Means of exchange or of payment which are not chartal are "natural", means. They may be differentiated (a) in technical terms, according to their physical characteristic— they may be ornaments, clothing, useful objects of various sorts — or according to whether their utilization occurs in terms of weight or not. They may also (b) be distinguished economically according to whether they are used primarily as means of exchange or for purposes of social prestige, the prestige of possession. They may also be distinguished according to whether they are used as means of ex- change and payment in internal or in external transactions.

Money, means of exchange or of payment are "tokens" so far as they do not or no longer possess a value independent of their use as means of exchange and of payment. They are, on the other hand, "material" means so far as their value as such is influenced by their possible use for other purposes, or may be so influenced.

This distinguishes money as the nominal unit of account from tokens that represent it. Randy Wray call this money versus the money thing.

Money is a cultural institution. Credit is based on contract, which was first established in custom and later in law. State money is a legal institution established by the state.

These concepts and conventions long predate contemporary analysis in the theory of money, including MMT.

Lars P. Syll’s Blog
The origins of MMT
Lars P. Syll | Professor, Malmo University

Heske van Doornen — The History of Money: Not What You Think

Most of us have an idea of how money came to be. It goes something like this: People wanted to exchange goods for other goods, but it was difficult to coordinate. So they started exchanging goods for money, and money for goods. This tells us that money is a medium of exchange. It’s a nice and simple story. The problem is that it may not be true. We may be understanding money entirely wrong.

The above story assumes that first there was a market, and then people introduced money to make the market work better. But some people find this hard to believe. Those who subscribe to the Chartalist school of thought give a different history. Before money was used in markets, they say, it was used in primitive criminal justice systems. Money started as—and still is—is a record of debt. It is a way to keep track of what one person owes another. There’s anthropological evidence to back up this view. Work by Innes, and Wray suggest that the origins of money are more like this:

The Minskys
The History of Money: Not What You Think

Heske van Doormen, UMKC

Merijn Knibbe — Cecchetti and Kharroubi on the non-neutrality of money

Is money ‘neutral’? Is it just a veil over ‘real’ transactions? Or does it affect the level and composition of ‘real’ expenditure? Stephen Cecchetti and Enisse Kharroubi recently published an article which in a very net way shows that money is non-neutral (as it is closely related to credit). It’s not a veil. It’s part of the essence of our economy. The abstract:….

Real-World Economics Review Blog
Cecchetti and Kharroubi on the non-neutrality of money

Merijn Knibbe

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

Joe Weisenthal — Everybody Should Read This Explanation Of Where Money Really Comes From

Good charts illustrating money creation by banks.

Business Insider
Everybody Should Read This Explanation Of Where Money Really Comes From
Joe Weisenthal

Robert Vienneau — Daniel Defoe On Debt As Money

Bills of exchange.

Thoughts On Economics
Daniel Defoe On Debt As Money
Robert Vienneau

BTW, there is confusion among some that the credit theory of money is incompatible with the chartalist theory, and that Randy Wray has made this mistake. IIRC Perry Mehrling asserted in a review of one of Randy's Understanding Modern Money (1998).

Randy's paper, Money, specifically states that money is debt, that is, a relationship of credit-debt. MMT espouses the credit theory put forward by Innes, in addition to the chartalist theory put forward by Knapp. They are complementary rather than contradictory. Let us see how.

A purely commodity money is denominated in real terms — amounts of wheat, copper, silver, or gold, for example, whose value is the market value in exchange. This amount may be used as a numeraire in exchange, and it also  might be established as the unit of account either by custom and convention, or by law or dictat. The latter is called "fiat," meaning "let it be done," i.e., "make it [such]."

Fiat money strictly speaking is money issued at a nominal value (face value) established by the issuer. The token may be a commodity like silver or gold, but the face value at issuance is usually different from the market value of the commodity used in the token by the amount of minting cost and seigniorage that the issuer adds.

This nominal or face value of a unit becomes the unit of account established by the issuer, regardless of any underlying real worth as a commodity. Thus, a unit of account (nominal value) gets established by law (fiat). This is called chartal by Knapp.

Chartal money is a unit of account (value) that may be represented by various tokens (money things), such as tally sticks, metal coins or paper notes, — or the value may exist simply as accounting entries, e.g., in the records of central banks.

