What the Crypto Community Fails to Understand about Banks and Money Creation
“The study of money, above all other fields … is one in which complexity is used to disguise truth or to evade truth, not to reveal it … The process by which banks create money is so simple that the mind is repelled.”
― John Kenneth Galbraith
(“Money: Whence It Came, Where It Went,” c1975)
A cursory look at the crypto community’s understanding of how money is created by banks reveals an unfortunate yet undifferentiated narrative about the “fractional reserve theory” of money creation, chanted ad nauseam with little to no objection on how empirically flawed this monolithic assertion is. Amidst the cacophony of rival interpretations of economic theory exchanged between extreme Keynesian no-coiners and Libertarian Bitcoin maximalists lies an overlooked, vile, and empirical truth about the way money is created in our society today by individual banks.
Given the Austrian school of economics’ role in forming the foundational economic principles that led to the creation of Bitcoin, the obvious distaste for the Keynesian schools of thought and its accompanying variations (e.g. post-Keynesians, new Keynesians, neo Keynesians, etc.) in the cryptosphere cannot be overstated. It’s however shortsighted of us as a community to ignore various useful empirical insights from those we tend to label “fiat and inflation apologists” provided it helps us in exposing the conceptual flaws on which the fragile edifice of our global financial system is built on. Militant armchair psychology, philosophizing, and highly abstract theorization without empiricism forms the crux of what is mainly wrong with the field of economics today.
The mission the crypto community has embarked on to build a parallel open, secure, decentralized, and permissionless global financial system requires us to fully grasp the legacy system it is trying to replace, and as such, empirical economic realities devoid of frivolous underlying economic assumptions trumps any irrational ideological aversion for other schools of thought, within economics or any other field, and should remain the guiding principle towards deciphering the complex economic realities we live in. Understanding the limitations of the varying schools of thought is the beginning of wisdom for anyone trying to understand economics and even more so, for those trying to build a more efficient financial system in the 21st century.
We proceed.
We shall explore, albeit briefly, the 3 competing banking theories over the last century, along with the implication of the empirical findings for the average citizen looking for the best asset class to store value going forward.
– Financial Intermediation Theory
– Fractional Reserve Theory
– Credit Creation Theory
“The activity of the banks as negotiators of credit is characterised by the lending of other people’s, i.e., of borrowed, money. Banks borrow money in order to lend it; … Banking is negotiation between granters of credit and grantees of credit. Only those who lend the money of others are bankers; those who merely lend their own capital are capitalists, but not bankers”
– Ludwig Von Mises (The Theory of Money and Credit, pg. 262)
The financial intermediation theory is a core tenet of mainstream neoclassical economics and posits that banks are mere financial intermediaries that collect deposits from “patient savers,” where the bank effectively borrows money from these savers at low-interest rates with short maturities. The banks then lend out these deposits to “impatient borrowers” at a higher interest rate with longer maturities. Banks are thus considered identical to other financial intermediaries such as credit unions, building societies, pension and mutual funds, etc. in their operations and are incapable of creating money on their own or collectively as the banking sector. This eventually leads to the erroneous exclusion of banks from neoclassical macroeconomic models, as they are considered to have no effect whatsoever on the wider financial system.
The crypto community is replete with endless narratives of how banks lend out more money than they have in reserves as a result of the crooked history and nature of the banking system which has, over time, managed to perpetuate this fraud with zero accountability (or something to that effect). The name “fractional reserve” is derived from a system where an individual bank gathers customer deposits in cash (gold was used in the past), and then turns around and lends out a portion of the cash it has in customer deposits and keeps a fraction of it left as a reserve.
This theory restates that banks individually act as financial intermediaries (as explained above) but asserts that as a whole, the entire banking system can collectively create money via “multiple deposit expansion” to the maximum reciprocal of the “required-reserve ratio.”
A simple example is as follows: We assume a monetary base of $100,000 in the economy and a 10% required-reserve ratio, which means the banks have to hold reserves equal to 10% of their customer deposits. Reserves are usually in the form of money the bank has in their reserve account with the central bank.
1. Hal deposits $100,000 into Bank A where total bank deposits in the economy now equal $100,000. Given the required-reserve ratio of 10%, Bank A holds $10,000 in reserves (10% of $100,000) and then goes on to loan Nick $90,000.
2. Nick then transacts with Adam who proceeds to deposit the $90,000 into Bank B. Total bank deposits in the economy have now increased to $190,000 from the initial $100,000 Hal deposited into Bank A.
3. Bank B also keeps 10% of the $90,000 Adam deposited as reserves and lends out the remaining $81,000 to Gavin who enters into a transaction with Satoshi.
4. Satoshi then deposits the $81,000 into Bank C and total bank deposits in the economy eventually add up to $271,000.
This money multiplier process continues until we reach the full reciprocal of the reserve ratio of 10% amounting to total commercial deposits of $1,000,000 in the economy from an initial deposit of $100,000.
It is worth noting that as the total deposits grew by $900,000 in the economy, so did the total debt (i.e. outstanding loans). The more debt in the system the bigger the economy and paying off the debt would have the opposite effect.
“Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.“
– Steve Keen (2009)
The credit creation theory of banking however empirically refutes the previously stated theories and argues that whenever a bank extends a new loan — by virtue of its accounting operations — it simultaneously creates a deposit (new money) for the borrower with the same amount.
E.g. If Charlie borrows $1,000 from Bank A, the bank creates a new loan on its books and simultaneously creates a new deposit in Charlie’s name (and credits it with the borrowed amount of $1,000). In the double-entry bookkeeping process of creating credit, the asset side of the balance sheet increases by the loan amount of $1,000 and on the liabilities side of the balance sheet the bank simultaneously creates a matching deposit in Charlie’s name of $1,000 without an equal corresponding reduction in the balance of anyone else’s account in the bank (as would have been the case in the financial intermediation theory). This increases Bank A’s balance sheet whereby new money was created and hence loans create deposits, not vice versa.
It further states that each bank can extend new loans (credit) without the need to accumulate prior deposits, cash, central bank reserves or funds from other banks before it extends a new loan, and issues of capital and reserve requirements are complied with afterwards and don’t necessarily form a precondition for the process of extending a loan. It concludes that loans create deposits where new loans create new money, and as people spend new money into the economy, new demand is also created and without strict regulation of this vast superstructure of credit, the economy usually ends up being wholly dependent on this credit-based demand. Unlike the financial intermediation theory, where the existing stock of money in an economy cannot grow and can only be reallocated, the credit creation theory contends that over time, as the process of bank lending creates new bank loans (credit) and new deposit money on each bank’s balance sheet, the periods of growth in monetary aggregates in the economy usually tends to correlate with outstanding bank loans (credit) in the economy.
The credit creation theory has existed for over a century and was further argued in the 20th century by the likes of Basil Moore in 1979 and fiercely publicized by the likes of Steve Keen in the past few decades.
However, It wasn’t until 2014 that Richard Werner conducted the first empirical test in the history of banking on all 3 theories to ascertain whether, in the loan process, banks merely deducted funds from existing deposits, external sources, or whether these funds were originated from newly created deposits. His study (found here and here) concluded for the first time, empirically, that banks individually (via the process of extending new loans) create new money ex nihilo. Thus the debate regarding money creation in the modern economy and its operational realities have finally been laid to rest and corroborated by the Central Banks themselves:
“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”
“… the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.”
– Bank of England (2014)
Published at Sun, 12 Jan 2020 12:33:51 +0000
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