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

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Mike Norman
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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)!)

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.