The MMT position is that money as a unit of account has traditionally been state currency whose nominal value as the unit of account in the jurisdiction of the domain in which it is issued is established by the sovereign through law or dictat. Increasingly, the unit of account used in exchange is not represented in the exchange by any money things. It's all done digitally by changing accounting records.

The money issued by the sovereign becomes the "debt" of the sovereign and the "credit" of the users of the currency as the sovereign's debt. The sovereign necessarily accepts its own debt in payment of liabilities to it, and the sovereign may also choose to accept only its own liabilities at its payment offices.

So the credit held by the user functions as a "tax credit." Since those with liabilities to the sovereign must obtain that which is necessary to meet those liabilities, chiefly taxes, there is demand created for the sovereign's tax credits. This demand, created artificially by the power of the sovereign, "drives" the currency.

There is no contradiction in money originating in debt, as Innes explained, and chartal money as described by Knapp. In modern economies, debt is generally denominated in the unit of account of the legal jurisdiction in which it originates, and currencies are freely tradable. So for all practical purposes, economies operate on chartal money that is also credit-debt.

Paul Davidson — Bitcoin and MMT

What is Bitcoin? According to Modern Money Theory, bitcoin can not be money since it is not accepted in payment of taxes by any government — nor is it issued by any government via the governed purchase of goods and/or services from the private sector. So what is bitcoin in terms of MMT?? I do not know what MMT proponents would respond to this query?

Professor Davidson seems to be confused over necessary v. sufficient conditionality wrt state money aka currency (Chartalism), and money as an IOU that is transferrable (Innes, Minsky).

Requirement of state money aka currency is sufficient to create demand for the unit of account that the state issues as the sole provider. In this sense, currency is a tax credit. Other forms of money are not unless the state agrees to accept them at its payment offices. If it doesn't then they must be exchanged for currency for payment of taxes, fees, fines, or other financial obligations to the state required to be settled in the state's unit of account.

Any IOU can serve as "money" as an exchange medium if a counterparty will accept in exchange.

However, the rest of Davidson's post is interesting. Bitcoins are neither issued by any state, nor does any state accept them in payment of taxes as far as I know, and they are not anyone's IOU either, in that they are "mined" digitally as an analogy to precious metals, gold in particular. Is gold bullion money? Some would say yes. Others would say it remains a commodity that can be bartered for other commodities, unless it is minted and issued as a money thing. How does Bitcoin fit into this scheme?

Real-World Economics Review Blog
What is Bitcoin?
Paul Davidson | Holly Professor of Excellence, Emeritus at the University of Tennessee in Knoxville

CDNDC — Assumptions

“I have found out what economics is; it is the science of confusing stocks with flows”— Michael Kalecki, quoted by Joan Robinson in Shedding Darkness

Stock-Flow Consistent Economics — A Post-Keynesian Economic Blog
Assumptions
CDNDC

Simon Wren-Lewis — Money as Credit

Some of this will be familiar, although what was new for me (but perhaps not to followers of Minsky or MMT) - and quite challenging - was the idea that this could all be traced back historically to a misconceived view of money itself. (According to Martin, the 17th century philosopher John Locke has a lot to answer for.) The threads developed from the historical account of the origins of money are numerous. For example money as credit is inevitably social, and so its value is bound to be politically determined. In a financial crisis, when the size of debts begin to encumber the economy, it is therefore quite logical and natural to adjust the value of money to redistribute between creditors and debtors.

mainly macro
Money as Credit
Simon Wren-Lewis | Professor of Economics, Oxford University

This is really quite fascinating. According to his CV, Professor Wren-Lewis "began his career as an economist in H.M.Treasury.... His current research focuses on the analysis of monetary and fiscal policy in small calibrated macromodels, and on equilibrium exchange rates....  In 2002 he wrote one of the background papers for the Treasury's 2003 assessment of its five economic tests for joining EMU. He was also the principal external advisor to the Bank of England on the development of its current and previous core macroeconomic models. A long time advocate of Fiscal Councils, his 2007 proposal was influential in the formation of the UK‘s Office of Budget Responsibility."

And he did not really understand the basics of money and credit? I don't fault him for this. This entire institutional system, from education to government to finance and economics is blindsided.

A crash course in MMT for economists is sorely needed.

Paul Meli — Does Credit Drive the Economy?

Much of the commentary on the economy seems to assume that it is driven by credit. The statement often made in blogs and news articles is that 90% or more of the money in circulation is private debt, the rest coming through net government spending, so clearly credit (debt) must be the main driver of the system. It's obvious. A caveman could see it.

