by From John Balder and the current issue of the RWER To explore the origins of the global financial crisis, the first step is to specify the relationship between banking, money and credit. According to the mainstream view, a bank serves as an intermediary between a borrower and a lender. As a pure intermediary, a bank has no impact on real economic activity. This view – taught in most Economics 101 textbooks – implicitly assumes that money is available in finite quantities that are regulated by the central bank. Several years ago, Paul Krugman and Steve Keen engaged in an enlightening back-and-forth about banking, money and credit. The discussion examined whether banks lend existing money (implying money is neutral) or newly create the money they lend (money is not neutral). Economist
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from John Balder and the current issue of the RWER
To explore the origins of the global financial crisis, the first step is to specify the relationship between banking, money and credit. According to the mainstream view, a bank serves as an intermediary between a borrower and a lender. As a pure intermediary, a bank has no impact on real economic activity. This view – taught in most Economics 101 textbooks – implicitly assumes that money is available in finite quantities that are regulated by the central bank.
Several years ago, Paul Krugman and Steve Keen engaged in an enlightening back-and-forth about banking, money and credit. The discussion examined whether banks lend existing money (implying money is neutral) or newly create the money they lend (money is not neutral).
Economist Category Result Krugman (2012) Money is neutral Banks lend already existing money Keen (2011, 2017) Money is not neutral Banks newly create the money they lend In support of neutral money (mainstream view), Krugman (2012) casually asserts:
“Think of it this way: when debt is rising, it’s not the economy, as a whole borrowing more money. It is rather, a case of less patient people – people who, for whatever reason want to spend sooner rather than later – borrowing from more patient people.”
Krugman notes that banks lend existing money as intermediaries between borrowers and savers. In other words, a bank must have $100 in deposits before it can make a loan for $100. Deposits create credit (or a bank liability is needed for a bank to create an asset). This view asserts that money is neutral and can be ignored, as it has no relevance for real economic activity. This view seems to be intuitive, in fact almost obvious; after all, if I do not have $10, I cannot lend it to you.
Conversely, Keen (2011) argued that banks newly create the money they lend. If true, this suggests that money creation impacts real economic activity and is not neutral. But how does a bank “create” money? When a bank makes a loan, it simultaneously creates a deposit (which is money) for the borrower in an identical amount.[1] For example, if I borrow $10,000 from my bank, the bank creates a deposit account in my name with $10,000 in it. In creating credit, a bank necessarily creates a deposit and thus, money. This is how double-entry bookkeeping works. Loans create deposits.
According to Richard Werner (2012), more than 95% of all money created in the US and UK is a direct result of credit creation by banks. When a bank creates credit, it also creates money. Post-Keynesians have been making this argument for more than three decades, though few have listened (e.g., Basil Moore was an early proponent) and this view was recently affirmed by the Bank of England (McLeay 2014a and 2014b): “Whenever a bank makes a loan it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” Yet, despite the factual basis of this claim, it has been ignored by neoclassical economists, given their attachment to equilibrium analysis.
Banks are authorized to create credit, ex nihilo (“out of nothing”) so credit (money) cannot be neutral. In creating credit, a bank creates money that a borrower uses to purchase goods and services that add to aggregate demand and economic growth. Banks are not limited to acting only as intermediaries that move money from savers to borrowers.[2] Importantly, banks also determine how credit and money are allocated. In the real-world, money creation distinguishes banks from other financial intermediaries (e.g., shadow banks) that can extend credit but do not possess the authority to create money. Within the financial sector, only banks are granted this authority. Money is a form of credit, an obligation to pay. In Werner’s (2012) words, “banks are the creators of the money supply” and “this is the missing link that causes credit rationing to have macroeconomic consequences.” In short, finance (banking, money and credit) matter!
[1] Keen (2011 and 2017) and Werner (1995, 1997 and 2012).
[2] Mainstream economics continues to assert that credit and money are neutral and do not impact real economic activity. Neoclassical economists have good reason to be defensive. Given the structure of their models, dropping the neutral money assumption will result in an indeterminate outcome.