“Great and mighty things which thou knowest not” [?]

In his recent paper, “A Lost Century in Economics:  Three Theories of banking and the conclusive evidence”, Richard Werner argues that the old “credit creation theory” of money is true (empirically “accurate”), while both the newer “fractional reserve theory” and the presently dominant “debt intermediation theory” are false.  For him, this matters mainly because the false theories are guiding current bank regulation and development policy, leading down a blind alley.

But it matters also simply because we need correct understanding of how the economy actually works, “we” meaning not just economists but also the general public.  “Today, the vast majority of the public is not aware that the money supply is created by banks, that banks do not lend money, and that each bank creates new money.”

Why is the public ignorant of the truth?  Much of Werner’s paper is devoted to an account of how the correct theory was pushed out of the conversation, first in the 1930s by the fractional reserve theory, and then after WWII by the debt intermediation theory.  One culprit was a shift toward deductive and away from inductive methods.  Another culprit, he suggests, was the self-interested “information management” by central banks, i.e. direct suppression of truth in their own publications.  And in this suppression, he further suggests, Keynesian academics were at the very least complicit:  “attempts were made to obfuscate, as if authors were at times wilfully trying to confuse their audience and lead them away from the important insight that each individual bank creates new money when it extends credit.”

In this history, Werner gives special attention to Keynes himself since Keynes seems to have held each of the three theories in succession throughout his life.  Keynes’ own intellectual trajectory thus foreshadows the subsequent evolution of monetary thought, and so probably is partly responsible for leading successive generations astray.   Just so, one apparent legacy of Keynes is that the Bank of England is currently holding all three theories at the same time!  “Since each theory implies very different approaches to banking policy, monetary policy and bank regulation, the Bank of England’s credibility is at stake.”  BoE credibility is thus a third reason that all of this matters.

But is it really true, as Werner claims, that these three theories are “mutually exclusive”?

He is at considerable pains to show that they are mutually exclusive, by using a succession of stylized balance sheet examples.  The credit creation theory says that banks make loans by creating deposits, essentially expanding their balance sheets on both sides by the same amount.  (The borrower of course also expands his own balance sheet, the loan being his liability and the deposits being his asset.  In my own “money view”, I call this a swap of IOUs.)  In this way, money (bank deposits) is created that was not there before.

By contrast, the debt intermediation view says that banks make loans by lending reserves that they are already holding, essentially swapping one asset for another, these reserves having previously been obtained by someone’s deposit.  The balance sheet expands when the deposit is made, not when the loan is made.  Banks merely intermediate between savers and borrowers, and do not create money.

In between these two views, the fractional reserve view says that individual banks make loans by lending reserves, but that the banking system as a whole can and does create money, up to a multiple of reserve holdings.  The banking system does create money, but only after and as a consequence of the central bank increasing reserves–this is the famous “money multiplier”.

So the difference between the theories seems clear, and it also seems like that difference should be testable empirically simply by watching actual bank balance sheets and seeing what happens when a loan is made.  Does the balance sheet expand or does it not?  With the cooperation of an actual bank, Werner books a dummy loan and finds that the balance sheet of the bank does in fact expand.  This he takes to be scientific proof that the credit creation theory is correct and the others are false.

Not so fast.  Let’s look a bit closer.

Let me begin by admitting my sympathy for Werner (as I have already hinted by mentioning my own “money view” as a version of the credit creation view).  In fact, Werner’s heroes–H.D. McLeod and Joseph Schumpeter–are my own heroes as well, and I suspect that graduate school exposure to these authors sent him off on his own intellectual journey just as it did me.  Even more, thirty years after that initial exposure, I find Werner’s (co-authored) money and banking textbook “Where Does Money Come From?” one of the best introductions to the subject.  Last fall I assigned Chapters 2 and 4 in the first two weeks of “Economics of Money and Banking” which I teach at Barnard College, Columbia University.  I’m sympathetic.

But I don’t think these three theories are quite as mutually exclusive as he makes them out to be.

For me, the central analytical issue is the distinction between “payment” and “funding”.