I believe this is a gross mischaracterization of how the system actually functions.

Where do these claims regarding credit domination of the system come from? Is it truth or fiction. From what I had seen it was nothing more than an article of faith, I had never come across any proof or support that this was actually the case.
Based on the claims, the "money supply" people must be alluding to is the supply of dollars in existence within the domestic non-government. This is pretty simple number to figure out…

The View From Mars
Does Credit Drive the Economy?
Paul Meli

Graham Hodgson — Dirk Bezemer about Positive Money

Bezemer opposes, Hodgson responds.

Positive Money
Dirk Bezemer about Positive Money
Graham Hodgson

Lord Keynes — Bitcoin is no Great Mystery

Lord Keynes reflects on Bitcoin.

Social Democracy For The 21St Century

Bitcoin is no Great Mystery

Lord Keynes

Matthew Zeitlin — Sorry, Libertarians, History Shows Bitcoin Isn't the Future

As we consider the digital-currency phenomenon that is Bitcoin, bear in mind that there are, broadly speaking, two accounts of the origin and history of money. One is elegant, intuitive and taught in many introductory economics textbooks. The other is true. 

The financial economist Charles Goodhart, a former member of the Bank of England’s Monetary Policy Committee, laid out the two views in a 1998 paper, “The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas.”

Bloomberg | The Ticker
Sorry, Libertarians, History Shows Bitcoin Isn't the Future
Matthew Zeitlin

Here's a link to Goodhart's paper, The Two Concepts of Money.

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.

Ann Pettifor — The power to create money 'out of thin air'

Happy New Year to all PRIME readers, and welcome to my latest PRIME publication, The power to create money out of thin air. At first sight, this is a long-delayed review of Geoffrey Ingham’s book, Capitalism (Polity Press, first published 2008). However like all the best reviews, it has become a hook on which to hang discussion of the author’s contemporary pet themes. Here, these include primarily, capitalism’s ‘elastic production of money’. However, I also take the opportunity of explaining why misunderstanding about the creation of money out of thin air is so widespread, and why orthodox economists are mainly responsible for the confusion.

Out of this discussion arises a further one about ‘fractional reserve banking’ – currently at the heart of debate surrounding an IMF Working Paper by Kumhof and Benes. Then I take a pop at the theory and policy frameworks that prevent (or claim to prevent) co-ordination between monetary and fiscal authorities.
The review challenges, too, the widespread assumption (long promulgated by the enemies of labour, but also held by others) that wage claims by trade unionists caused, or led to, the inflation of the 1970s.

But Ingham’s book raises important issues which are and will be at the heart of politics and economics in 2013: with a deeper understanding of capitalism’s ability to create ever expanding amounts of credit-money, how does a democratic society once again rein in, regulate and subordinate the private finance sector to the wider public interest? How does society regain control over the public good that is credit and a sound banking system, and use both for financing society’s most important needs – including the need to tackle the threat of climate change?

And finally, how can public goods (including liquidity) avoid being confiscated by the finance economy? And how can they be restored to public accountability?

PRIME — Policy Research in Macroeconomics
The power to create money 'out of thin air'
Ann Pettifor | Director of Policy Research in Macroeconomics (PRIME) and a fellow of the New Economics Foundation, London

Note: Geoffrey Ingham is also the author of The Nature of Money.

From the comments there:

Andi
: So is PRIME advocating MMT?


Ann Pettifor: 
Andi, thanks for your query. First, this analysis is mine, and does not represent the views of all the network of economists linked to PRIME. Indeed we disagree on some points. Second, as a network we have many good friends in the MMT community, have great respect for their work, and many of our approaches are aligned. But cannot say that PRIME as a network of economists is ‘advocating MMT’. But we sure are closer to them than to the orthodox community…


Lord Keynes — My Posts on the Origin of Money

I have assembled a set of two lists of links and a bibliography below, as follows:

(1) my posts on the origin of money and the debate between David Graeber and Robert P. Murphy;

(2) some external links on the debate between David Graeber and Robert P. Murphy, and

(3) a bibliography on the origin of money.

First, however, I will give a quick summary of Graeber’s view on the origin of money in his recent book (Graeber 2011).

Social Democracy for the 21st Century
My Posts on the Origin of Money
Lord Keynes