Let us suppose, with Werner, that Citibank makes a mortgage loan to me of $200,000, simply by swapping IOUs.  I then transfer my new asset (the new Citibank deposit) to you, and you transfer your house to me.  As my payment clears, you have a new deposit in your own bank (let’s say Chase, to make it interesting), Citibank has a “due to” at the clearinghouse, and Chase has a “due from”.  Again, to make it interesting, let’s suppose that Citibank has no reserves, so it enters the interbank market to borrow some, from Chase.  At the end of the day, what we see is that the Citibank balance sheet is still expanded, so is Chase’s, and so is mine.  Only your balance sheet stays the same size, since you have swapped one asset (your house) for another (money).  That’s the payments perspective.

What about the funding perspective?  If we follow the balance sheets through, it is clear that your money holding is the ultimate source of funds for my borrowing. (You lend to Chase, which lends to Citi, which lends to me.)  In this sense, we can think of both Chase and Citibank as intermediaries, channeling funds from one place in the economy to another.  But, in this example, there is no saving and there is no investment.  The sale of the house adds nothing to GDP, it is just a transfer of ownership.  The expansion of the banking system has facilitated that transfer of ownership by creating a liability (the deposit) that you apparently prefer to your house, at the same time acquiring an equivalent asset of its own (the loan).  Citibank collects the spread between the mortgage rate and the interbank rate; Chase collects the spread between the interbank rate and the deposit rate.

But all of that is only what happens right at the moment of payment.  What happens afterwards depends on the further adjustment of all of these balance sheets.  One way this could all work out is that Citibank packages my mortgage with others to create a mortgage backed security, and that you spend your Chase deposit to acquire a mortgage backed security (perhaps indirectly through a mutual fund that stands in the middle).  In this scenario, the newly created money is newly destroyed, the balance sheets of both Citi and Chase contract back to their original size, and the end result is that you are funding my loan directly.  But again, no saving and no investment, just a change in your asset allocation, away from money toward fixed income investment.

Obviously this final scenario is a limiting case on one side.  The limiting case on the other side is that you (or whoever you transfer your money to) are willing to hold the newly created money balances as an asset, so you continue to fund my loan indirectly.  Now when Citibank securitizes and sells, it is able to repay its interbank liability to Chase, and for simplicity let’s say that Chase uses that payment to acquire a different money market asset.   One way this could all work out is that a shadow bank–money market funding of capital market lending–acquires the security and uses it as collateral for wholesale money market borrowing from Chase.  Again, no saving and no investment, but the new money stays in circulation and is not destroyed.

These are the limiting cases, and obviously anything in between is also possible, depending on the portfolio decisions of Citibank, Chase, and you.  But in all the cases, the debt intermediation view of banking is perfectly consistent with the credit creation view of banking.  One focuses on the ultimate funding, while the other focuses on the initial payment.

That said, I have to agree with Werner that the credit creation process is all too commonly left out of the story–most modern courses never even mention the payments system–and it is a real (and important) question how this came to be so.  It is a further real (and important) question why the intellectual memory of how the process actually works was left to marginalized sections of academia–Werner mentions specifically the Austrians and post-Keynesians.  I’m not so sure that it was a central bank plot, though I do think that the shift in academic fashion toward studying equilibrium of a system of simultaneous equations played a role in obscuring the kind of dynamic balance sheet interactions that are the essence of the story.

What I would emphasize however is not the negative but the positive.  The fact of the matter is that today the credit creation view is out of the shadows, and no longer the exclusive property of the marginalized.  In evidence of this, I would direct your attention to the two Bank of England papers that Werner himself cites:  here and here.  But I would add to that also the most recent report coming out of the Group of 30 “Fundamentals of Central Banking, Lessons from the Crisis”.  On page 3 you will find the following:

“In a barter economy, there can rarely be investment without prior saving.  However, in a world where a private bank’s liabilities are widely accepted as a medium of exchange, banks can and do create both credit and money.  They do this by making loans, or purchasing some other asset, and simply writing up both sides of their balance sheet.”

That’s the truth that Werner wants central banks to admit, and now it appears that they have admitted it.  The next question is what difference it makes, and that’s a question for next time.  Already it should be clear that progress toward answering that question will require us to be more careful about issues of payment versus funding.

P.S.  BTW, the title of this post is taken from Jeremiah 33:3 which Werner references in a footnote to his title: “should grains of wisdom be found in this article, the author wishes to attribute them to the source of all wisdom.”  Werner is apparently listening to powers higher than just McLeod and Schumpeter!